Supreme Court

Legislative Intent or Error: Puzzle of Indian Tax Policy

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Introductory Questions 

Let me start with a question: how does one discover legislative intent in a provision of tax statute? Through a plain reading of the provision or through a subsequent statement by the State’s legal counsel stating its intent? Positivist thinking would point us to the former, and rightly so. A statement, even a sworn statement in a court shouldn’t override what is contained in the statute. Deference to the legislature cannot extend to a point where despite what the statute contains, court interprets the provision based on legislature’s statement explaining its intent. 

The question in your mind may be: why am I asking this question? Well, for those who follow tax developments, you may already know. For others, I’m asking the question in the context of Safari Retreats case and the latest amendment to CGST Act, 2017 via the Finance Act, 2025. 

One key question that the Supreme Court had to answer in Safari Retreats case was: Did the legislature intentionally use the conjunction ‘or’ instead of ‘and’? Or did the legislature commit a mistake? A simple question that acquires tremendous urgency if a taxpayer needs the answer to assess its tax liability which in this was a few crores. 

During the hearing, the State’s counsel argued that use of the conjunction ‘or’ was a legislative error and further pressed that ‘or’ should be read as ‘and’. What should have been the ideal response of the Supreme Court? One view – subscribed by the State – is that Supreme Court should have declared ‘or’ means ‘and’ and interpreted the provision accordingly even if it meant throwing all grammar and interpretive rules out of the court complex. Or was there more justification in the Supreme Court responding the way it did: legislative intent can only be revealed by the legislative text and not by the State counsel’s statement about the text. And in doing so, restrict the amount of deference that courts accord to the legislature in tax laws.   

And equally importantly, how should we respond? Resign to yet another retrospective amendment to a tax statute and raise our hands in exasperation while letting out a huge sigh. Or do we try to understand this entire episode like a puzzle and use it as an example of how Indian State approaches tax policy. I prefer to do the latter, and hence this article.  

‘Or’ Means ‘And’

I’ve commented on the case in detail here and here. In this article, I intend to provide a limited overview of the controversy with an aim to highlight Indian State’s tax policy choices. 

In 2019, the Orissa High Court allowed taxpayer to claim Input Tax Credit (‘ITC’) on construction of a shopping mall. In 2024-25, one of State’s arguments before the Supreme Court was that use of ‘or’ instead of ‘and’ was a legislative error. The reason for the argument, from a revenue perspective, was straightforward: it would ostensibly allow the State to block the taxpayer’s ITC claim. But the State was aware of the ‘legislative error’ since 2019, why not correct the error via a legislative amendment and bury the issue instead of making elaborate arguments before the Supreme Court? Commenting on the same the Supreme Court in its judgment observed the following: 

The writ petition in which the impugned decision was rendered is a six-year-old writ petition. If it was a drafting mistake, as suggested by learned ASG, the legislature could have stepped in to correct it. However, that was not done. In such circumstances, it must be inferred that the legislature has intentionally used the expression “plant or machinery” in clause (d) as distinguished from the expression “plant and machinery”, which has been used in several places. (emphasis added) (para 43)

As is evident, the Supreme Court rejected the State’s claim of an error. If use of ‘or’ was indeed an error, there was ample time for the State to step in and rectify it. And its failure to do so, in my books, counts as lack of bona fide. For the Supreme Court it was sufficient to dismiss the entire argument and proceed solely on the basis of what was written in the statute.  

What did the State achieve by not amending the law and correcting what it claimed was a ‘legislative error’? For one, if the Supreme Court had actually ruled that ‘or’ should be read as ‘and’, it would have armed the State with a decision that could have been conveniently used by it to block ITC in the future as well. 

Second, if the Supreme Court refused to interpret ‘or’ to mean ‘and’, the State could have claimed that the decision did not reflect ‘legislative intent’. Both things did happen. The latter is no longer a surprise. Each time the State loses a major tax case, its response is that the judicial decision does not reflect legislative intent. And subsequently, it leads to an amendment of the provision in question. And even more often, the amendment is given retrospective effect.   

Legislative Intent – Legislative Error 

The Supreme Court in its above cited paragraph makes it sufficiently apparent that legislative intent must be reflected through the statute itself. If the State claims that a legislative error crept into the statute, it should have rectified it in the intervening 6 years it had to act on it. 

Legislative intent thus cannot be superimposed on a statute by the State on discovering its error or mistake. That would upset the balance of power in State’s favor and would violate a cardinal rule of tax law interpretation, i.e., strict interpretation of tax statutes is necessary to determine the taxpayer’s liability. 

But does that mean that legislative error can never be acknowledged by courts? Apparently so.

One, there is no telling if an error is truly an error. In Safari Retreats case, the petitioners pointed out that:

In the model GST law, which the GST Council Secretariat circulated in November 2016 for inviting suggestions and comments, the expression “plant and machinery” was used both in clauses (c) and (d) of Section 17(5). However, while enacting the law, the legislature has advisedly used the expression “plant and machinery” in clause (c) and “plant or machinery” in clause (d) of Section 17(5). Therefore, the intention of the legislature cannot be brushed aside by contending that the use of the word “or” in Section 17(5)(d) is a mistake of the legislature. (para 9)

In such circumstances, who is to know if the legislature intentionally replaced ‘and’ with ‘or’ when finalising the text of the bill or an error crept in while editing the Model law. Presumably only the State can reveal the mystery through detailed document history and accompanying notes on the provisions. But do we want to go down that rabbit hole. Forget us, I doubt the State would like that like that level of transparency in law making. 

Second, it would defeat a core tenet of not just tax law but also law in general. Tax liability is as per the law that exists and not what the law was intended to be. A taxpayer has no way of knowing what the legislature ‘intended’ to enact except by interpreting the provisions as they exist. And if one argues that the legislative debates, and other pre-legislative reports would provide a clue, it is a heavy burden to impose on the taxpayer. Then not only must the taxpayer know the law but also whether the law contains an error or not. Hardly just or fair. And one would argue such a stance is also devoid of common sense.

Puzzle of Indian Tax Policy

Hidden in the steps of Safari Retreats case and its aftermath is the puzzle of Indian tax policy decisions. 

One, why wait for the Supreme Court’s decision and then amend the provision retrospectively? Because beyond the immediate urgency of losing or wining a case, was a question of policy. Do we allow taxpayers to claim ITC on construction of shopping malls when they further rent it for business? While a timely amendment of ‘or’ to ‘and’ may not have answered the question with certainty, it would have provided a clear signal of proactive policy making including correcting errors. Instead, the post-decision amendment reveals a policy of amending laws as per convenience.   

Two, where were the States? Since the entire dispute centred around CGST Act, 2017 we expect response from the Union, but GST is a federal levy. Why didn’t any State openly and persuasively argue for an amendment and perhaps end a long winding litigation? It was only after the Supreme Court’s judgment, that States were visible. But just about. States were on board for the GST Council’s recommendation for amendment. Or at least no State objected to the amendment. So, my impression is that either ALL States were either clueless about the litigation or all of them unanimously approve retrospective amendments to GST laws instead of proactive amendments to thwart resource consuming litigation. Maybe, this is the kind of uniformity that was aimed through GST. 

Third, why file a review after deciding to introduce the amendment? Again, it seems the Court’s stamp of approval or its views on the amendment will prevent sprouting of similar issues from the provision. In this case, though the litigation may not end because even the amendment may not prove enough as courts will still need to interpret the phrase ‘plant and machinery’. But a review seems like a circuitous way of making tax policy when there can be direct and straightforward ways. Only we prefer to be clever by half and like to prevent transparency on fundamental tax policy issues. Else, the State may be held to its word and that is not something it will enjoy. 

Way Forward 

The promise of no retrospective amendments to GST laws was buried long ago. And now it is dead. We can only hope for a more sane approach to tax disputes and a saner reaction to court decisions that are not in the State’s favor. Else, the familiar cycle of dispute, decision, amendment will continue till perpetuity until one fine day we feel the need to ‘simplify’ GST by removing all the Provisos and Explanations which were added via numerous reactive amendments.    

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

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

Part I: Om Prakash Judgment and Customs Act, 1962 

Om Prakash Judgment 

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

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

Amendments to Customs Act, 1962 

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

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

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

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

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

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

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

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

Article 246A Has a Broad Scope 

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

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

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

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

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

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

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

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

Reason to Believe and Judicial Review  

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

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

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

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

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

Justice Bela M. Trivedi’s Concurring Opinion  

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

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

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

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

Conclusion 

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

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

            

Safari Retreats: Supreme Court Adopts a ‘Strict’ Stance

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

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

Introduction 

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

17. Apportionment of credit and blocked credits.— 

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

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

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

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

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

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

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

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

Arguments 

Petitioners 

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

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

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

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

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

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

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

The State

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

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

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

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

First Pillar of the Judgment: Strict Interpretation of Tax Statutes  

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

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

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

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

Second Pillar of the Judgment: Functionality Test 

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

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

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

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

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

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

Meaning of ‘On Own Account’ Lacks Proper Reasoning 

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

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

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

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

Implications and Way Forward 

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

Fee for Technical Services: Future Demands Answers

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Introduction 

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

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

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

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

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

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

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

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

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

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

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

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

Interpretation of IT Act, 1961 Needs to be Dynamic 

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

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

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

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

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

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

Facts 

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

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

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

 Ratio 

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

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

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

The Supreme Court made three observations to support its conclusion: 

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

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

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

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

Enduring Relevance 

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

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

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

   

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

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

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

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

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

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

Pre-GST Interpretation 

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

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

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

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

Rapidly Swinging Pendulum under GST

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

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

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

Way Forward 

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

Taxation of Perquisites: SC Rules on Constitutionality

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Challenge 

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

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

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

SC Decides: Not Unconstitutional

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

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

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

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

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

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

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

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

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

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

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

Tax Exemption to be Interpreted Strictly: Dilip Kumar Case 

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

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

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

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

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

Interpretation of Tax Exemption for Beneficial Purpose: Mother Superior Case 

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

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

Conclusion 

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

Rainbow Papers Case and the Art of Misinterpretation

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

Interpretive Question 

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

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

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

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

Section 30(2), IBC

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

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

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

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

State as a Secured Creditor 

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

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

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

Review of Rainbow Case 

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

Conclusion 

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

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

Kerala versus Union: Dispute Lingers 

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

Summary of Arguments 

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

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

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

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

Littany of Issues 

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

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

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

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

Injunction is Ousted 

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

Conclusion 

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

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