IT Act 1961

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

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

Facts 

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

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

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

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

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

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

Section 43-B, IT Act, 1961 

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

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

Shimla HC Answers Two Questions 

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

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

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

Conclusion 

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

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

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

Facts 

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

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

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

Revenue’s Stand 

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

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

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

Decision 

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

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

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

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

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

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

Fee for Technical Services: Future Demands Answers

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Introduction 

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

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

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

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

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

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

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

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

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

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

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

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

Interpretation of IT Act, 1961 Needs to be Dynamic 

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

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

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

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

ESOPs-Related Compensation Present an Interesting Dilemma

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Introduction 

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

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

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

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

Facts 

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

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

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

Characterizing the Compensation – Summary of Arguments  

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

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

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

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

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

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

ESOPs are not a Capital Asset – Madras High Court

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

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

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

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

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

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

ESOPs are not Perquisites – Delhi High Court 

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

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

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

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

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

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

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

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

ESOPs are Perquisites – Madras High Court 

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

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

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

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

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

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

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

Conclusion 

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

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

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

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

Facts 

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

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

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

 Ratio 

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

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

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

The Supreme Court made three observations to support its conclusion: 

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

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

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

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

Enduring Relevance 

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

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

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

   

SAAR v/s GAAR: Inauguration of an Interpretive Dilemma 

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

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

Petitioner’s Arguments 

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

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

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

Where – 

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

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

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

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

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

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

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

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

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

Revenue’s Arguments 

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

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

High Court’s Observations 

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

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

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

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

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

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

Conclusion

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

Section 71(3A), IT Act, 1961 is Constitutional: Delhi HC

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In a recent judgment, the Delhi High Court held that Section 71(3A), IT Act, 1961 was constitutional and did not violate Art 14 and/or Art 19(1)(g) of the Constitution. The High Court’s primary reasoning was that the introduction of sub-section (3A) to Section 71 did not take away a vested right of the assessee but only introduced a new condition for an assessee to set off the loss. 

Section 71, IT Act, 1961

Section 71(1), IT Act, 1961 allows an assessee to set off loss under one head of income against income under another head of income, subject to certain conditions. To the said conditions, Finance Act, 2017 added another condition by introducing a new sub-section (3A) which states that: 

Notwithstanding anything contained in sub-section (1) or sub-section (2), where in respect of any assessment year, the net result of the computation under the head “Income from house property” is a loss and the assessee has income assessable under any other head of income, the assessee shall not be entitled set off such loss, to the extent the amount of the loss exceeds two lakh rupees, against income under the other head. (emphasis added)

The condition of claiming a set off of loss, not beyond two lakh rupees was challenged by the assessee before the Delhi High Court. 

Assessee’s Challenge 

The asssesee made the following main arguments in its attempt to assail the constitutional validity of Section 71(3A), IT Act, 1961: first, that that prior to the amendment assessee had an unhindered right to claim set of loss and promissory estoppel should be applied against the State since introduction of Section 71(3A) amounted to breach of a promise; second, the assessee claimed that the impugned sub-section created unreasonable restrictions on taxpayer rights and was violative of Art 14 and Art 19(1)(g) of the Constitution. 

The State’s arguments, in short, were that the Section 71(3A) was not a revenue harvesting measure but an anti-abuse provision. In the absence of an upper limit, high income taxpayers were paying huge amount as interest payments and setting off the same against incomes from other heads. 

High Court’s Analysis 

The Delhi High Court noted that as per the facts: when the assessee constructed his house in 2014, he was entitled to claim deductions – without an upper limit – on interest payments made for housing loan; but, from Assessment Year 2018-19, the deductions were limited to a maximum of Rs 2 lakhs. The introduction of the upper limit was challenged by the assessee as an unreasonable restriction on taxpayer rights. 

The Delhi High Court noted that assessee’s challenge to Section 71(3A) was founded on the impugned sub-section having a retroactive effect, i.e., applicability of a law/provision to a fact situation where assessee has vested rights. And a successful challenge to retrospectivity was only possible if a vested right of the assessee was disturbed by introduction of the impugned sub-section. The High Court noted that neither the previous nor the amended provision created an indefeasible right in the petitioner’s favor to set off the losses. (para 24) 

In the absence of a crystallised right, the Delhi High Court added, the assessee’s argument that impugned sub-section violates Article 14 does not hold water. The High Court’s reasoning was that the impugned sub-section does not take away the right of assessee to set off losses in toto, but only circumscribes it and imposes conditions. And further, a new class of taxpayers has not been created by the impugned provisions but only new conditions have been imposed on an existing class of taxpayers. Further, the State has provided a clear rationale for imposing the conditions, i.e., to prevent misuse of the provision by high-income taxpayers. Thus, the High Court concluded that the criteria of reasonable classification and intelligible differentia were met by the impugned sub-section and it was not violative of Article 14. The High Court added that the provision was not manifestly arbitrary either. Finally, the High Court also rejected the assessee’s challenge vis-à-vis Article 19(1)(g) and noted that the restriction was proportional and reasonable and not in violation of the assessee’s right to do business. 

Conclusion 

The assessee’s case that a vested right has been taken away by a retroactive amendment to Section 71 did not have much traction to begin with. The legislature has the discretion to limit the tax benefits, in this case, the deductions were restricted to a certain amount to prevent certain high-income taxpayers from misusing the provision. While the introduction of said limit also affected taxpayers such as the assessee in this case, it was still not a right of the assessee to claim such a deduction. The mere fact that the assessee could claim the deduction without any limit from 2014 until 2018, was not enough for it to claim a vested right for such deductions. And the Delhi High Court correctly dismissed the claim of violation of Article 14 and Art 19(1)(g) of the Constitution.     

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

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

A Residential House -> One Residential House in India 

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

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

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

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

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

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

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

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

Purchase of Two Houses 

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

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

Cap of Ten Crores 

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

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

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

Conclusion 

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

Tax Treatment of Mandatory CSR: Alignment of CGST Act, 2017 and IT Act, 1961

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In this article, I elaborate on one of the several changes introduced by Finance Act, 2023 to CGST Act, 2017. Section 17, CGST Act, 2017 was amended via Finance Act, 2023 to clarify that the goods or services or both used to comply with mandatory CSR obligations, i.e., CSR obligations under Section 135, Companies Act, 2013, would not be eligible for Input Tax Credit (‘ITC’). The amendment sought to achieve two objectives: first, it clarified law on a point which attracted contradictory opinions by authorities for advance rulings (‘AARs’); second, it tried to ensure that the tax treatment of mandatory CSR activities under CGST Act, 2017 aligns with that of IT Act, 1961. I suggest that while the former objective may have been fulfilled, the latter remains questionable since the tax policy vis-à-vis mandatory CSR is itself confusing under IT Act, 1961.  

Confusion to Clarity: ITC on Mandatory CSR Activities

Section 16, CGST Act, 2017 states that a registered person shall be entitled to ITC charged on any supply of goods or services or both ‘which are used or intended to be used in the course or furtherance of his business’ and the said amount shall be credited to the electronic ledger of the person. As regards CSR, AARs were confronted with the question if CSR activities undertaken by a registered person should be understood ‘in the course of business’.   

In Re: M/s Dwarikesh Sugar Industries Limited the applicant wished to know if it can claim ITC on expenses incurred to fulfil its mandatory CSR obligations. AAR endorsed the interpretation adopted in a pre-GST case, i.e., Essel Propack case and noted that since the applicant was ‘compulsorily required to undertake CSR activities in order to run its business’, CSR activities should be treated as incurred ‘in the course of business.’ (para 12) AAR emphasised the compulsory nature of CSR and reasoned that it should not be equated with gift, since the latter had a voluntary element.

In Re: M/s Adama India Pvt Limited the applicant relied on Re: M/s Dwarikesh Sugar Industries Limited and Essel Propack case to support the contention that ITC on its mandatory CSR activities should not be blocked. Curiously, AAR did not examine scope of the term ‘business’ or ‘in the course of business’ used in CGST Act, 2017, but instead relied on the Companies (CSR Policy) Rules, 2014 which defined CSR activities undertaken by a company to not include activities undertaken in pursuance of the normal course of business. But the definition of CSR under these Rules has a different purpose and context. And reliance on Companies (CSR Policy) Rules, 2014 would be understandable if the term ‘business’ was not defined or was unclear under CGST Act, 2017. Section 2(17), CGST Act, 2017 contains an elaborate definition of business to which AAR paid no attention.  

In Re: M/s Adama India Pvt Limited, AAR also refused to refer to Essel Propack case reasoning that it was decided under pre-GST laws, but strangely it considered Companies (CSR Policy) Rules, 2014 as relevant to GST. While it may be reasonable to suggest that cases decided under pre-GST regime (in this case excise law regime) need not always be applicable in the GST regime; but, such a line of argument would only be persuasive if there was a marked difference in the applicable provisions in pre-GST and GST laws, which wasn’t the case as far the impugned issue was concerned. Even so, AAR should have examined the scope of ‘business’ under CGST Act, 2017 and the nature of mandatory CSR activities instead of referring to other legislative sources.   

In Re: M/s Polycab Wires Private Limited, Kerala AAR held that goods distributed by the applicant for free – and shown as CSR expenses – were not eligible for ITC under Section 17(5)(h), CGST Act, 2017. While AAR did not state it expressly, it seemed to equate the applicant’s free distribution of goods – as part of its CSR Activities – to gift or free samples. While for the latter, ITC is expressly blocked under Section 17(5)(h), CGST Act, 2017, it was an error to equate gifts and free samples with goods distributed under the CSR initiative. The applicant distributed goods at the request of Kerala State Electricity Board and thus, it was not entirely out of the applicant’s volition nor was it a compulsory CSR activity under Companies Act, 2013. AAR avoided the tough question on how to best classify the impugned CSR activity.

Thus, as is evident, AARs were struggling to adopt convincing reasoning and were arriving at different conclusions regarding eligibility of taxable persons to claim ITC on their CSR activities. Nor were they meaningfully distinguishing between mandatory and voluntary CSR activities.  

Ostensibly, to clear the confusion caused by contradictory advance rulings, Section 139, Finance Act, 2023 introduced the following clause to Section 17(5), CGST Act, 2017:

(fa) goods or services or both received by a taxable person, which are used or intended to be used for activities relating to his obligations under corporate social responsibility referred to in section 135 of the Companies Act,2013; 

Section 17(5), CGST Act, 2017 enumerates the situations in which ITC is blocked, and the insertion of above clause in Section 17(5), CGST Act, 2017 means that goods or services or both used to fulfil mandatory CSR obligations will not be eligible for ITC.. And to this extent, the law on ITC vis-à-vis mandatory CSR activities is sufficiently clear post the enactment of Finance Act, 2023. 

Clarity to Confusion: Mandatory CSR under IT Act, 1961

Blocking ITC for mandatory CSR via Section 17(5)(fa), CGST Act, 2017 superficially aligns with the tax treatment of mandatory CSR under IT Act, 1961. Section 37, IT Act, 1961 states that any expenditure – not being an expenditure of the nature described in Sections 30 to 36 – laid out or expended wholly and exclusively for the purpose of business or professions shall be allowed in computing the income chargeable under the head ‘Profits and gains of business or profession’. Section 37, IT Act, 1961 is a residual provision and allows an assessee to claim expenditure if some of the expenditure does not meet the requirements under specific heads, from Sections 30 to 36 of IT Act, 1961. The primary requirement under Section 37, IT Act, 1961 being that the expenditure should be for the purpose of business or profession. However, Explanation 2 to Section 37 clarifies that:

For the removal of doubts, it is hereby declared that for the purposes of sub-section (1), any expenditure incurred by an assessee on the activities relating to corporate social responsibility referred to in section 135 of the Companies Act, 2013 (18 of 2013) shall not be deemed to be an expenditure incurred by the assessee for the purposes of the business or profession. 

The above Explanation to Section 37 expressly disallows an assessee from claiming deductions on expenses incurred in fulfiling mandatory CSR obligations. 

However, the confusion on mandatory CSR expenses and IT Act, 1961 is two-fold: first, if mandatory CSR expenses satisfy the requirements of Sections 30 to 36, an assessee can claim deductions. This implies that there is no across the board bar on claiming mandatory CSR expenses under the IT Act, 1961 but the prohibition is only under Section 37 resulting in an uneven tax treatment of mandatory CSR IT Act, 1961; second, Section 80G states that an assessee cannot claim deductions if the mandatory CSR money is contributed to the Clean Ganga Fund or the Swach Bharat Kosh Fund. There is no express prohibition against mandatory CSR money contributions to any other fund listed under Section 80G creating a confusion about the objective of partial disallowance for only two funds.   

Conclusion

It is evident that the State does not view mandatory CSR activities as integral to or in the course or furtherance of business for tax purposes. The introduction of Section 17(5)(fa), CGST Act, 2017 reinforces the deeming fiction previously incorporated under Explanation 2, Section 37, IT Act, 1961. As far as these two provisions are concerned, mandatory CSR is not treated as an activity in the course or furtherance of business. The issue is partial bar against mandatory CSR expenses under IT Act, 1961. The limited scope of bar under both provisions – Section 80G and Section 37 only – raises the question as to why mandatory CSR is treated as business expense under other provisions. Reflection of a confused tax policy as far as IT Act, 1961 is concerned. 

Finally, the reasons for denying tax benefits for mandatory CSR activities seem to be rooted in the State’s conception of CSR activities as a backstop to its own welfare measures. And since the denial of tax benefits is limited only to mandatory CSR activities, there is room to suggest that the State does not wish to ‘subsidise’ only some CSR activities, as tax benefits are not denied to voluntary CSR activities. ITC is not blocked for voluntary CSR activity neither is deduction of expenses barred – even partially – for voluntary CSR. Creating a ‘two-track’ tax policy vis-à-vis CSR expenses.      

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. 

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