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.    

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.      

Dividend Distribution or Reduction of Share Capital: DDT’s Long Shadow on Cognizant

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Dividend Distribution Tax (‘DDT’) – abolished in April 2020 – was one of the most contested taxes in India as it taxed dividends in hands of companies which distributed dividends. Making companies liable to pay dividend tax was opposite to widely followed classical system of dividend taxation wherein dividends are taxed in the hands of shareholders. The various questionable policy reasons for introduction of DDT aside, DDT also created incentives for companies to find innovative ways to put money in the hands of its shareholders without declaring dividends. One such alternative way was buyback of shares. The alternate means of transferring money in hands of shareholders has been questioned in various cases, most recently and prominently in the Cognizant ruling by ITAT Chennai – currently under appeal before the Madras High Court – where Cognizant was held liable to pay DDT of Rs 19,000 crores (appx.). I look at ITAT’s decision and analyze whether ITAT has imposed tax liability on Cognizant based on persuasive reasons or otherwise.  

Scheme of Amalgamation and Tax Payments  

M/s Cognizant Technology Solutions India Pvt Ltd. (‘assessee’) purchased its own shares from non-resident shareholders under a ‘Scheme of Amalgamation & Compromise’ sanctioned by the Madras High Court under sections 391-393 of the Companies Act, 1956. The scheme was sanctioned in April 2016, when DDT was still in force. The result of the scheme and buyback of shares by the assessee was that the shareholding of its Mauritius based shareholders increased while that of the US-based shareholders decreased. Thus, a significant capital base of the assessee moved to Mauritius because of the scheme. Though the assessee maintained that its reasons for restructuring were corporate structure streamlining, improving earnings per share, reduce fluctuations in terms of foreign currency fluctuations, and improving overall capital structure of the company.  

After approval of the scheme, in Financial Year 2016-17, assessee bought back 94,00534 equity shares of face value of Rs 10 each from its shareholders at a price of Rs 20,297/ per share. Assessee deducted TDS before making payments to the US -resident shareholders since their capital gains arose in India but did not withhold tax for its shareholder resident in Mauritius because the transaction was not liable to tax in India as per the India-Mauritius DTAA.

Revenue’s Arguments for Levy of DDT 

The Revenue’s contention was that the consideration paid by assessee to its own non-resident shareholders comes within the ambit of Section 2(22)(a)/2(22)(d) of the IT Act, 1961 and the assessee is liable to pay DDT under Section 115-O of the IT Act, 1961.  

Section 2(22)(a) of the IT Act, 1961 defines dividend to include any distribution by a company to its shareholders to the extent of accumulated profits of the company, whether capitalized or not, whether such distribution entails release by the company all or any part of the assets of a company. Section 2(22)(d) further includes within the definition of dividend any distribution made to the shareholders by a company on reduction of its share capital to the extent company possesses accumulated profits. 

Revenue Department’s argument was that the sum paid by the assessee after approval of its scheme by the High Court was akin to distribution of accumulated profits by a company to its shareholders, whether capitalized or not, and was taxable under Section 2(22(a), IT Act, 1961. Alternatively, the Revenue Department argued that the consideration paid by the assessee on purchase of its own shares was akin to distribution of accumulated profits on reduction of its share capital and was taxable under Section 2(22)(d), IT Act, 1961. Either way, the Revenue Department’s argument was that the consideration paid was on reduction of share capital amounted to dividend as defined under IT Act, 1961 and was thus taxable under Section 115-0 of the IT Act, 1961. 

Assessee Resists Levy of DDT 

One of the assessee’s arguments was that Section 2(22)(a)/2(22)(d) are not attracted in the impugned case since distribution of profits would imply absence of quid pro quo. While in the current case there was an offer by the company and acceptance by the shareholders and therefore there is no ‘distribution’ of profits in the true sense. Further, the provisions require that the reduction of capital should be co-terminus with distribution of profits, while in the impugned case the reduction was a result of scheme approved by the High Court. ITAT rejected both prongs of the argument: first, it noted that distribution does not require quid pro quo or lack thereof, only requirement is that the payment and disbursal of profits should be made to more than one person; second, the ITAT held that the assessee is trying to assign a hyper-technical meaning to ‘reduction of share capital’ and to attract Section 2(22)(a)/2(22)(d), it is immaterial if the reduction is a result of the scheme or otherwise. 

Assessee’s second argument was that once the scheme was approved by the High Court, the approval operated in rem and was binding on the Revenue Department. The scheme could not be re-characterised by the Revenue Department to levy taxes on the assessee. The ITAT clarified that the approval of the scheme is subject to the condition that it does not grant immunity to the assessee from payment of taxes. Also, the High Court in approving the scheme only acts an umpire to note if the conditions prescribed under the statutory provisions have been met. Finally, the ITAT clarified that the Revenue Department is not seeking to recharacterize the scheme but merely analyse its tax implications. And assessee cannot legitimately argue that the scheme once approved by the High Court excludes the applicability of IT Act, 1961.   

Assessee further contended that the reduction of its share capital was sui generis under Sections 391-393 of Companies Act, 1956 and not under Section 77. Thereby, it was taxable only via buyback tax provided under Section 115QA, IT Act, 1961. Section 115QA included only buyback of shares under Section 77A in its scope and included all other forms of buyback in its scope only from 2016 onwards. The assessee’s contention was that its buyback was not under Section 77A but under Sections 391-393 and thus the transaction was not taxable under Section 115QA. ITAT dismissed assessee’s categorization of its transaction and held that no buyback of shares can take place solely under Sections 391-393 and the buyback is necessarily read with section 100-104. Thus, no buyback of shares can take place under Sections 391-393 alone. Finally, ITAT concluded that all forms of buyback – except under Section 77A – are included in the definition of dividend since they entail release of assets of a company. And since assessee’s buyback – by its own admission is not under Section 77A – the distribution of consideration is covered by the definition of dividend.     

Use of ‘Colorable Device’ by Cognizant 

ITAT was clear and unambiguous in its conclusion that the assessee adopted a colorable device to evade taxes. ITAT noted that the ‘real intent’ of the scheme was to artificially shift the capital base of the company to Mauritius. The other reasons cited by the assessee to streamline corporate structure, increase earnings per share were discounted by ITAT. Further, ITAT noted, assessee was wished to evade taxes by resorting to buyback under general provisions instead of specific provisions, since latter would have triggered their liability to tax. Thus, ITAT concluded:

Therefore, from the facts of the present case, it is undoubtedly clear that the scheme as such is only a colourable device intended to evade legitimate tax dues. Such colourable devices which do not have any commercial purpose can be excluded for physical nullity and the AO empowered to ‘look through’ rather ‘look at’ the transactions. This is further established by the fact that there is no commercial nexus between the company activities and Mauritius and this fact has been specifically dealt by the lower authorities. (para 43)

The cumulative factors led ITAT to conclude that the scheme amounted to distribution of accumulated profits, the consideration paid amounts to dividend under Section 2(22)(a)/2(22)(d) read with Section 115-O and thus is taxable under the IT Act, 1961. 

‘Tax Exemption’ Enjoyed by Cognizant

Another fact, though should have been irrelevant, was found germane to the issue by ITAT. The ITAT noted that the assesee had enjoyed ‘tax exemption’ of Rs 30,000 crores (appx) as the assessee has accumulated profits of Rs 33,000 crores (appx) and has not declared interim dividend since 2006-07. (para 31) The assumption in this statement is that the assessee by not declaring dividends was enjoying tax exemption, since under DDT regime, tax was payable by a company only on declaration of dividend. The fact that wasn’t articulated by ITAT was that DDT was introduced to disincentivize companies from declaring dividends and encourage them to invest their profits in growth of the companies. So, fulfilling the objective of DDT amounted to enjoying a tax exemption? Also if the taxable event under DDT is distribution of dividends, and a company chooses not to distribute dividends, how does it amount to a company enjoying ‘tax exemption’? It is at best a case of tax planning. A company can choose not to declare dividend if it feels it will add to its tax liability. The decision not to declare dividend hardly amounts to ‘enjoying’ a tax exemption. Whether the impugned buyback of shares amounts to distribution of dividends should have been interpreted on its own terms, rather than making prior dividend policy of the assessee relevant to determine its tax liability.  

Conclusion 

ITAT relied heavily on the facts to characterize assessee’s transaction as a colorable device intended to evade tax under the IT Act, 1961. The use of general provisions of Sections 391-393 instead of specific provision of Section 77A to buyback its shares, hyper technical interpretation of reduction of capital and distribution of profits, all were interpreted against the assessee to term the scheme as a colorable device intended to evade DDT. The factual matrix – as captured in ITAT’s decision – certainly doesn’t seem to favor the assessee and even the definition of dividend is wide enough to include the distribution of profits – even if as part of buyback – under the scope of DDT. Whether the arguments and facts are argued and interpreted in a different manner in the High Court and whether any other factors are considered in determining the tax liability of assessee will be known soon. 

But, ITAT seems to have stacked the odds against assessee especially by making it prior dividend policy relevant to the impugned case. However, ITAT’s decision is heavily reliant on the interpretation of the definition of dividend which inter alia includes distribution of profits, a stipulation which is certainly fulfilled in the current case. The assessee’s arguments that there was quid pro quo and thus there was no distribution of profits, and that reduction of share capital was a result of the scheme and not co-terminus with distribution do not hold much water. The assessee’s arguments come across as ‘hyper-technical’ as ITAT rightly pointed out. It is to be seen whether assessee adopts alternate or additional arguments in the High Court.              

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.    

Intersection of Trusts, DTAAs, and IT Act, 1961: Profile of ADIA Case

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Abu Dhabi Investment Authority (‘ADIA’) is currently embroiled in a tax dispute in India that involves questions about its eligibility to claim tax benefit under India-UAE DTAA, recognition of foreign trusts in India, and interpretation of provisions of IT Act, 1961 on taxability of revocable trusts and their representative assessees. The Bombay High Court, in October 2021, held that ADIA was entitled to avail the tax exemption under India-UAE DTAA despite ADIA making the investments and earning income through a trust registered in Jersey. The High Court held that AAR’s ruling – against which an appeal was filed before the High Court – that ADIA was not entitled to tax exemption was erroneous. An appeal against the High Court’s decision is currently pending before the Supreme Court. I rely on the High Court’s judgment to highlight some of the novel questions that arise in the case.   

Facts 

The case involves Green Maiden A 2013 Trust (‘trust’) settled in Jersey. ADIA was both the settlor and sole beneficiary of the trust while Equity Trust (Jersey) Ltd. was the trustee. Under its Deed of Settlement, the trust was a revocable trust and ADIA in its capacity as a settlor contributed two hundred million dollars in the trust. ADIA’s reasons for settling the trust and using it for investment in India were that UAE did not offer a legal framework for settling trusts or incorporating a sole shareholder subsidiary company. Also, ADIA preferred making illiquid investments through separate legal entities which ensured it does not have to directly deal with portfolio companies. The trust through which ADIA made investments was registered with SEBI under the relevant Foreign Institutional Investor and Foreign Portfolio Investor regulations.     

ADIA’s case was that since the capital contribution made to the trust were revocable, any income earned by trust on investments made in India should be treated as income of ADIA itself. Under Article 24, India-UAE DTAA, any income earned by Government of one of the Contracting States is exempt from tax, and in case of UAE, Government includes ADIA. If the income of trust was treated as income ADIA, the income would be eligible for exemption under the said provision. The Revenue resisted such interpretation by arguing that the income was of the trust registered in Jersey and India-UAE DTAA could not be invoked, but the Bombay High Court rejected the Revenue’s assertion.     

Relevant Statutory Provisions 

Before I dig deeper into the issues and arguments, it is important to highlight the relevant provisions of IT Act, 1961:

Section 61, IT Act, 1961 states that all income arising to any person by virtue of a revocable transfer of assets shall be chargeable to income tax as the income tax of a transferor and shall be included in his total income. Section 63, IT Act, 1961 states that a transfer shall inter alia be revocable if it in any way gives transferor a right to reassume power directly or indirectly over whole or any part of the income directly or indirectly. And Section 63(b) specifically states that transfer shall include a trust. Finally, Section 161(1)(iv), IT Act, 1961 states that a “representative assessee” means in respect of income which a trustee appointed under a trust declared by a duly executed instrument in writing whether testamentary or otherwise, receives or is entitled to receive on behalf, or for the benefit, of any person, such trustee, or trustees. 

Arguments on Income and DTAA 

ADIA’s argument was that as per the Deed of Settlement, ADIA has the right to terminate the trust before end of its term, ADIA can re-assume power over entire income arising from investments in portfolio companies as well as principal amount in portfolio companies meaning that all capital contributions made or to be made by ADIA were revocable transfers under Section 63, IT Act, 1961. Thus, in view of Section 61, all income from investments made by trusts shall be chargeable as part of total income of the transferor/settlor, i.e., ADIA.

ADIA made an alternative argument and argued that even presuming Section 61 was inapplicable, under Section 161(1)(iv) the trustee, i.e., Equity Trust (Jersey) Ltd. can only be taxed ‘in the like manner to the same extent’ as the beneficiary. Thus, the income assessed in the hands of the trustee ‘will take colour’ of that of ADIA’s income and will be eligible for exemption under Art 24, India-UAE DTAA. (para 14) The argument that the tax liability of the representative assessee is co-extensive with that of the assessee is on firm footing especially if one reads Section 166 whereunder the Income Tax Department is not barred from directly proceeding against the assessee. For example, it can proceed either against the trustee or beneficiary of a trust for recovery of tax. Either way, ADIA added, it is the beneficial interest in trust that that is taxable in the hands of the trustee and not the corpus of the trust. And more importantly, as per ADIA, any income for which the representative assessee/trustee is liable is income of the beneficiary.  

The Revenue’s arguments were that: first, there is no DTAA between India and Jersey, thus the trust which was settled in Jersey was taxable as a non-resident under IT Act, 1961; second, Indian Trusts Act, 1882 will not be applicable to foreign trusts though it conceded that there is nothing in the IT Act, 1961 which suggests that Sections 60-63, 161, 166 will not be applicable to foreign trusts; lastly, that ADIA would have been eligible for tax exemption under Art 24, India-UAE DTAA if it had invested in India directly.     

The High Court decided in favor of ADIA by interpreting the relevant provisions of IT Act, 1961 strictly. I elaborate on the High Court’s observations below.        

Recognition and Validity of Trusts 

There were two major aspects regarding trusts that were discussed in the case: first, as per ADIA, Sections 61-63, 160, 161, and 166 do not expressly state that they are not applicable to foreign trusts; second, was whether the settlor of a trust can also be its beneficiary.

The Bombay High Court approached the first issue in a straightforward fashion and noted that there is nothing in Sections 61 and 63 that restricts their applicability to foreign trusts and the argument that India has not ratified the Hague Convention on the Law Applicable to Trust and their Recognition does not resolve the issue one way or the other. (para 26) The High Court relied on H.M.M. Virkamjit Singh Gondal case to note that even foreign trusts are recognized under the IT Act, 1961. As regards the second issue, the High Court relied on Bhavna Nalinkant Nanavati case to note that the only restriction on trusts is that the settlor cannot be the trustee and sole beneficiary of a trust, while in the impugned case the settlor – ADIA – was only a beneficiary and not trustee which is permissible. 

Once the applicability of IT Act, 1961 to foreign trusts was established, and correctly so, the High Court’s other conclusions relying on other relevant judicial precedents were inevitable and resolved the issues satisfactorily.      

Merit(s) of High Court’s Decision  

The Bombay High Court’s decision is laudable for evaluating the factual matrix appropriately and applying the relevant law. Since the decision is currently under appeal and pending before the Supreme Court, any comment on the outcome of the case is mere speculation for a distant observer. Nonetheless, a perusal of the Bombay High Court’s decision reveals certain merits in its reasoning and conclusion. 

Most notable aspect of the Bombay High Court’s decision is its engagement with the intent of Sections 60-64, IT Act, 1961, colloquially referred to as ‘clubbing provisions’. AAR, as per the High Court, had noted that the intent of clubbing provisions is to ensure that a taxpayer does not circumvent tax payments by ensuring that it does not receive income from a property but still retains control over that property. The High Court observed that AAR’s observation that if ADIA had invested directly in India, it would have been exempt from tax does not appreciate why ADIA had not directly invested in India. The reason, the High Court noted, as been explained in detail by ADIA, was commercial expediency. Again, this is a correct understanding and optimum application of the relevant provisions to the commercial transactions. Clubbing provisions have an anti-tax evasion intent and are intended to prevent use of devices such as trust for tax evasion. But, if an entity is entering into commercial transactions which makes it difficult to obtain a tax benefit, then the commercial reasons for such transactions should be understood. However, acknowledging commercial reasons and commercial expediency is a tricky territory and needs to be navigated appropriately. The combination of facts in the impugned case justified High Court’s conclusion, but commercial expediency cannot always be treated as sacrosanct to determine eligibility for tax benefits and may not be a prudent approach in all factual scenarios.  

Further, it is indeed novel that the Income Tax Department was emphasizing on the formal nature of transaction while the taxpayer was trying to underline the substance of it. The former was arguing that since the investment was made by a trust from Jersey, ADIA cannot claim tax exemption under India-UAE DTAA while ADIA was trying to emphasise that since it was the settlor of a revocable trust and its beneficiary, the income of Jersey trust was effectively ADIA’s income. Typically, one witnesses the Income Tax Department trying to invoke substance of a transaction to justify taxation or recharacterize the transaction. The roles seemed to have reversed in the impugned case.  

Finally, the case also reflects the intricate nature of trusts and how determining their taxability is sometimes more peculiar than that of other forms such as corporates. The revocable/irrevocable nature of trusts, their discretionary nature, foreign trusts, representative assessees all add layers that make their taxability an intricate affair, as in the impugned case. 

Water Cess: States Run into a Constitutional Hurdle

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Two States – Himachal Pradesh and Uttarakhand – in their attempts to generate additional sources of revenue have run into constitutional hurdles. Both States attempted to levy a ‘water cess’, a tax on use of water by power generation companies but the Courts declared the same as unconstitutional. Both the Himachal Pradesh High Court and the Uttarakhand High Court have declared the respective levies of both States as unconstitutional. The High Courts of both States held that while the States are terming the levy as a water cess/tax, it was in effect a tax on electricity and States do not have the power to levy tax on electricity. In this article, I focus on the nature of tax, State’s competence, and the possible ramifications of the judgments on State’s efforts to generate additional sources of revenue. 

Cess on ‘Drawl of Water’ or ‘Generation of Electricity’

Both the legislations – of Himachal Pradesh and Uttarakhand – levied tax on drawl of water of generation of electricity. The Himachal Pradesh Water Cess on Hydropower Generation Act, 2023 (‘Act of 2023’)in the Statement of Objects and Reasons stated that the water cess on hydropower generation will be imposed on consumption of water and head available in the project, which is the difference in levy at entry and exit of water conductor system. The Himachal Pradesh High Court referred to the relevant provisions of the Act of 2023 and observed that it was clear that water cess was not on ‘water’ but on ‘water drawn for hydropower generation’. And since there is no generation of electricity without drawl of water, in the absence of generation of electricity no water cess is imposed. 

The Himachal Pradesh High Court also referred to the Notification issued under the Act of 2023 wherein the tax rates were determined by considering the head-height and not the quantum of water. The greater the height from which water falls on the turbine, greater the momentum resulting in electromagnetic field causing generation of electricity meant, as per the High Court, that the tax was on user of water, but user of water for generation of electricity. The High Court added that it was clear that if tax was on quantum of water, then height from which the water fell would be irrelevant and that:

            The “use of water” in fact does not go by the text of the impugned Act. It is “generation of electricity” that is the “bone” and “water drawn” is only the “flesh”. The taxable event is “hydropower generation” and not the “usage of water” because if there is no generation, there is no “tax”. Moreover, if the cess was on “usage of water”, then how could the height, at which the water falls on the turbine, be made the taxable event? (para 41)     

The Himachal Pradesh High Court was clear that the nature and character of water cess was such that it was inextricable with electricity generation, and it was a misnomer that the tax was levied on water and not on generation of electricity. (para 42)

The Uttarakhand High Court made similar observations vis-à-vis the Uttarakhand Water Tax on Electricity Generation Act, 2012 and observed that the user for the purpose of water tax was not a person who draws water, but a person who draws water for the purpose of generation of electricity. And further the measure of tax was not the volume of water used, but the units of electricity generated which was evident from the fact that for different heights different tax rates were prescribed. The High Court observed:

The measure of tax definitely is as per cubic meter water used but it depends on the height available for power generation. Higher the height, more is the tax per cubic meter water. Had it been tax on mere drawal of water, there would have been no necessity to correspond the use of water with the height available for power generation. (para 178) 

The measure of the tax, the Uttarakhand High Court concluded was on generation of electricity, thus the tax was in pith and substance a tax on generation of electricity and not on use of water. (para 179)

 The Himachal Pradesh High Court and the Uttarakhand High Court, correctly understood the nature of tax. Both the High Courts correctly adopted the approach of looking at the substance of the levy, and were not guided by its nomenclature alone. In doing so, they were able to correctly identify the nature of levy and concluded that it was not on use of water, as claimed by States, but on its use for generation of electricity. 

State’s Competence 

States tried to justify their competence to levy the impugned water cess/water tax by relying on and referring to various legislative entries of the Seventh Schedule. Some of the legislative entries of List II, that were referred to were: Entry 49 which provides for ‘Taxes on lands and buildings’, Entry 50 which provides for ‘Taxes on mineral rights subject to any limitations imposed by Parliament by law relating to mineral development’, Entry 45 which provides ‘Land revenue, including the assessment and collection of revenue, the maintenance of land records, survey for revenue purposes and records of rights and alienation of revenues’, Entry 17 which states ‘Water, that is to say, water supplies, irrigation and canals, drainage and embankments, water storage and water power subject to the provisions of entry 56 of List I as well as Entry 18 which provides for ‘Land, that is to say, right in or over land, ..’

While the High Court spend considerable space in interpreting each of the legislative entries, there are three broad points worth mentioning: first, water cess/ tax could not be justified by States by relying on Entry 17 or entry 18 since these are general legislative entries and taxes can be levied by States or the Union only by referring to tax legislative entries; second, water cess/tax could not justified as a tax on minerals, because while States argued that water is a mineral as held in Ichapur case, the Court’s observation in Ichapur was in the specific context of Petroleum & Mineral Pipelines (Acquisition of Right of User in Land) Act, 1962 and could not be applied in the impugned case; and third, the High Courts refused to interpret the water cess/tax as a tax on land despite State’s assertion that water flows on land, and land includes water and air because the High Courts refused to give an unusually wide interpretation to the term land and also High Courts were not convinced that there is a proximate relation between the water cess/tax and the land. The Uttarakhand High Court summarized its observations on the issues as: 

Now, this Court has held that in the instant case, the water drawn from the source though falls on generator attached to land, but it is not use of water on land and it is also not land revenue for the simple reason because it is not only fall of water on land, but it is use of water for electricity generation that makes a taxable event. The pith and substance of the Act is water tax for generation of electricity. Therefore, the State Legislature is not competent to levy the tax under E 45 and 49 L II of S VII. (para 181) 

The States were on the backfoot in their attempt to justify that the water cess/tax was within their legislative competence. And the drafting of statutory provisions and Notifications for tax rates, left little doubt that the tax was on generation of electricity, but the nomenclature used was that of a water tax. Equally weak was the State’s attempt to justify water as part of land. Finally, it is worth pointing out that the High Courts did not give enough credence to financial necessity of States to adjudicate a constitutional issue and correctly so as the need for additional sources of revenue cannot triumph Constitutional limits.   

Revenue Ramifications for States 

The revenue ramifications of States not being able to levy water cess are likely to be multiple. The obvious one is that States with rich water resources will not be able to use these water resources for generating additional revenue, at least for now. The Statement of Objects and Reasons of The Himachal Pradesh Water Cess on Hydropower Generation Act, 2023 clearly stated that the State of Himachal Pradesh has limited revenue generation resources, it faces financial constraints and the immense water resources can be used as a useful source for revenue generation. Similar reasons can be assigned to the State of Uttarakhand, in fact, the levy of water by the latter was one of the reasons cited by the State of Himachal Pradesh to levy its water cess. But, as I mentioned above, these reasons cannot inform interpretation of the Constitution, even if Constitutional constraints lead to revenue squeeze for States.  

Successive Finance Commissions in their awards have enjoined States to explore additional revenue sources. While the recommendations of the Finance Commissions are well meaning, there are major hurdles for States to explore additional sources of revenue. To begin with, the distribution of tax bases under the Constitution is such that the taxes with greater buoyancy and wider bases have been allocated to the Union. And since 2017, relatively lucrative indirect taxes in State’s domain have been subsumed under GST. To the extent, States are being innovative such as by levying water cess, they are testing and also understanding the limits of their competence. While in the impugned cases, Courts have rightly not upheld the water cess, it will take equally innovative and proactive measures from various States to further test their taxation powers in their attempts to be able to finance themselves and not become increasingly dependent on the Union for their finances. 

Conclusion    

Both the judgments discussed above rely on a wide set of judicial precedents to determine the scope of each of the legislative entries that States used to justify their legislative competence. The High Courts correctly identified the nature of levy and its substance and relied on the relevant statutory provisions and Notifications to hold the levy as unconstitutional. Of course, the States can redraft the legislations in constitutionally compatible manner since resource crunch is a recurring issue. The thing worth seeing would be if States modify the way they wish to levy water cess/tax or will they now focus their efforts at trying to find other sources of revenue.  

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.     

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

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

Reasons for Income Tax Exemption to Political Parties 

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

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

Income from Souvenirs 

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

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

Scope of Section 13A

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

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

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

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

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

Willful Ignorance of Section 13A

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

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

Conclusion 

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

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