TDS

Religious Vows and Income Tax Obligations: Harmony to Clash 

by

The Supreme Court is currently seized of a matter which, at its core, involves determining to what extent do the religious beliefs of a person exempt them from withholding tax obligations under the IT Act, 1961. In this article, I will focus on the issues involved and refer to the relevant judgments of the Madras High Court – Single Judge Bench and Division Bench, as well as the judgment of a Single Judge Bench of the Kerala High Court, currently under appeal before a Division Bench. The judgments reveal differing opinions and unravel layers of the central dilemma – should interpretation of tax law accommodate personal religious beliefs, or should tax law be indifferent to religious beliefs, irrespective of the hardship it may cause.    

Background 

The controversy involved nuns, sisters, priests, or fathers who provided their services as teachers in schools. The schools were provided grant-in-aid by the State Government under its grant-in-aid scheme. Christian religious institutions/religious congregations (‘societies’) which controlled the schools and represented the cause of the teachers before the High Court(s) contended that the teachers were bound by Canon law as they taken vows of poverty to the Christ. As a result of their vows, the teachers had suffered a civil death, were incapable of owning property and thus their salaries belonged to the society in question. The teachers were obligated to ‘make over’ their salaries to the societies and did not possess any title over them. And it was the society which accounted for the money in its tax returns and not the teachers. In view of the above, the petitioners contended that the salaries of teachers cannot be subjected to deduction of tax at source as stipulated under IT Act, 1961.  

Before I summarise the arguments adopted by the parties, it is vital to understand the successive Circulars and Instructions issued by CBDT on the issue. I’ve summarised the content of each Circular in a chronological fashion.  

Circular No.5 of 1940, issued on 02.01.1940: Medical fees, examination fees or any other kind of fees received by the missionaries are taxable in the hands of the missionaries themselves, even though they are required by terms of their contracts to make over the fees to the societies. The Circular stated that not only does the accrual happen in favor of the missionaries but there is an actual receipt by them. 

Circular No.1 of 1944, issued on 24.01.1944: Cited the principle of diversion of income and noted that the fees received by missionaries is not their income and clarified that where a missionary employee collects fees in payment of bills due to the institution, the amount collected will income of the institution and not of the employee. No income tax will be collected on fees received by missionaries for services rendered by them which as per their conditions of service they are required to make over to the society. 

Circular F. No. 200/88/75-II (AI), issued on 05.12.1977: Referred to the Circular of 1944 and reiterated that since the fees received by the missionaries is to be made over to the congregation there is an overriding title to the fees which would entitle the missionaries exemption from payment of income tax. 

CBDT Letter, F. No. 385/10/2015-IT (B), issued on 26.02.2016: Observed that the Circular of 1944, which was reiterated in 1977, was only applicable on amounts received as fees as payment of bills due to the institutions and does not cover salaries and pensions. And while Circular of 1977 mentions the word ‘salary’, the operative portion only dealt with fees. 

CBDT Letter, F. No. 385/10/2015-IT (B), issued on 07.04.2016: Reiterated the position in previous letter and noted that salary and pension earned by member of congregation in lieu of services rendered by them in their individual capacity are taxable in the hands of members even if same are made over to the congregation. No exemption from TDS is envisaged under the Circulars and Instructions of the Board. 

The shift in stance on TDS obligations, from 1944 to 2016, is evident from a summary of the above Circulars. The shift though was not caused by any substantive change in the underlying law but facts. From 2015 onwards, the teachers were to be paid salaries in their individual accounts via ECS, while previously the grant-in-aid from the State Government was credited as a lumpsum amount to the account of the societies itself. Prior to 2015, no withholding tax was deducted, primarily because that was the interpretation of the 1977 Circular. However, in 2015, before crediting the salaries to individual accounts of teachers, the Pay and Accounts Officer addressed a communication to the Principal Commissioner of Income Tax (Chennai) as to whether tax is to be deducted from salaries of teachers and received a reply in the affirmative, which the societies alleged was contrary to the Circulars issued until then. Nonetheless, it triggered a chain of events which culminated into CBDT Instructions of 2016 which also affirmed that tax should be deducted and thereafter societies filed writ petitions before the Madras and the Kerala High Court challenging the orders of deduction of tax. 

Diversion of Income vis-a-vis Application of Income 

The Revenue’s stance that religious beliefs do not exempt from withholding tax obligations highlighted the apolitical character of IT Act, 1961. And the Division Bench of the Madras High Court agreed with this argument and premised its interpretation of provisions relating to withholding tax partly on that assumption. (paras 29-30) In my view though, the Revenue’s case hinges on the core issue that the salary of teachers which they are bound to make over to the societies is an application of the teacher’s income and not a diversion of income. The petitioners contended otherwise: that the societies had an overriding title on the teacher’s salaries due to their vow of poverty and making over the salaries amounts to diversion of income and not application of income. 

Application of income, under direct tax law, means a person applies the income or spends it on an avenue of his choosing ‘after’ its receipt. This could mean donation of the entire income to another person, transferring a part or entirety of the income to a dependent based on a previous promise or otherwise parting with the income after receiving it. In such cases, since the income is received by the person and is accrued in their favor, it is taxable in the person’s hands. The subsequent application of income for charitable or other purposes is immaterial to chargeability of income in the hands of the person who receives the income in the first place.  

Diversion of income, fully expressed as ‘diversion of income by an overriding title at source’, implies that the person has diverted their income, by a contractual arrangement or otherwise, to another person and never receives the income. It is important that not only does the person not receive the income, but more crucially the accrual does not happen in favor of the person who diverts their income. Diversion of income can happen in various ways. If a person, as part of an employment or professional contract, dedicates a portion of his income to a charity whereby a charity has a right to receive such money every month, it can be said that the person has diverted that portion of their income and created a charge in favor of the charity. The portion of money earmarked for charity neither accrues in the person’s favor nor does it receive that income. The diversion needs to happen at the source of income to create an overriding title in favor of the other person. But, if the contractual terms are such that the entire income accrues in favor of the person and thereafter a portion of income is diverted towards charity, it will not amount to diversion of income but application of income. 

Courts in India have tried to demarcate the two concepts through various decisions. And while an articulation of the concepts is coherent, their application to various fact situations remains a challenge. Courts have, for example, observed that diversion of income happens where third person becomes entitled to receive the amount before an assessee can lay claim to receive it as its income, but no diversion of income happens when it is passed to a third person after receipt of income even if it may be passed in discharge of an obligation. These broad dictums while understandable need to be applied to situations that are rarely straightforward such as the current case involving nuns and fathers who have taken a vow of poverty.     

Have Teachers Diverted Their Income?  

Based on the above summary exposition of application and diversion of income, it is apposite to examine if the teachers who have taken a vow of poverty diverted their income or were they recipients of income which they applied in favor the societies. From a Canon law perspective since the teachers had suffered a civil death and were no longer capable of owning property, the case is that of diversion of income. And the teachers should not be taxable. And as the petitioners argued, the teachers were merely conduits, and the income was that of the societies. But such an approach tends to completely discount or at least dilutes relevance of the provisions under IT Act, 1961. 

The Division Bench of Madras High Court and the Single Judge Bench judgment of the Kerala High Court disagreed with the above line of argument and gave the IT Act, 1961 more primacy. Both the Courts in their respective judgements observed that the societies did not have a legal right to receive the salaries as they accrued to individual teachers. While the precepts of canon law might require the teachers to part with their salaries, it was held that the said obligation was in the realm of personal law and did not entitle the societies to receive salaries from the State Government. It can be said that from the State Government and Revenue’s standpoint, only teachers were entitled to receive the salaries, but from the standpoint of societies teachers were mere conduits to receive the money and the right to receive the money was of societies. The latter view, of course, is based primarily if not entirely on personal law.  

The single judge bench of the Madras High Court – against which a writ appeal was decided by the Division Bench of the Madras High Court – however, said the above conclusion did not give ‘due regard to personal law’ and the Revenue Department cannot ignore the personal law of the teachers. And by applying the test of distinction between diversion and application of income enunciated by Courts in previous decisions, Single Judge of the Madras High Court held that the correct conclusion is that the teachers only receive the salary on behalf of their societies as they do not partake in any part of their income. And no tax should be deducted at the time of disbursal of their salaries.      

The question then is to what extent, if at all, should income tax accommodate the religious beliefs of the teachers? If the religious belief is to be accommodated, the teachers would have to be considered as fictitious persons – and also in accordance with the long-standing practice of the Income Tax Department as per its pre-2016 Circulars – and only societies would be considered recipients of income via a deeming fiction. This would save the teachers – who do not receive any benefits of portion of their income in reality – from income tax obligations of filing returns and claiming refunds, etc. If the societies are accounting in their income tax returns, it should not be a problem as it has not been since 1944. 

What is the case for not accommodating the religious beliefs? One, there is no express provision in IT Act, 1961 that exempts people from withholding tax obligations on the ground of their religious beliefs. At the same time, I would suggest that accrual, which is one crucial basis to determine chargeability of income, may be a more pertinent lens to view this issue. For example, if the salary accrues to the teachers – due to their services provided on basis of their qualifications, as argued by the Income Tax Department – then it can be said that IT Act, 1961 and its withholding tax obligations applies to them, and the teachers are merely applying their income by making it over to the societies under their personal vows. In the alternative, if the accrual happens in favor of societies, then it is a clear case of diversion of income. But can personal religious vows transfer titles in property? Doubtful. Though if the societies can argue – and I’m not sure they have – that the teachers are bound to transfer salaries to them not just because of their personal vows but also under their contractual obligations with the school/societies, there may be room to suggest that diversion of income happens under contractual terms as well, creating an escape from withholding tax obligations. 

Story of CBDT Circulars 

Apart from the above, a sister issue is that of the validity, content, and scope of Circulars. The Income Tax Department has contended before the Courts that the Circulars that were issued under the IT Act, 1922 and do not represent the legal position under IT Act, 1961. Further, it has been argued the Circulars issued before 2016, only clarify the legal position as regards the fees received by teachers in a fiduciary capacity and not the salaries and pensions. For example, while the Circular of 1977 mentions salaries, the operative part of the Circular only refers to fees. The Division Bench of Madras High Court has opined that the Circulars suffer from vagueness, do not refer to the contemporary position such as the requirement of crediting salaries of teachers in their individual bank accounts such via ECS. Further, the Madras High Court in the same judgment has held that the Circulars can only act as a guide to interpretation and are not binding on Courts. And more importantly, the CBDT does not have the power to grant exemptions when the statutory provisions do not permit such exemptions.  

The Single Judge Bench of the Madras High Court opined that the Principal Commissioner of Chennai could not have issued directions to deduct tax by ignoring the previous valid Circulars. But, the Revenue has a persuasive argument in stating that pre-2016 Circulars only refer to fees and not salaries and pensions. The Single Judge of the Madras High Court questioned the validity of 2016 Instructions on the ground it covered the same subject matter as the previous Circulars. While the Division Bench held that the pre-2016 Circulars did not apply to salaries, but only fees. This, again, is a matter of interpretation. A perusal of the Circulars does suggest that the pre-2016 Circulars clarify tax obligations on fee and refer to salaries incidentally. Even if fee is interpreted to encompass salaries, the more crucial fact in my view is that the manner of crediting salaries has changed. Post-2015, teachers are supposed to be paid salaries via ECS in their individual accounts undeniably making them recipients of the income. This fact was not considered in pre-2015 Circulars necessitating issuance of new directions in 2016. Change in facts can change the interpretation of law. I doubt there is much grouse in that argument.  

Conclusion

I think the ‘correct’ answer in this case depends on various parameters and what is accorded due importance. The Single Judge of the Madras High Court invoked Fundamental Rights relating to religion under Article 25 and 26 to support his conclusion in favor of the teachers, while the Division Bench dismissed their relevance to the issue. Similarly, as highlighted above, if personal law is given primary consideration, then the conclusion favors the teachers, while if a strict interpretation of the withholding tax provisions is followed then as the Division Bench of the Madras High Court observed, there is no exemption based on personal religious beliefs. In my view, a deeper look into accrual and by extension diversion and application of income may provide us an insight as to how to satisfactorily resolve this issue. The Single Judge of Kerala High Court, for example, based its conclusion by reasoning that the salary accrued to the teachers who provided service in their individual capacity and not to the societies. The right to receive income is that of the teachers who entrust their salaries to the societies under a personal vow. (para 16) And, this is a fair conclusion and understanding of the arrangement. In fact, this is what the first Circular of 1940 also infers, but in the context of fees. Last, it is worthwhile to underline that the validity of Circulars and Instructions and the interpretation placed on them may ultimately prove to be crucial in determining the fate of this case.       

DTAAs are Relevant for TDS Provisions under IT Act, 1961 

by

In a recent judgment[1], the Karnataka High Court reiterated the ratio of Engineering Analysis case, more specifically the applicability of Double Taxation Avoidance Agreements (‘DTAA’) vis-à-vis withholding tax obligations under the IT Act, 1961. 

Introduction 

The assessee was an International Long Distance (‘ILD’) licence holder and was responsible for providing connectivity to calls originating/terminating in India. The assessee entered into agreements with non-resident telecom operators for the aforesaid purposes and was required to pay them inter-connectivity charges. In the impugned case, the centrepiece was an agreement assessee entered into with a Belgium entity which had no permanent establishment in India. Equally, all the equipment and necessary submarine cables were situated outside India. 

Arguments 

The Revenue made several arguments, the core, for the purpose of this post was that the assessee failed to discharge its statutory obligation to withhold tax/deduct TDS before making the payments to the Belgium entity. The Revenue argued that the agreement between the assessee and the Belgium entity did not specify that the income was not taxable in India and if in the opinion of the assessee no tax was deductible it should have approached the Assessing Officer and secured a nil certificate. The Revenue further argued that the income belonged to the payee. 

The assessee, on the other hand, argued that the payments made by the assesee could neither be considered as royalty, fee for technical services or business profits since no part of the business activity was conducted in India. The assessee also resisted Revenue’s attempt to apply the expanded definition of royalty amended via insertion of Explanations to Section 9(1)(vi) and instead argued that the definition of royalty under DTAA needs to be relied on.  

Observations of the High Court 

The High Court engaged with the questions relating to the interplay of DTAAs and withholding tax provisions. It cited the GE Technology case[2] and Engineering Analysis case[3] which had held in the context of Section 195, IT Act, 1961 that DTAAs are relevant while implementing tax deduction provisions. Relying on the said observations, the Karnataka High Court in the impugned case held that the assesee can take the benefit of DTAAs. And that the ITAT – whose order was under appeal – was wrong in stating that DTAA cannot be considered in proceedings under Section 201, IT Act, 1961. 

Another crucial question that the Karnataka High Court answered by relying on Engineering Analysis case was that the amendment to Section 9(1)(vi) by insertion of Explanations did not amend the DTAAs. The amended definition of royalty was thus only applicable if IT Act, 1961 was the relevant legal instrument. The High Court further clarified that in Engineering Analysis case it was observed that Explanation 4 added to Section 9(1)(vi) vide the Finance Act, 2012 was not clarificatory. Explanation 4 expanded the definition of royalty. And Supreme Court had observed that the person under Section 195, IT Act, 1961 cannot be expected to do the impossible, i.e., apply the expanded definition of royalty for assessment years when such definition was not factually in the statute. In view of the same, the High Court answered that the assesee was not obliged to withhold tax since the Assessment Years in question were 2008-09 and 2012-13 while the Explanation 4 expanding the definition of royalty was added to the IT Act, 1961 via Finance Act, 2012. Though this point was moot since the High Court had held that the assessee was entitled the benefits under DTAA (and consequently rely on more favorable/narrow definition of royalty.). 

While the High Court’s above observations were sufficient to clarify that the assessee did not have any obligation to deduct TDS on payments made to its Belgian contractual partners. The High Court also added, in response to an argument made by the assessee, that the Revenue Department did not have the power to bring to tax income arising from an extra-territorial source. The High Court held that: 

It is also not in dispute that the facilities are situated outside India and the agreement is with a Belgium entity which does not have any presence in India. Therefore, the Tax authorities in India shall have no jurisdiction to bring to tax the income arising from extra-territorial source. (para 22)

Conclusion

The Karnataka High Court’s observations are an unqualified endorsement of the ratio in Engineering Analysiscase especially regarding the interplay of TDS provisions and the applicability of DTAAs. The High Court’s observations bring specific clarity to the benefit of DTAAs available during proceedings under Section 201, IT Act, 1961. Whether the impugned case will be the subject of appeal is unknown, but the Revenue does not have a persuasive case against the assessee based on the facts and ratio of the High Courts’ judgment.  

[1] M/s Vodafone Idea Limited v Deputy Director of Income Tax, available at https://www.livelaw.in/high-court/karnataka-high-court/vodafone-idea-deduct-tds-inter-connectivity-usage-bandwidth-charges-karnataka-high-court-233692  

[2] GE India Technology Centre Private Limited v CIT (2010) 327 ITR 456 (SC). 

[3] Engineering Analysis Centre of Excellence Private Limited v CIT (2021) 125 taxmann.com 42 (SC). 

LinkedIn