"Principal Place of Business" and "Residence" of corporations

The United States Supreme Court will soon be hearing arguments in Hertz Corp. V. Friend (08-1107). The case concerns a corporation which carries on business in more than one state. The question before the Court pertains to the proper test for determining where the “principal place of business” of such a corporation would be situated. Among the various tests which will be considered are the “nerve center” (or location of headquarters) test; the “center of corporate activities” test; the “place of operations” test and the “total activities” test. Descriptions of each test, and an analysis of the various cases in US law applying those tests, can be found in the petition for writ of certiorari. Shantanu Naravane has discussed the case on Indian Corporate Law.

Analoguous questions have arisen under Indian law; particularly under Section 6 of the Income Tax Act. An Indian company is, of course, a resident; but can there be instances of a company incorporated outside India being treated as a resident of India?

Purely looking at the Act (and ignoring the possible applications of tax treaties), “resident” is defined in Section 6. The concept of residence bears no relationship to the concept of citizenship. Section 6 defines the requirements of residence for both natural persons as well as artificial persons. Insofar as a natural person is concerned, the requirement is related to presence in India for the prescribed number of days. For artificial persons, such a prescription in terms of the number of days is not useful. Hence, in such cases, residence is to be determined on the basis of control and management. According to the treatise by Sampath Iyengar, this test refers to “the controlling and directing power, the head and brain” of the artificial person concerned. This perhaps corresponds to the “nerve center” test at issue before the United States Supreme Court in Hertz. Thus, the control and management of an artificial person’s affairs will be situated where decisions are taken in relation to the vital policies of the person [San Paulo (Brazilian) Railway Co. Ltd. v. Carter, (1896) AC 31)]. The test is a de facto one, not a de jure one [B.R. Naik v. CIT, (1945) 13 ITR 124 (Bom.); CIT v. Chitra Palayakat Co. (1985) 156 ITR 730 (Mad.). Also see: Todd v. Egyptian Delta, (1928) 14 TC 119].

As a general rule, therefore, the place of registration of a company ought not to be relevant following this logic. However, Section 6(3)(i) specifically provides that an Indian company is a resident of India. Thus, in the case of a company, the first question must be whether the company is an Indian one or not. If it is, the enquiry is over – the company is a resident. If it is not, then the enquiry must proceed to the next stage of the test of de facto control and management.

A brief discussion of the issues from an international tax policy angle is found here. DTAAs usually define residence specifically; for instance, Article 4 of the India-Mauritius DTAA states:

“ARTICLE 4 - Residents - 1. For the purposes of this Convention, the term resident of a Contracting State means any person who, under the laws of that State, is liable to taxation therein by reason of his domicile, residence, place of management or any other criterion of similar nature. The terms resident of India and resident of Mauritius shall be construed accordingly.”

The question of what “liable to taxation” means has been thoroughly discussed in Azadi Bachao Andolan v Union of India. (The concept of ‘residence’ under DTAAs in general has also been discussed). The Court observed:

“It is urged by the learned Attorney General and Shri Salve for the appellants that the phrase liable to taxation is not the same as pays tax. The test of liability for taxation is not to be determined on the basis of an exemption granted in respect of any particular source of income, but by taking into consideration the totality of the provisions of the income-tax law that prevails in either of the Contracting States… Merely because, at a given time, there may be an exemption from income-tax in respect of any particular head of income, it cannot be contended that the taxable entity is not liable to taxation. They urge that upon a proper construction of the provisions of Mauritian Income Tax Act it is clear that the FIIs incorporated under Mauritius laws are liable to taxation; therefore, they are residents in Mauritius within the meaning of the DTAC… We are inclined to agree with the submission of the appellants that, merely because exemption has been granted in respect of taxability of a particular source of income, it cannot be postulated that the entity is not liable to tax as contended by the respondents… Liability to taxation is a legal situation; payment of tax is a fiscal fact.”

The Impact of the withdrawal of Circular 23 of 1969: 'Attribution' and 'Business Connection'

(This note is also posted on the Indian Corporate Law blog)

Through Circular No. 7 of 2009, the CBDT has withdrawn Circular No. 23 of 1969 (“Circular 23”). Circular 23 explained the position relating to ‘business connection’ under Section 9 of the Income Tax Act, 1961.

The Circular was relied upon in the arguments in the Morgan Stanley case before the Supreme Court; as also by the Bombay High Court in SET Satellite. These decisions had laid down the broad proposition that in an international transaction, if the non-resident compensates its permanent establishment (“PE”) at arms-length price, no further profits of the non-resident would be attributable to the PE in India.

With the SET Satellite decision set to come up before the Supreme Court, concerns have been raised as to the implications of the withdrawal of this circular. In particular, does the view in Morgan Stanley or SET Satellite need to be reconsidered in light of the withdrawal of the Circulars? Furthermore, what is the extent to which income from a business connection is taxable in India, after the withdrawal of the Circular?

The principle of Morgan Stanley:

The principle enunciated by the Supreme Court in Morgan Stanley on the question of attribution of income to India is as follows:

“The impugned ruling (of the AAR) is correct in principle insofar as an associated enterprise, that also constitutes a PE, has been remunerated on an arms-length basis taking into account all the risk-taking functions of the enterprise. In such cases, nothing further would be left to be attributed to the PE…”

This was followed by the Bombay High Court in SET Satellite:

“In our opinion considering the judgment, if the correct arm’s length price is applied and paid then nothing further would be left to be taxed in the hands of the foreign enterprise…”

In both these cases, Circular 23 was cited before the Court; yet it did not for part of the Court’s reasoning. In SET Satellite, on this issue, the Bombay High Court directly followed Morgan Stanley (the decision has been previously discussed here). In Morgan Stanley itself, Circular 23 is mentioned in the Supreme Court judgment only when the Supreme Court notes that the AAR placed reliance on the Circular. No reliance is placed on the Circular in the reasoning/conclusion of the Supreme Court itself. The reasoning of the Court is premised on the conceptual relation (and not a relation introduced solely by Circular 23) between a correct transfer pricing analysis and attribution of profits. This relation has been discussed in the previous post on SET Satellite.
Now, if Circular 23 played no part in the actual reasoning of the Court, then the withdrawal of that Circular cannot in any manner require that the principle laid down by the Court be reconsidered. Accordingly, while fears have been expressed that the withdrawal of the Circular will strengthen the Department’s case against SET Satellite in the Supreme Court, it is arguable that those fears are misplaced.

The extent to which income from a business connection can be taxed in India:

Circular 23 stated that “Section 9 does not seek to bring into the tax net the profits of a non-resident which cannot reasonably be attributed to operations carried out in India.” Concerns might be raised as to whether the withdrawal of the Circular changes this basic position.

Circular 23 discussed issues related to extent of taxable income under Section 9. The relevant part of Section 9 provides that all income accruing or arising “directly or indirectly, through or from a business connection in India” is deemed to accrue or arise in India. According to the relevant Explanation 1 to the Section:

“in the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India…”

Thus, the position that only that income which is reasonably attributed to India is covered under Section 9, is clarified in the Section itself. This position is thus due to the Explanation to the Section and not due to Circular 23. Circular 23 only clarified how this would apply in practice – it did not, indeed it could not have, deviated from the principle of attribution which is mandated by the Section itself.

Circular 23, in paragraph 1, itself states that it is a consolidation and restatement of previous clarifications (or the scope of the corresponding Section in the 1922 Act). Paragraph 3 of the Circular again clarifies that “The following clarifications would be found useful in deciding questions regarding the applicability of the provisions of section 9 in certain specific situations…” From this, it is evident that the Circular does not even purport to lay down any specific legal principle; it only discusses the application of the principle in Section 9 to various fact situations.

Conclusion:

There is at least an arguable case that the withdrawal of the Circular makes no difference to the legal position – either on attribution to PEs or on extent of income taxable under Section 9. What, then, was the need to ‘withdraw’ the Circular? The CBDT claimed that there was misuse of the Circular which resulted in assessees claiming relief not in accordance with the provisions of Section 9. Perhaps, the CBDT wanted to give the Revenue wider scope for ingenuity in argument; however, in my view, the legal position would remain unchanged.

The Death Penalty in India: (Mis)Reading Bariyar?

The debate over the death penalty in India heated up when two Judges of the Supreme Court (one of them being Justice Sinha) disagreed in Swamy Shraddananda on the principles to be adopted in death penalty sentencing, requiring referral of the matter to a larger Bench. The there-Judge decision (discussed here) in Shraddhananda perhaps gave momentum to the move of part of the higher judiciary towards abolition. Following from this, Justice Sinha’s judgment in Santosh Kumar Bariyar makes a strong case for abolition. The argument which runs through these cases is that similar facts have been treated differently in different cases. Whether to impose the death sentence or not is more often than not determined by the personal choices of the judges. This – when it comes to a form of punishment as extreme as the death penalty – is unacceptably arbitrary and contrary to constitutional principles. Bariyar in particular strongly emphasised the arbitrariness point and also advocated a pre-sentencing hearing where it must be specifically proved that the accused is beyond all possible reform. Discussions of the case are found here and here.

Now, a recent judgment (September 18, 2009) of Justice Bedi in Jagdish v. State of Madhya Pradesh imposes the death penalty. The point here is not whether on facts, the death sentence was justified or not. Rather, what is particularly striking is the extremely limited discussion on Bariyar. Here is what the Court says:

“We have also examined the mitigating circumstances referred to in Bachan Singh's case (supra) and in Santosh Kumar Satishbhushan Bariyar…”

There is no other mention of Bariyar in the judgment. Bariyar may or may not have its own faults – but this almost trivial dismissal of the case – implying that it has nothing new to say other than reiterating Bachan Singh – is problematic. As this analysis shows, Bariyar does make an important contribution to death penalty jurisprudence. Love it or hate it, it is hard to trivialize it. Yet, Justice Bedi in Jagdish seems to have done just that. On Law and Other Things, Tarunabh Khaitan mentions, “If the ruling in this case is followed sincerely, DP is all but dead.” Jagdish indicates that it might be too optimistic to hope that Bariyar would be “followed sincerely”.

It might be too simplistic to simply dismiss this as turning on the "personal predilection" of Judges (this is not to say that personal predilection is not a factor in death cases at all). For, even more recently (October 2009), Justice Bedi in Sebastian v. State of Kerala commuted a sentence of death to imprisonment for life relying on Shraddananda. What this would seem to indicate is that the implications of Bariyar have been overlooked. Bariyar – rather than Shraddananda – is the one which makes the strongest case for abolition, raising the Article 14 point most strongly; and also calling for pre-sentencing evidence. These points appear to have been missed by at least some subsequent judgments.

Meanwhile, Indian death penalty jurisprudence continues to become more confusing by the day.

Withdrawal of CBDT Circular 23 of 1969: Impact on Territorial Nexus requirements

According to ITAT Online, CBDT has withdrawn Circular No. 23 of 1969. The Circular was one which had been heavily relied on in transfer pricing cases such as Morgan Stanley (Supreme Court) and SET Satellite (Bombay High Court). The decision in SET Satellite has been discussed here (although the impact of the Circular has not been considered in that post). Whether the withdrawal of the Circular affects the legal position laid down is a matter which remains to be seen. The Circular itself – along with an analysis of cases discussing the Circular – is found here.

Several of the paragraphs in the Circular merely gave recognition to the fact that territorial nexus is required for the operation of the Income Tax Act. For instance, paragraph 7 reads:

“OF THE PROFIT ASSESSABLE UNDER SECTION 9 - Section 9 does not seek to bring into the tax net the profits of a non-resident which cannot reasonably be attributed to operations carried out in India. Even if there be a business connection in India, the whole of the profit accruing or arising from the business connection is not deemed to accrue or arise in India. It is only that portion of the profit which can reasonably be attributed to the operations of the business carried out in India, which is liable to income-tax”.

It is submitted that the legal position on this point will remain the same despite the withdrawal of the Circular. The extent of profits accruing through a business connection taxable in India will turn on to what extent territorial nexus with India is present. Even without the Circular, it is arguable that the requirements of nexus would be satisfied only if the extent of profits taxed is that portion which can reasonably be attributed to operations in India. Withdrawal of the Circular cannot mean that the provisions begin to have extraterritorial effect without the establishment of nexus. The application of the territorial nexus doctrine to the Income Tax Act has been discussed here (in the context of Section 9) and here (in the context of TDS).

ITAT Special Bench decision on 'Royalty'

The ITAT Special Bench decision in New Skies Satellites v. ADIT has resolved the conflict between two earlier decisions – Asia Satellite (85 ITD 478) and PanAmSat (9 SOT 100) – on the issue of “Whether on the facts and circumstances of the above mentioned cases the income from Bandwidth/transmission charges for uplinking/downlinking signals/data transmission through the use of transponders in the satellite is taxable in the hands of above mentioned foreign companies in accordance with provisions of the Income Tax Act read with relevant provisions of Tax treaties with respective countries…”

Three specific questions were referred to the Special Bench:

1. Whether the services rendered by the assessees through their satellites amount to ‘secret process’ or only ‘process’.
2. Whether the term ‘secret’ occurring in the phrase ‘secret formula or process’ in Explanation 2 to Section 9(1)(vi) of the Income Tax Act, 1961 qualifies the word ‘process’ as well as ‘formula’.
3. Whether the payment received by the assessees from their customers on account of use of their satellites for telecommunication and broadcasting amounts to ‘royalty’; and if so, whether the same is taxable under Section 9(1)(vi) read with the relevant DTAA provisions involved.

Importantly, the Special Bench held that the word “secret” does not qualify “process”; and therefore, “to fall within the meaning of royalty as envisaged in these provisions, it is not necessary that the services rendered must be through “secret process” only. Even services rendered through simple process will also be covered within the meaning of royalty.” The decision in PanAmSat was accordingly overruled.

I will post a detailed note on the decision shortly. The decision can be downloaded from this link.

Part VI - The Article 14 argument

(The earlier posts are available as Part I, Part II, Part III, Part IV and Part V)

It can further be contended that the proposed tax would be unconstitutional on the ground of being highly arbitrary and violative of Article 14 of the Constitution. This is so because in the proposed tax, there is no nexus between the measure of the tax and the nature of the tax. This has been held sufficient to strike down a taxing statute.

The Supreme Court has consistently held that the measure of the tax does not determine the nature of the tax. However, the measure must still maintain a nexus with the “essential character” of the levy and is a relevant consideration in judging the nature of the levy Where this is not the case, the Court has struck down the tax. For example, a tax purportedly on tea ‘estates’ was invalidated because the measure of tax was ‘despatches’ of tea (Buxa Dooars Tea Co. v. State of West Bengal, AIR 1989 SC 2015). Yet another example is provided in a case where the Bombay High Court held that the levy of entertainment tax under Entry 62 could not be on the basis of “gross capacity” but had to be related to the number of movies actually screened (Ramesh Waman Toke v. State of Maharashtra, AIR 1984 Bom 345). This reasoning was approved by the Supreme Court (Western India Theatres v. Cantonment Board, Poona, AIR 1959 SC 582). Although this was doubted subsequently in Express Hotels, AIR 1989 SC 1949, the Supreme Court held in that decision that the nexus is established only “if the levy can reasonably be said to be amenable to a potential conception…” In that case, the provision in question was s. 4 of the West Bengal Act which levied luxury tax on restaurants as a lump-sum for every square meter of area used for providing luxuries. If the restaurant could demonstrate that no luxuries were provided, the Act would not apply.

In the facts of the present case, the tax is sought to be justified as an income tax. The object being taxed, effectively, is the receipt of immovable property. The measure of the tax is however based not on any amount received, but on the stamp duty value of the property transferred. This measure can at best have a nexus with a tax on land, or a tax on transfer of property. As argued above in paragraphs 8-9, if the nature of the present tax is one of tax on property or a tax on land, then the same directly falls under List II and must be struck down on lack of competence. If the levy is one under List I, therefore, the inescapable conclusion is that there is no nexus between the nature and the measure.

Hence, the tax must fall on grounds of arbitrariness and unconstitutionality vis-à-vis Article 14.

(This concludes the series of posts of the constitutionality of the newly amended Section 56 of the Income Tax Act, 1961. I look forward to suggestions, opinions, criticisms, feedback on strengthening the arguments, and any other comments.)

Part V - Is it a tax on land and buildings?

(Part I is available here; Part II is available here; Part III is available here and Part IV is available here)

Even if the above arguments fail, it is still possible to consider that the present levy falls within the ambit of a tax on lands and buildings under Entry 49 of List II. Given the above reasoning on residuary powers, it must be held that Entry 49 of the List II which contemplates tax on land and buildings includes a tax on any aspect related to land and buildings. This would therefore contemplate a tax on the transfer of land and buildings as well. Therefore, the present levy is one which is chargeable to tax under Entry 49 of List II.

In fact, this particular reading of the nature of the proposed tax is strengthened considerably by the Notes on Clauses to the Finance Bill. The relevant portion of the Notes on Clauses indicates that “the proposed amendment seeks to tax specified properties… received without consideration”. Thus, admittedly in the Notes on Clauses itself, the tax is seen is substance to be one on certain properties. The properties concerned are immovable properties. Insofar as this applies to land and buildings, this would be squarely covered under Entry 49 of List II, which pertains to tax on land and buildings. This is in the exclusive legislative competence of the State Legislatures. On this ground alone, the proposed tax must fall.

Furthermore; the levy is also susceptible to an Article 14 challenge, as shall be discussed in the concluding Part VI.

'Income' tax on transfers of Immovable Property: Part IV - Nothing but a Stamp Duty?

(Part I is available here; Part II is available here; Part III is available here)

It is an accepted principle that entries must be read as broadly as possible. However, this cannot logically apply to the residuary entry also. Reading entries broadly means as a necessary logical consequence that the residuary entry must be read narrowly. In assessing whether Entry 97 would apply, it is essential to once again consider the nature of the proposed levy. It is submitted that the present levy can practically be seen to be nothing more than a levy of stamp duty. The Constitution includes a tax on transfer of movable property; but there is no specific entry pertaining to tax on transfer of immovable property. It is impossible to imagine that such an important source of revenue was not in the contemplation of the founding fathers. Thus, the power to levy a tax on immovable property must be taken to be covered under stamp duties.

Now, the power to levy stamp duty is in the Concurrent List (Entry 44, List III). However, the rates of stamp duty (in relation to immovable property) are a matter left to the competence of the States under Entry 63 of List II. Parliament has the power to legislate on rates on stamp duty only for the specific matters specified in Entry 92, List I. All other rates of stamp duty are under Entry 63 of List II. For transfers of immovable property, the rates of stamp duty would clearly fall within Entry 62 of List II. In the present case, the levy seeks to tax the transfer of immovable property. As explained earlier in this paragraph, ‘stamp duty’ must be taken to include taxes on transfers of immovable property. This means that Parliament is effectively seeking to levy an additional stamp duty. Disguising this as income is nothing but colorable legislation; as Parliament is effectively seeking to charge the rates of income tax on what is effectively a stamp duty. The Parliament cannot directly legislate on the rates of stamp duty. What Parliament cannot do directly, it cannot do indirectly either. Hence, levying a tax on the transfer of immovable property and disguising that as income cannot be permitted; as that would effectively mean that the Parliament can legislate on the rates of stamp duty – a subject which is the exclusive prerogative of the States.

In any event, the proposed levy would be a tax on land and buildings, within the legislative competence of the states under List II.

'Income' tax on transfers of Immovable Property: Part III - The Scope of the Residuary Entry

(Part I of this series is available here; Part II is available here)

The next question arises as to whether the tax can be justified under Entry 97, i.e. the residuary entry. It is an arguable proposition that a tax purportedly on income can only be justified under the entry pertaining to income. The contention can be taken, that if Parliament seeks to tax ‘income’ – and in the present case, this is manifestly the intention of Parliament – then the only relevant entry is the entry pertaining to income. What is sought to be justified as an income tax – if it is not actually a tax on income under Entry 82 – cannot be justified under the residuary entry. There is faint obiter in Kesavananda (Kesavananda Bharti v. State of Kerala, AIR 1973 SC 1461) supporting this proposition. The logic behind this is that the residuary entry was intended by the framers to be used in cases where the proposed law was on a subject-matter which could not be contemplated by the framers. Hence, the residuary entry must be given a narrow meaning. Further, as taxes on income was clearly a matter which was in the contemplation of the framers, what purports to be a tax on income must be assessed only vis-à-vis the income entry and not the residuary entry.

This line of argument can be strongly countered by other cases of the Supreme Court which allow for so-called ‘rag-bag’ legislations. For instance, the levy of excise duty on processing, bleaching etc. was challenged on the ground that this did not constitute ‘manufacture’ and that the law was therefore ultra vires Entry 84 on List I (which gives the competence to Parliament to levy excise duty). The Court held that the law would in any event be valid under Entry 97 since a piece of legislation can be defended with reference to more than one legislative Entry (Empire Industries, (1985) 3 SCC 314).

More recent decisions of the Supreme Court however seem to provide ground for arguing that if a tax is purported to be enacted under a specific entry, it must be tested on the touchstone of the essential elements of that entry itself. Thus, it has been held that the existence of ‘service’ is essential to the levy of service tax as a matter of legislative competence. This proposition draws some support from the decision in of the Supreme Court (Kalyana Mandapam (2004) 5 SCC 632). In that case, the question was whether the application of the Finance Act, 1994 to “mandap-keepers” was valid. The Court upheld the provision, but only because it found on facts that there was in fact the provision of service by mandap-keepers, such as lighting arrangements, furniture.

It therefore appears possible to argue that once a tax is purportedly of a specific nature under an Entry, then the competence of the legislature to enact that particular tax is to be assessed by reference to whether the elements of the directly relevant Entry are satisfied.

In the present case, the amendment proposes to widen the ambit of ‘income’ chargeable to tax – the amended provision specifically states that it seeks to charge income-tax. The directly relevant entry is therefore the one related to levy of income tax itself. The principles governing that Entry therefore cannot be deviated from. Accordingly, as what is sought to be taxed is not income, the legislation which purports to tax that as income must fall.

In any event, even assuming that Entry 97 can be relied upon counter to the arguments proposed thus far, it still needs to be noted that a law under Entry 97 will be constitutionally valid only if it is not one dealing with subject-matter under an Entry in another List. Hence in assessing whether the proposed levy falls under the residuary Entry 97, it must be seen whether the legislation can be justified under any entry either in the State List – List II – or the Concurrent List – List III. If it can be so justified, then recourse to Entry 97 would not be permissible. The next couple of posts will discuss this aspect.

'Income' Tax on Transfers of Immovable Property: Part II - Entry 82 and Entry 86 of List I

(Part I of this note is available here)

Entry 82:

The first question which arises is whether the proposed tax can be said to be a tax on income in terms of Entry 82. Essentially, the question turns on the meaning of ‘income’ under the Constitution. ‘Income’ has not been defined in the Constitution. Under the Income Tax Act itself, no clear definition of income is available. It has been held that the term ‘income’ is of a wide amplitude – anything which can properly be described as income is taxable unless specifically exempted (Emil Webber v. CIT, 200 ITR 483 SC).

At the outset, it is essential to clarify that the ambit and meaning of a constitutional entry cannot possibly be increased or changed by an Act of Parliament. If the definition of ‘income’ under the Income Tax Act were held to be determinative of the meaning of the term under the Constitution, then that would amount essentially to an Act of Parliament amending the content of Entry 82 itself. This would not be a permissible exercise of legislative power. This point is confirmed by analogies of sales tax and service tax. In the case of sales tax, it has been held that an artificial definition of ‘sale’ in an Act of the Legislature cannot alter the meaning of ‘sale’ under the Constitutional Entries dealing with taxes on the sale of goods (State of Madras v. Gannon Dunkerley, IX STC 353 SC). It was only after a Constitutional Amendment introducing the concept of ‘deemed sale’ in the Constitution itself vide Article 366(29A) that an artificial definition of ‘sale’ could be justified in terms of legislative competence. Indeed, the principle behind Gannon Dunkerley has been reaffirmed by the Supreme Court several times (see for instance BSNL v. Union of India, 282 ITR 273 SC). So too, in the case of service tax, the relevant legislative entry in List I is Entry 92-C. For recourse to this Entry, it is not the wording of the relevant legislation (in the case of service tax, the Finance Act, 1994) which is conclusive – what is sought to be taxed must in reality be a service if the tax is sought to be justified under Entry 92-C. By analogy, it is evident that what is sought to be taxed under the Income Tax Act must in reality be ‘income’ for the purposes of that tax to be sustained under Entry 82. Thus, it has been held that while ‘income’ in Entry 82 is to be read broadly, that does not mean that an amount which by no stretch of imagination can be called ‘income’, can be taxed under Entry 82. Entry 82 must refer to amounts which can rationally be said to be ‘income’ as generally understood (A. Sanyasi Rao v. Govt. of Andhra Pradesh, 178 ITR 31 AP).

This brings one to the conceptual understanding of ‘income’ – for it is only that conceptual understanding which would govern the scope of the term in Entry 82, and not any legislative definition.

The law being considered here is effectively one which seeks to levy ‘income’ tax on what is essentially a gift. The question therefore arises as to whether a gift can be said to be ‘income’. In particular, can the stamp duty value of immovable property received as a gift be treated as ‘income’ of the donee within the meaning of Entry 82? The answer to this question must be in the negative.

It has been held that voluntary payments made continuously, even if over a long period of time, without consideration and without any source of income depending entirely on the whim of the giver, are not income (Siddhartha Publications v. CIT, 129 ITR 603 Del). Income must refer to something which flows from property (Tuticorin Alkali v. CIT, 227 ITR 172 SC). Thus, for something to be categorized as income, it must flow from something which can properly be called a source. The donor of a gift cannot possibly be regarded as a ‘source’. It has also been held that when large sums of money are received by an assessee in India from abroad, the mere fact that moneys were received is insufficient to indicate the moneys received as the income of the assessee (CIT v. Sunita Vachani, 184 ITR 121 Del). Again, where an insurer was paying certain annuities to the wife of an ex-employee on a purely gratuitous basis, it was held that the same could not conceptually be ‘income’ (CIT v. Rajalakshmi Venkatakrishnan, 215 ITR 596 Mad.). Thus, there appears to be a clear distinction conceptually between ‘income’ and ‘gift’.

The Department seems to accept the position that gifts are not ordinarily income. In Circular No. 158 dated December 27, 1974, it was stated, “gifts of a purely personal nature will not be chargeable to income tax, except where they can be regarded as an addition to the salary or when they arise from the exercise of a profession or vocation.” Of course, the Circular left open the door for gifts to be taxed as income under an artificial definition provided by statute. Nonetheless, the statute itself must pass the test of constitutionality. On the question of the conceptual meaning or ordinary meaning of income – the meaning to be assigned to Entry 82 – it appears clear that gifts are not ‘income’. Thus, they cannot be taxed as such under Entry 82. Of course, it remains to be seen whether the receipts can be taxed under any other Entry.

Entry 86:

A receipt can well represent something which is neither income nor an addition of capital value. Indeed, it appears that a ‘gift’ is very much an ideal example of such types of receipts. Entry 86 talks about taxes on the capital value of the assets. The levy here does not even purport to tax the capital value of an asset. It proposes a tax on a receipt of a thing which cannot fairly be said to income. The levy of tax is on the receipt of the thing – the value of the asset concerned is sought to be used as a measure of tax. The proposed tax is not on the value of the asset – it is a tax on the receipt of the asset and the measure of the tax is sought to be arrived at by looking at the notional value of that asset.

Entry 86 may perhaps apply to capital gains tax. Coming to the proposed amendment, however, there are no capital gains involved in the mere receipt of an asset. The gains if any would arise on a subsequent transfer of the asset for consideration. Therefore, Entry 86 would have no application in the present fact scenario.

That leaves us with Entry 97, which will be discussed in subsequent posts.

'Income' tax on transfers of Immovable Property: Part I - Introduction to the Constitutional Issues

Introduction:

Section 26 of the Finance (No. 2) Act, 2009 added a sub-clause to Section 56 (2) of the Income Tax Act, 1961. Section 56 deals with “Income from Other Sources”. After the amendment, the relevant part of Section 56 (2) reads as under:

56 (2). In particular, and without prejudice to the generality of the provisions of sub-section (1), the following incomes shall be chargeable to income-tax under the head "Income from other sources", namely:-
…
(vii) where an individual or a Hindu undivided family receives, in any previous year, from any person or persons on or after the 1st day of October, 2009,-
…
(b) any immovable property,—
(i) without consideration, the stamp duty value of which exceeds fifty thousand rupees, the stamp duty value of such property;

Thus, among other things, the amendment has artificially expanded the definition of “income from other sources” so as to practically make transfers of immovable property without consideration subject to charge of income tax in the hands of the transferee. The constitutional validity of such expansion can be analysed as follows.

Under Article 246 of the Constitution of India, 1950, the Parliament has the competence to legislate on matters enumerated in List I of the VII Schedule to the Constitution. In analyzing the legislative competence of the Parliament to levy such a charge as is described in paragraph 1 above, reference must be made to Entries 82 and 86 of List I in the VII Schedule to the Constitution of India, 1950. Article 246 read with Entry 82 gives the Parliament the competence to legislate on “taxes on income other than agricultural income”; while Article 246 read with Entry 86 gives the Parliament the competence to legislate on “taxes on the capital value of the assets, exclusive of agricultural land, of individuals and companies”. Besides this, it will be necessary to consider the impact of Entry 97 of List I, which (when read with Article 246 and 248) indicates that parliament has the power to enact on any matter not enumerated under Lists II and III, including any tax not mentioned in those lists.

In the next few posts, I propose to argue that the levy under Section 26 of the Finance Act, 2009, (amending certain parts of Section 56 of the Income Tax Act), is unconstitutional.

Structure of these posts:

As stated above, the levy may be justified under Entries 82, 86 and 97 of List I. In the following posts, it is argued that “income” in Entry 82 would not contemplate this type of levy. It is argued that Entry 86 also would not include this type of levy. [See Part II]

The strongest arguments for upholding the validity of the levy are based on Entry 97 of List I, i.e. the residuary entry. In this connection, I argue that where a tax is purported to be of a specific type, only the directly relevant entry can be looked at. In other words, as the tax is overtly stated to be an income-tax, only the entry on taxes pertaining to income would be relevant. Hence, Entry 97 cannot even be relied on. However, this appears to be a weak argument – readers comments strengthening this argument are welcomed (and any other comments are welcomed too!); hence it is essential to consider whether the tax would fall under Entry 97, conceding that Entry 97 can be relied on. [See Part III]

For a law to be valid under Entry 97, it is essential that the law would in pith and substance not fall under any Entry in List II or List III. It is argued that the present taxis likely to fall under any one of two entries in List II. Under the Constitution, the power to tax movable properties is specifically granted; but the corresponding power to tax immovable properties is not. It is argued that such an important source of revenue could not have been missing from the minds of the drafters; as such, the entry on ‘stamp duty’ must be taken to include taxes on transfers of immovable property. In such cases, the power to tax is with the Union; however the power to decide on the rates of tax is with the States. By describing certain transfers as ‘income’; Parliament is effectively giving itself the power of deciding the rates as well. This means that Parliament is doing indirectly what it cannot do directly. It could not have directly decided the rates of stamp duty – under the doctrine of colorable legislation, it cannot do so indirectly by artificially bringing those transfers under ‘income’. The present legislation by artificially expanding the definition of income seeks to do just that, and is ultra vires on that ground. [See Part IV]

Assuming that this argument does not succeed, it is argued that the present tax must be considered in pith and substance to be a tax on lands and buildings. The power to tax lands and buildings must include the power to tax transfers thereof. In fact, the Notes on Clauses appended to the Finance Bill themselves accept that what is proposed is a “tax on certain properties”. The power to impose taxes on lands and buildings is with the State Legislatures under Entry 49 of List II. As such, the proposed levy is outside Parliamentary competence. [See Part V]

Further, it is possible to argue that the amendment must fail the test of Article 14 of the Constitution. There must be some nexus between the nature of tax and the measure thereof. In the present case, even assuming that despite the earlier arguments the actual nature is of a tax on income, then the measure is an artificial value of stamp duty value. Stamp duty value can be aid to have a nexus with a stamp duty, not with an income tax. Hence, it might be argued that the levy is arbitrary and unconstitutional under Article 14. [See Part VI]

As the argument is fairly long, I have broken it into several parts. Through this series of posts, I invite comments and opinions from all readers; and suggestions as to how the arguments can be strengthened further.

Socio-Legal Review: Call for Papers

The Socio-Legal Review, NLSIU, has released its call for papers for its forthcoming volume. The call is reproduced below:


The Socio-Legal Review (SLR) is a student-edited, peer-reviewed interdisciplinary journal published annually by the Law and Society Committee. The Journal aims to be a forum that involves, promotes and engages students and scholars to express and share their ideas and opinions on themes and methodologies relating to the interface of law and society. SLR thus features guest articles by eminent scholars as well as student essays, providing an interface for the two communities to interact.

The Journal subscribes to an expansive view on the interpretation of “law and society” thereby keeping its basic criteria for contributions simply that of high academic merit, as long as there is a perceivable link. This would include not just writing about the role played by law in social change, or the role played by social dynamics in the formulation and implementation of law, but also writing that simply takes cognizance of legal institutions/ institutions of governance/administration, power structures in social commentary and so on. Through this effort, the journal also hopes to fill the lacunae relating to academic debate on socio-legal matters among law students.

Contributions should be mailed only in a soft copy to slr@nls.ac.in, the subject of the mail being ‘Submission for 2010 volume’. Biographical information is to be provided in a removable title page. The Journal is accepting contributions for Articles and Short Articles. With reference to Articles, contributions should not ordinarily exceed 8000 words. With reference to Short Articles, contributions should not ordinarily exceed 3000 words. The Editorial Board reserves the right to reject without review manuscripts that exceed the word limit substantially. The last date for submission is January 31st, 2010.

SAT Decision on Takeover Regulations: Two Viewpoints

The Indian Corporate Law blog carries a couple of posts by two practitioners having divergent viewpoints on the correctness of a recent Securities Appellate Tribunal order in Narayanan v. SEBI, Appeal No. 139/2009 and a connected matter. Avinash Balsubramanium, a practicing lawyer based in Chennai, critiques the reasoning of the SAT here. Mr. Somashekhar Sundaresan, partner at J. Sagar, who appeared for the Appellant in the case, supports the SAT order here. Readers interested in securities litigation and the Takeover Regulations will find the linked posts interesting and informative.

The Enforceability of Multi-Tiered Dispute Resolution Procedures

A couple of previous posts discussed the validity of agreements to negotiate in good faith. It is noteworthy that the principles bearing on the validity of such agreements are often in question in relation to the jurisdiction of arbitration tribunals. This is because of the fact that several arbitration agreements contain clauses on mediation/negotiation. Parties in such multi-step or multi-tiered dispute resolution clauses agree to first negotiate; and failing negotiations, arbitrate the dispute. But is the clause requiring negotiation mandatory? Can arbitration be commenced without the former step? This question can often turn on the enforceability of the first step of the multi-step dispute resolution procedure. Just to conclude the discussion on good faith and agreements to negotiate, I thought it fit to highlight a few articles freely available on the internet in this connection.

1. An article available here analyses the common law position – particularly the English and Australian position – in depth.
2. Eric Suter, “The Progress from Void to Valid for Agreements to Mediate” [(2009) 75 Arbitration 28] discusses the enforceability of agreements to mediate in the context of multi-tiered dispute resolution clauses.
3. Klaus Berger, “The Law and Practice of Escalation Clauses” [(2006) 22 (1) Arbitration International 1] analyses the phenomenon of multi-step dispute resolution procedures; and includes a discussion on the leading cases on the point. The leading English cases discussed in the article include Cable & Wireless v. IBM, [2002] 2 All ER 1041; Channel Tunnel v. Balfour Beatty, [1993] 2 WLR 262; and Halifax Financial Services v. Intuitive Systems, [1991] 1 All ER 303.

'Pre-contractual' Understandings and the Duty to Negotiate in Good Faith

A previous post highlighted an ICSID case on how negotiations between parties can unexpectedly result in a binding legal relationship being formed. For any contractual liability to arise, it is essential that the parties must have an intention to enter into a legal relationship. This test – whether such an intention was present – will often be useful in determining whether “agreements in principle” or “memorandums of understanding” or like documents can – without any further contract – be enforceable under principles of contract law.

In seeing whether understandings reached by parties are binding, the remarks of Parker J in Von Hatzfeldt-Wildenburg v. Alexander [1912] 1 Ch. 284 appear to be relevant. According to him, the absence or presence of a binding contractual relationship depends on whether the preparation of a formal document was a condition of the contract; or whether the formal document was to be merely a record of the expressed will of the parties. In the former case, no binding contractual relationship exists; in the latter, it does. Under Parker J’s test, if the preliminary understanding is sufficiently definite, it will be presumed that parties intended to enter into a binding legal relationship. The leading Indian textbook, Pollock and Mulla, summarised the position by saying that what needs to be determined is “… whether the formal document is of such a nature that it was the very condition of the contract or whether it was commemorative of the evidence on the point…” (12th edn., page 213)

Insofar as the existence of a duty to negotiate in good faith is concerned; in an extreme form, the contents of this duty might be expressed thus:

“A party who manifests a willingness to enter into a contract at given terms should not be able to freely retract from her manifestation. The opposing party, even if he did not manifest assent, and unless he rejected the terms, acquires an option to bind his counterpart to her representation or charge her with some liability in case she retracts…”

(Omri Bin-Shahar, Contracts without Consent: Exploring a New Basis for Contractual Liability, 152 U. Penn. L. Rev 1829)

Common law is unlikely to recognise such a broad formulation of the duty. Indeed, since Routledge v. Grant (1828), it is settled law that a party is free to withdraw its offer, unless there is a consideration for the offer being kept open. Further, in Watford v. Miles [1992] 1 All ER 453, specifically, the House of Lords held that there could be no duty to negotiate in good faith for an undefined amount of time. This position is distinct from the position in many civil law countries – under civilian systems, offers cannot easily be revoked, unless they are made expressly subject to revocation. Civilian systems are, then, more likely to impose an obligation to conduct negotiations in good faith (this is covered within the civilian doctrine of ‘culpa in contrahendo’). The Convention on the International Sale of Goods (CISG) – born out of a compromise between common law and civil law systems – also recognizes such a ‘good faith’ obligation in Article 7. Nonetheless, it cannot be said that common law refuses to recognise any good faith obligation at all. For instance, an Australian case – Renard Constructions v. Minister for Public Works (1992) 26 NSWLR 234 – suggests that a duty to negotiate in good faith can be imposed on grounds of reasonableness. Claims may arise under quasi-contract principles too.

[Note: On the role of good faith in international sales transactions under the CISG, see John Klein, Good Faith in International Transactions. India is not yet a party to the CISG. On the advantages and disadvantages of ratifying the CISG, see this article]

'Agreements in Principle' and Binding Contractual Relationships

The Kluwer Arbitration Blog highlights a recent decision of the ICSID – Azpetrol International Holdings v. The Republic of Azerbaijan – which discusses important principles of contract law. Prof Andrew Newcombe has posted a note on the decision here; and he says:

"The question before the tribunal in Azpetrol was whether an exchange of emails between counsel for the parties resulted in a binding settlement agreement. Applying English contract law principles, the tribunal found that there was a binding settlement agreement. As a result, the tribunal held that it lacked jurisdiction under Article 25(1), ICSID Convention, because there was no longer a legal dispute between the parties. The award serves as a cautionary tale for counsel negotiating settlement agreements."

The decision is available here; and the relevant analysis of the Tribunal is found from page 24 (paragraph 67) onwards. This includes an interesting discussion of whether the requirement of ‘intention to create legal relations’ was present; and whether ‘agreements in principle’ are on their own binding. On this point the Tribunal noted:

"(The Tribunal) is not persuaded that the term “agreement in principle” is inevitably used in English law and in the practice of English lawyers to refer to a non-binding agreement. The Claimants did not produce any authority which went that far. The authorities on which they relied (Attorney-General of Hong Kong v. Humphreys Estate, [1987] AC 114; Cobbe v Yeoman Management Ltd., [2008] UKHL 55) show that the term can be used in that way but those cases concerned agreements for the sale of land, one of the rare cases in which English law provides that a contract must be evidenced in writing in order to be binding, and they do not suggest that the term is invariably used in that way. Similarly, the leading commentary (Chitty on Contracts) does not, in the Tribunal’s view, sustain the broad principle advanced by the Claimants."

A connected issue in this regard pertains to pre-contractual liability in general. What liability arises in pre-contractual negotiations? Is there a duty in common law to negotiate in good faith? The Harvard Law Review recently published an article in this regard authored by Professors Alan Schwartz and Robert Scott – “Precontractual Liability and Preliminary Agreements”.

Derivatives: Questions in Taxation and Contracts

A recent post on the Indian Corporate Law blog had highlighted a recent decision of the Income Tax Appellate Tribunal, Shree Capital Services v. ACIT. The decision dealt with the treatment of derivatives transactions in income tax law. The post is available here. Another analysis of the decision has recently been made available on ITAT Online.

Outside of tax, the legality of derivatives has been analysed in Rajshree Sugars by the Madras High Court. The decision contains a detailed analysis of the distinctions between a derivatives transaction and a wager. A note is posted here.

Service Tax and the Residuary Entry

In Home Solution Retail v. Union of India, the Delhi High Court was called upon to decide a challenge to a certain service tax notification. Essentially, the Court was asked to declare that a levy of service tax on renting of immovable property was ultra vires the Finance Act, 1994 (which levies service tax); and would in any event be ultra vires the competence of the Union Parliament. The High Court decision turned on the first aspect of the notification being ultra vires the Act, and the Court did not go into the question of the legislative competence of the Parliament. The decision has been discussed on the Indian Corporate Law blog by V. Niranjan.

As noted above, the decision leaves open the constitutional issue of whether the Union Parliament would have the competence to levy “service tax” on immovable property. The main question in this regard is whether Parliament has the power to levy service tax on activities in relation to immovable property under the residuary entry – Entry 97 of List I (Union List) of Schedule VII. A negative answer would be possible only if tax on activities in relation to immovable property would come under any of the State List (List II) entries. In a recent article, after discussing several aspects of the case, Mr. Arvind Datar, Senior Advocate, argues that such a levy would fall under Entry 49 of List II. He states:

Entry 49 of List-II should also receive the widest possible interpretation. The reference to “tax on land and buildings” will also include any incidental service that is rendered along with the building. If there is a building tax to be levied by the State Government, it will be difficult to argue that the State Legislature will not have the competence to levy tax on the amenities as well that are provided by the landlord. Once such a levy comes within the competence of State Legislature, it will be automatically excluded from List-I…

The full article is available here.

Indian Journal of Constitutional Law: New Issue and Online Symposium

Volume III (2009) of the Indian Journal of Constitutional Law is now out. The Journal is published by the Constitutional Law Society of NALSAR, Hyderabad; and is the leading specialist constitutional law journal in the country.

The Table of Contents can be accessed here; and the full-text of the articles should be available shortly. Among the pieces which I look forward to reading with interest is one by Prof. Kent Roach, “Judicial Review of the State’s Anti-Terrorism Activities: The Post 9/11 Experience and Normative Justifications for Judicial Review”. A release by the IJCL states, “In this article, Prof. Roach examines the inter-play between deference to the decisions of the Executive and Legislature and existing norms of Judicial Review in a context that has arisen of the post 9/11 era of Anti-Terrorism efforts. In doing so, he proposes that while Judicial Review of Anti-Terrorism measures can be justified by the need to protect the rights of unpopular minorities and the nature of proportionality review, the surge of such efforts owing to an increased need of security demands a certain amount of creativity in reviewing such efforts which ought to inevitably be influenced by deference to the decision making capacity of the other two organs of the State…”

In this context, an article in a recent issue of the National Law School of India Review might also be of relevance – Mrinal Satish and Aparna Chandra, “Of Maternal State and Minimalist Judiciary: The Indian Supreme Court’s Approach to Terror-related Adjudication. The abstract of that article says that “based on the contrast between two sets of Supreme Court decisions - decisions in terror-related cases (where national security is pitted against civil liberties) and decisions related to fundamental right in general – the authors make two arguments. First, that the Supreme Court has been inconsistent in its treatment of these two categories of cases – it has employed the minimalist approach in terror-related cases while adopting a less deferential approach in general Fundamental Rights adjudication. Second, that doing so, the Indian Supreme Court has been inconsistent…”

The Indian Journal of Constitutional Law is hosting an online symposium around these themes. According to the IJCL, “Prof. Christina Eckes from the Amsterdam Centre European Law and Public Policy, University of Amsterdam and Dr.Shylashri Shankar from the Centre for Policy research, India will be the Primary Respondents to Prof.Roach’s article and will challenge the propositions put forth by him as well as the normative justifications backing them. Ms.Aparna Chandra will be an additional Respondent.” More details are available here.

Update: The full-text of the current issue of the IJCL is now available here.

Duties of Non-executive Directors: A Recent Judgment

I have written a post on the Indian Corporate Law blog on a recent decision of the Inner House of the Court of Session in Scotland, Commonwealth Oil and Gas Co. v. Baxter and Eurasia. The case extensively discusses the previous case-law on the duties of directors, and also reaffirms the position that non-executive directors have the same fiduciary duties as executive directors. The post is available here.

The Supreme Court of the United Kingdom

The new Supreme Court of the United Kingdom has begun hearing cases earlier this month. The Supreme Court replaces the Appellate Committee of the House of Lords as the final Court of appeal in the United Kingdom. Lord Philips is the first President of the Supreme Court. Biographies of all the Justices are available here. More information on the Court is available on its website and also on Wikipedia. Prof. Andrew le Seur’s account of the events leading up to the formation of the Court is available here.

Lord Philips has expressed the reason for creation of the Supreme Court (according to a report in the Telegraph), saying, “For the first time, we have a clear separation of powers between the legislature, the judiciary and the executive in the United Kingdom. This is important. It emphasises the independence of the judiciary, clearly separating those who make the law from those who administer it. As Justices of the Supreme Court we will be more visible to the public than we ever were when sitting as members of the House of Lords. This is desirable as the court will only decide points of law of public importance.” Concerns have been raised, however, that the Supreme Court will – upon its formal separation from the House of Lords – take on an increasingly activist role.

It will be interesting to see whether these fears will come true – and if they do, whether the outcome would necessarily be undesirable.

Deciphering the Uneasy Relationship between Azadi Bachao and McDowell

Several posts on this blog have concentrated on the “substance over form” debate in the interpretation of documents in general; and over “substance over form” doctrines in taxation in particular. One question which has not been entirely clear is: to what extent does the decision of the Supreme Court in McDowell v. Commercial Tax Officer, AIR 1986 SC 649, (which allowed a deeper examination of economic substance over legal form) continue to override the later observations of a smaller Bench of the Supreme Court in Azadi Bachao Andolan, [2003] 263 ITR 706?

The main opinion in McDowell was delivered by Justice Ranganath Mishra. Most of the observations on substance-over-form, however, are to be found in the concurring judgment of Justice Chinappa Reddy. In Azadi Bachao, Justice Srikrishna used this to get around the otherwise binding judgment in McDowell. Commenting on Justice Chinappa Reddy’s view, Justice Srikrishna noted:

"…it does not appear that the rest of the learned Judges of the Constitutional Bench contributed to this radical thinking…"

Justice Srikrishna then went on to quote the following paragraph from Justice Mishra’s judgment in McDowell:

"Tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuges… "

Using this paragraph, Justice Srikrishna concludes on this point thus:

"This opinion of the majority is a far cry from the view of Chinappa Reddy, J… "

This is particularly interesting, if one were to examine Justice Mishra’s judgment in McDowell in its entirety. Here is what Justice Mishra actually says (the paragraph immediately after the one quoted by Justice Srikrishna is particularly interesting in this context):

"26. Tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay the taxes honestly without resorting to subterfuges.

27. On this aspect one of us, Chinnappa Reddy, J., has proposed a separate and detailed opinion with which we agree. "

Thus, while undoubtedly, Justice Chinappa Reddy’s opinion was a concurring opinion, the majority (per Justice Mishra) expressly agrees with that opinion! Given this, it would appear to be an arguable case that Azadi was decided per incuriam as it failed to note that the majority had expressly agreed with the concurring opinion on the point. Of course, this is not to say that Azadi is incorrect on principle; what I merely seek to highlight is that there is arguably a way around Azadi because of the binding precedent of McDowell.

However, a recent decision of the Bombay High Court appears to have foreclosed the Revenue from exploiting this precedent-based gap. In CIT v. Akshay Textiles, [2008] 304 ITR 401, Justice Rebello of the Bombay High Court has observed:

"…the ratio of McDowell as understood by the Supreme Court in Azadi Bachao Andolan is the law, considering that that is how the Supreme Court understood the ratio decidendi of the judgment in McDowell… "

Accordingly, it appears that Azadi has settled the position insofar as the substance-over-form debate is concerned, taking the view that the legal form of the transaction between the parties cannot be ignored for the purpose of ascertaining tax liability. It is no more possible for the Revenue to argue on McDowell’s reasoning – what survives of McDowell is only that part which emerged unscathed from Azadi. And that is perhaps true on precedent more generally.

The proper principle to be applied was stated in Indian tax jurisprudence as early as in 1953, by a Bench of the Bombay High Court of Chagla CJ and Tendolkar J in Provident Investment Co. v. CIT, [1953] 24 ITR 33. Their Lordships stated:

"…the authorities make it clear that it is not competent to the Court to look to the substance of the matter independently of the real transaction arrived at between the parties. If a transaction creates certain legal rights and obligations, then the Court must give effect to those legal rights and obligations and must not, overlooking these rights and obligations, try and fathom what was in substance the nature of the transaction entered into by the parties. The Court in not confined merely to looking to the form of the transaction. It is open to the Court to ignore the form and ascertain the real nature of the transaction. But while it is open to the Court to ignore the form, it is not open to the Court to overlook or to ignore the true legal position that arises out of a document or documents in which the parties have chosen to embody the transaction or transactions. "

Further, the position in Provident Investment Co. has not been changed; and has in fact been affirmed on several occasions by Courts in India. Justice Shah expressed the principle in even stronger form in CIT v. Raman & Co., [1968] 67 ITR 11:

"Avoidance of tax liability by so arranging commercial affairs that charge of tax is distributed is not prohibited. A taxpayer may resort to a device to divert the income before it accrues or arises to him. Effectiveness of the device depends not upon considerations of morality, but on the operation of the Income-tax Act. Legislative injunction in taxing statues may not, except on peril of penalty, be violated, but it may lawfully be circumvented… "

This view has been reiterated in Azadi, and continues to be good law. At least for now – if the Direct Taxes Code draft in its current form becomes law, India will probably have a substance-over-form regime even stronger than that contemplated in McDowell.

Can non-compliance with Accounting Standards be justified?

The relationship between the Accounting Standards and the “true and fair” standard has been discussed earlier on this blog. As stated in the earlier post, the Supreme Court’s observations in JK Industries v. Union of India, [2008] 143 Comp Cas 325 (SC), appeared to have settled the issue in Indian law. The Court had stated:

…implementation of the Accounting Standards and their compliance are made compulsory and mandatory by the aforestated sections 211 (3A), (3B) and (3C)… Before introduction of Sub-sections (3A), (3B) and (3C) in Section 211 (w.e.f. 31.10.98), these Standards were not mandatory. Therefore, the companies were then free to prepare their annual financial statements, as per the specific requirements of Section 211 read with Schedule VI. However, with the insertion of Sub-sections (3A), (3B) and (3C) in Section 211 the P&L a/c and the balance-sheet have to comply with the Accounting Standards … non-compliance with these Standards would lead to violation of Section 211 inasmuch as the annual accounts may then not be regarded as showing a "true and fair view”...

A recent decision of the Bombay High Court, however, indicates that the question is still an arguable one. In Re Hindalco, [2009] 94 SCL 1 (Bom): MANU/MH/0927/2009, Justice Khanwilkar observed:

On conjoint reading of Sub-sections (3A) and (3B) of Section 211, it necessarily follows that deviation from the accounting standards is permissible subject, however, to compliance of the requirement of disclosure in the profit and loss account and balance sheet of such deviation and the reasons for such deviation and financial effects thereof; in other words, deviation of accounting standards is not wholly prohibited, but is regulated by the provisions of Section 211 of the Act

In making these observations, the Bombay High Court did not refer to JK Industries. The Bombay High Court’s view is premised on the fact that Section 211(3B) itself states that where the accounting standards are not complied with, the company has to disclose certain particulars (such as the reasons and effect of the deviation). Thus, a consequence of non-compliance is provided for in the Act itself; non-compliance then, under the language of Section 211(3B), would be justified in some circumstances. This Supreme Court’s observations are to the effect that compliance with the accounting standards is inherent in “true and fair view” in Section 211(1) itself. The observation that “with the insertion of Sub-sections (3A), (3B) and (3C) in Section 211 the P&L a/c and the balance-sheet have to comply with the Accounting Standards” appears slightly unjustified; insofar as Section 211(3B) directly contemplates a situation of non-compliance. Furthermore, the observations of the Bombay High Court also appear to be in tune with the English position on the point, discussed in the earlier post.

In sum, the Bombay High Court’s decision seems to have reached the right conclusion on principle; however, non-consideration of the Supreme Court’s decision in JK Industries might render it per incuriam and non-authoritative.

(Another version of this note is posted on the Indian Corporate Law blog)

'Charitable Purposes' and the Proviso to Section 2(15)

ITAT Online reports a judgment of the Chandigarh Bench of the ITAT in Himachal Pradesh Environment Protection and Pollution Control Board v. CIT, dealing with the scope of the term ‘charitable purpose’ in Section 2(15) of the Income Tax Act.

A Proviso inserted in the definition of ‘charitable purpose’ in Section 2(15) by the Finance Act, 2008 was capable of creating uncertainty in the legal position of whether a trust would be treated as a charitable trust exempt u/S 11, if it earned some fees incidentally to its charitable functions. The decision of the ITAT clarifies the scope of the proviso. The Tribunal observed, “It is also important to bear in mind that the insertion of Proviso to Section 2(15) does not mean that in case an assessee is to receives any payment for anything done for trade, commerce or business, the assessee will be hit by the said proviso…” Reliance was placed on CBDT circular No. 11, dated 19th December, 2008 . In view of the decision and the CBDT circular, it appears that trusts would be excluded from ‘charitable purposes’ by the Proviso only when the charitable purposes are a “mask or a device to hide the true purpose which is trade, commerce, or business…”

On a different note, the Mumbai ITAT Bar Association digest of recent income tax cases, updated till September 2009, is available here.

EJIL Discussion on the Use of Force

The blog of the European Journal of International Law, EJIL: Talk!, is carrying an interesting series on whether American drone attacks on terrorist outfits operating in Pakistan are a violation of international law. The latest post is available here, but it appears that there will continue to be more posts on the issue on the blog. The posts provide for some interesting analysis on the law on use of force by states.

Readers may recollect that I had written two posts on the legal question of Pakistan’s responsibility for the Mumbai attacks. I had concluded in those posts that “it may be difficult for India to prove that the state of Pakistan itself is responsible for the Mumbai attacks... However, insofar as India alleges that ‘elements in Pakistan’ (not controlled by the state of Pakistan) are involved, the standard of proof which India must satisfy is much lower… the statements from Pakistan that there is ‘not sufficient evidence’ are misplaced... This means that although Pakistan is not responsible for the attacks themselves, it is responsible for allowing its territory to be used for the attacks. State Sovereignty includes – by necessary implication – an obligation not to allow a state’s territory to be used by non-state actors to carry out armed attacks against other states.” This analysis appears to be further substantiated in one of the posts on the EJIL blog, where Prof. Jordan Paust comments: “First, we can’t impute al Qaeda or Taliban attacks on our soldiers, which are continuous and well-known, to Pakistan merely because Pakistan is incapable of policing its territory. Pakistan would have “state responsibility” (but not “imputation” or “attribution” see Nicaragua v. U.S., 1986 I.C.J.)… so Pakistan could be subject to sanctions not involving the use of armed force if Pakistan financed or even tolerated such attacks (according to the 1970 UN General Assembly Dec. Principles of International Law, etc., and Nicaragua v. U.S., 1986 I.C.J.) unless Pakistan had effective control over al Qaeda or Taliban operations or later adopted them as its own (U.S. v. Iran, 1980 I.C.J.)…” This passage afford support for the view that by “tolerating” the attacks, Pakistan incurs some form of state responsibility; but not enough to attribute the attacks themselves to Pakistan.