Bombay High Court on Section 111A: Western Maharashtra Development v. Bajaj Auto

In Western Maharashtra Development Corporation v. Bajaj Auto Limited, Arbitration Petition No. 174 of 2006, decided on 15^th February, 2010 (the pdf version of the judgment is available here), the Bombay High Court has held that Section 111A of the Companies Act, 1956 mandates that there can be no restriction whatsoever on the transferability of shares in a public company. Consequently, an agreement granting a right of pre-emption in respect of some such shares has been held as patently illegal. Justice D.Y. Chandrachud held, “The principle of free transferability must be given a broad dimension in order to fulfill the object of the law. Imposing restrictions on the principle of free transferability, is a legislative function, simply because the postulate of free transferability was enunciated as a matter of legislative policy when Parliament introduced Section 111A into the Companies' Act, 1956. That is a binding precept which governs the discourse on transferability of shares. The word "transferable" is of the widest possible import and Parliament by using the expression "freely transferable", has reinforced the legislative intent of allowing transfers of shares of public companies in a free and efficient domain… The effect of a clause of preemption is to impose a restriction on the free transferability of the shares by subjecting the norms of transferability laid down in Section 111A to a preemptive right created by the agreement between the parties. This is impermissible…”

The argument was taken that a right of pre-emption in an agreement between two parties, embodied in the Articles of Association of the company, bound only the two specific parties and was not a general restriction on transferability. This argument was rejected. The judgment of the Supreme Court in Madhusoodhan v. Kerala Kaumudi (which in turn had distinguished on facts the earlier decision in V.B. Rangaraj v. Gopalkrishnan) was held to be applicable only to private companies. The Bombay High Court followed the judgment of the Delhi High Court in Pushpa Katoch v. Manu Maharani Hotels in reaching its conclusion. It noted, “56. Counsel appearing on behalf of the Respondent submitted that Section 111A has no application to contracts for the transfer of particular shares between particular shareholders when incorporated in the Articles of Association. The submission is that restrictions which bind third parties are bad. Section 111A was intended to curb the power of the Board of Directors to obstruct transfers and clearer words would be required to destabilize bargains which are the heart of commerce. 57. The submission that Section 111A would not interdict "an agreement between particular shareholders relating to the transfer of specified shares" is based on the judgment of the Supreme Court in Madhusoodhanan (supra). In that case, as already noted earlier, the Supreme Court noted that the Karar was an agreement between "particular shareholders relating to the transfer of the specified shares". What is significant is that the Company in that case was a private Company. The Supreme Court noted with some emphasis that in the case of a private Company, the Articles of Association would restrict the right of shareholders to transfer shares and prohibit invitation to the public to subscribe for shares or debentures of the Company. The position in law of a Public Company is materially different. By the provisions of the Companies' Act, 1956, restrictions on the transferability of shares which are contemplated by the definition of a "private company" under Section 3(1) (iii) are expressly made impermissible in the case of a public company by the provisions of Section 111A. Once that be the position, the submission urged on behalf of the Respondent cannot be accepted. In essence, the submission of the Respondent is that the provisions of Section 111A should be read as being subject to a contract to the contrary. A restriction to that effect cannot be read into the provision of Section 111A; firstly because, such a restriction is not mentioned in the statutory provision; secondly, the word "transferable" is of the widest import; and thirdly, the context in which the provision has been introduced, is susceptible to the inference that it should be given a wide meaning. Where the language of the statute is plain and unambiguous, neither the consequence nor the conduct of parties would be of relevance…”

The implications of the judgment are discussed by Mr. Somashekhar Sundaresan in his post on Indian Corporate Law. I will analyse the judgment in another post subsequently.

Taxation and the Budget: An Initial Assessment of the Finance Bill, 2010

From the perspective of taxation (particularly income tax and service tax), the budget proposes changes in several areas. Importantly, the Finance Minister has clarified that the Direct Taxes Code will be introduced from 1^st April, 2011. The GST will also be sought to be implemented from that date. In this post, I shall look at a few issues in income tax and service tax that may arise out of the Finance Bill, 2010.

The definition of “Charitable purposes”:

A Proviso added to the explanation to Section 2(15) of the Income Tax Act by the Finance Act, 2008, had resulted in some confusion as to whether an institution which incidentally earned some fees in connection to its charitable activities would be entitled to take advantage of the benefits granted to charitable institutions. In Himachal Pradesh Environment Protection and Pollution Control Board v. CIT, the Income Tax Appellate Tribunal had held that the Proviso only excluded those institutions in which the charitable purpose was a “mask” or a device to hide the true purpose of trade and commerce. Thus, the test under the Proviso in determining whether an institution advanced an object of general public utility and was a charitable institution or not; was whether or not the charitable purpose was a mask to shield commercial activities or not.

The Finance Bill, 2010, adds a further Proviso that “the advancement of any other object of general public utility” shall continue to be a “charitable purpose” if the total receipts from any activity in the nature of trade, commerce or business, or any activity of rendering any service in relation to any trade, commerce or business do not exceed Rs.10 lakhs in the previous year. The interpretation of this may result in some ambiguity. The new Proviso is sought to be inserted with retrospective effect from 1^st April, 2009.

The Revenue can perhaps argue that this further Proviso indicates that the test for whether the first Proviso applies or not; is not whether the charitable activity is a “mask” for commercial activities. Instead, the first Proviso would apply in every case where fees are earned by the institution, except (as per the second Proviso) where the fees do not exceed Rs. 10 lakh. It seems a possible construction that in every case where fees received exceed Rs. 10 lakh; the first Proviso would apply – even if the charitable purpose is not a mask for commercial activities. The newly inserted Proviso seems to indicate, in other words, that the test is not just of what the true nature of the activities of the institution is, but is instead a blanket test applicable to all institutions which earn fees from charitable purposes – whether the charitable purpose is a device or not, is immaterial. If the fees received are over Rs. 10 lakhs, the institution would not be carrying out a charitable purpose.

Assessees can, of course, argue that the second Proviso is an additional test to satisfy; over and above the test that the charitable purpose is a mask. That interpretation would mean, however, that those activities which are simply a mask or a device for commercial purposes, would still be entitled to take the benefit of “charitable purposes” if the fees they earn are less than Rs. 10 lakhs. The Memorandum accompanying the Finance Bill seems to indicate that the construction in favour of the Revenue is the true intent behind the Bill. It specifically refers to the “absolute restriction” imposed by the First Proviso. As a matter of policy, however, there may not be a strong reason to say that an organization which carries out genuine charitable activities is not established for a charitable purpose if incidental to its activities it earns some fees. What view the judiciary will take of the effect of the new Proviso is a matter which remains to be seen after the enactment into law of the Bill.

Section 9:

The controversy in the taxation of non-residents in interpreting Section 9 of the Income Tax Act has been discussed on several occasions earlier. Essentially, under the judgment of the Supreme Court in Ishikawajima, for Section 9(1)(vii) to be applied in order to say that fees for technical services are deemed to accrue or arise in India, it is essential that the service is both rendered and utilized in India. An Explanation was inserted in 2007 attempting to modify this rule. However, as was held by the Karnataka High Court in Jindal, on a plain reading, the Explanation did not do away with the principle of Ishikawajima. This Explanation is sought to be replaced by a new one, again with retrospective effect from 1976. The new Explanation specifically states that it is not necessary that the services should be rendered in India. On its text, it is now clear that the rule in Ishikawajima is not good law.

There may perhaps be a constitutional challenge open to the new Explanation, as being  in violation of territorial nexus requirements – it is debatable whether that challenge would succeed. It is unclear as to how strongly the nexus doctrine would apply to a Union law; and in any case, the mere existence of a nexus is sufficient (the strength of the nexus not being relevant). The Union can well contend that even now, services must be utilized in India even if not rendered in India, and that constitutes territorial nexus. If the Explanation stands as it presently is post-enactment, one thing would be clear: the income of a non-resident shall be deemed to accrue or arise in India under Sections 9(1) (v), (vi), and (vii) whether or not (i) the non-resident has a residence or place of business or business connection in India; or (ii) the non-resident has rendered services in India.

LLPs:

The Finance Bill proposes to clarify that the transfer of assets on a conversion of a company into a Limited Liability Partnership will not be regarded as a transfer of assets for the purpose of capital gains, if certain conditions are met. These conditions include that the company’s total sales, turnover or gross receipts in the three previous years should not exceed Rs. 60 lakh. Thus, for companies not within that limit, a conversion to a limited liability partnership will result in capital gains liability. Several other conditions are also mentioned. Furthermore, under Section 115JAA as it now stands, certain tax credits are allowed to companies which are covered under Section 115JA and 115JB for MAT purposes. This credit will not be allowed – under the proposed sub-section (7) to Section 115JAA – to successor LLP’s on a company’s conversion to an LLP.

Procedure:

There was a controversy between some High Courts about whether a High Court has the power to condone delays in filing appeals under Section 260A of the Income Tax Act. The weight of authority suggested that there was no such power to condone delays under Section 260A. The Bill gives High Courts the power to condone delays, with retrospective effect from 1^st October, 1998. This is likely to lead to a huge flood – literally, thousands – of applications for restoration of appeals which were dismissed on account of delay.

Service tax:

The Delhi High Court had held in Home Retail that the renting of immovable property on its own would not constitute a service. The Finance Bill, 2010 indicates that renting of immovable property itself would be a taxable service under the Finance Act, 1994. This amendment is also retrospective, with effect from 1^st June, 2007. Furthermore, as the accompanying Memorandum states, under the existing law in relation to service tax, IT software services are included as taxable services only in those cases where the service is used in furtherance of business or commerce. This limitation is sought to be dropped by amending Section 65(105)(zzzze) of the Finance Act, 1994 – information technology software service will be taxable services irrespective of the use to which the service is put to.

______

In sum, in both service tax and income tax, the Finance Bill, 2010 continues the trend of the legislature to upset judicial decisions by retrospective amendments. There are some changes sought to be introduced in terms of income tax slabs, higher TDS limits have been made available, and the rate of MAT has been increased. From a legal viewpoint, several proposals merit greater debate and scrutiny.

Does a Landlord retain Possession over leased property?

In an earlier post distinguishing between a lease and a licence, it was seen that the basic difference between the two is that a lease creates an interest in the property; and there is no such interest created through a licence. In a recent judgment, the Supreme Court has held that a landlord remains in legal possession of his leased property. The question before the Supreme Court in Sadashiv Shyama Sawant v. Anita Anant Sawant was basically this: “where a tenant in exclusive possession is dispossessed forcibly by a person other than landlord, can the landlord maintain a suit under Section 6 of Specific Relief Act, 1963 against such person for immediate possession?” Section 6 of the Specific Relief Act allows a person “dispossessed” to maintain a suit for recovery of possession. A clear requirement is, then, that the plaintiff must have juridical possession over the property, before he can maintain a suit under Section 6. 

In sum, the Court has held that a landlord who is undoubtedly the owner continues to be in legal possession even when the property is leased to a tenant who is in “exclusive possession” of the property. In effect, “exclusive possession” can only refer to actual physical, and not legal, possession. I will comment in detail on this reasoning in a subsequent post.

In the words of the Court, “As noticed above, the views of the High Courts differ about maintainability of suit for possession by the landlord under Section 9 of 1877 Act in respect of property let out to the tenant who has been dispossessed forcibly by a third party. That language of Section 6(1) of the Act and first paragraph of Section 9 of 1877 Act is exactly identical admits of no doubt. The key words in Section 6(1) are "dispossessed" and "he or any person claiming through him". A person is said to have been dispossessed when he has been deprived of his possession; such deprivation may be of actual possession or legal possession. Possession in law follows right to possession. The right to possession, though distinct from possession, is treated as equivalent to possession itself for certain purposes... A landlord by letting out the property to a tenant does not lose possession as he continues to retain the legal possession although actual possession, user and control of that property is with the tenant. By retaining legal possession or in any case constructive possession, the landlord also retains all his legal remedies. As a matter of law, the dispossession of tenant by a third party is dispossession of the landlord...”

3rd NLSIR Symposium on Corporate Law and Governance

The National Law School of India Review (NLSIR), the flagship journal of the National Law School of India University, Bangalore, will be hosting the 3^rd Annual NLSIR Symposium, 'Indian Corporate Law and Corporate Governance: At the Crossroads', in Bangalore, on 10^th and 11^th April, 2010. Extracts from the concept note for the Symposium may be of interest to our readers.

__________________

The 1st NLSIR Symposium, ‘Challenges to India’s Patent Regime’, and the 2nd Symposium, ‘Towards Unification: Perspectives on International and Investment Arbitration’, saw participation from members of the judiciary, leading practitioners, academics and students. Among the participants in the previous Symposia were Justice Ar. Lakshmanan, Justice P. Naolekar, Justice Jayasimha Babu, Justice N. Kumar, Mr. Arvind Datar, and Mr. Gourab Banerjee.

The 3^rd NLSIR Symposium seeks to address crucial issues in contemporary corporate law and governance. There is no more appropriate time to consider this area of law. The Satyam episode has provoked widespread concerns regarding Indian corporate governance mechanisms. Even outside the area of corporate governance, it is necessary to ask whether the 1956 Companies Act continues to serve the interest of Indian corporations, their stakeholders and the Indian public. Does the proposed Companies Bill even begin to address these questions? What is the fate of the National Company Law Tribunal (NCLT) and company adjudication generally? These are some of the questions that it is necessary to urgently resolve, to understand the journey Indian company law has had over the past fifty years, and the course it must chart in the future. The four Sessions of the Symposium will seek to analyse these and other related issues.

The Sessions:

The First Session looks at the role of the corporate vehicle in tax planning. This is among the crucial issues facing Indian tax law today; as exemplified through the Vodafone tax controversy. When does the use of the corporate form cross the line between permissible tax planning and impermissible evasion? The Second Session looks at issues pertaining to the role of the independent director and the statutory auditor. In the backdrop of the Satyam scandal, questions have arisen as to the appropriate role of independent directors and auditors in maintaining and evolving corporate governance norms. These questions will form the focus of the Second Session. The Third Session looks at company adjudication and the ‘tribunalisation’ of justice. With the NCLT case still pending before the Supreme Court, it is time to ask what form of adjudicatory mechanism will best serve the needs of India today. Further, are typical remedies of oppression/mismanagement sufficient to protect shareholders? It is time to evolve new forms of remedies; as done recently in Hong Kong in the form of multiple derivative actions? What is the role and extent to which Courts should interfere in commercial arrangements in order to protect minority shareholder interests? The Fourth Session of the Symposium seeks to undertake a holistic analysis of the Companies Act, 1956. Does the new Bill actually show promising signs? What more can be done – if anything at all needs to be done – to refashion company law and corporate governance to meet the challenges posed in today’s commercial scenario?

The Panelists:

Panelists at the Symposium include Mr. Sandip Bhagat (partner, S&R Associates), Mr. V. Umakanth (former partner Amarchand Mangaldas and Ph.D. scholar, National University of Singapore), Mr. Somashekhar Sundaresan (partner, Jyoti Sagar Associates), Mr. Siddharth Raja (partner, Narasappa, Doraswamy and Raja) and Ms. Kristin van Zwieten (D. Phil. scholar, University of Oxford). Leading members of the Bar and from the judiciary are also expected to attend.

Submissions and Participation as Delegates:

The NLSIR invites contributions of up to 10000 words on any of the themes to be discussed in the Symposium. Selected papers will be presented by the authors at the Symposium and will be published in the Symposium issue of the NLSIR. Contributions, and requests for any further information, may be mailed to mail(dot)nlsir(at)gmail(dot)com.

Practitioners, academicians, corporate houses and students are invited to register as delegates. Further details will be available on request. Special packages are available for group registrations. Interested readers can contact the Organising Committee of the Symposium at the above email addresses.

Writing of Bad Debts: Commercial judgment given primacy

One of the recent controversies in income tax is related to the treatment of bad debts. Does an assessee have to prove, as a matter of fact, that a debt has become irrecoverable before it can be written off as a bad debt; or is it enough if the debt is written off as bad in the books of account? The Supreme Court has settled the question of law in favour of the assessee, by preferring the latter interpretation.

Prior to 1989, the relevant provision in the Income Tax Act, Section 36(1)(vii), allowed deductions of “any bad debt, or part thereof, which is established to have become a bad debt in the previous year…” The 1989 amendment replaced this with “any bad debt, or part thereof, which is written off as irrecoverable in the account of the assessee for the previous year…” The intent of the legislature – it appears clear from the amendment – was to respect the commercial judgment of the assessee in treating a debt as ‘bad’ in the books of account; without the assessee having to establish that the debt was in fact irrecoverable.

This reading of the amendment was preferred by the Special Bench of the Income Tax Appellate Tribunal in DCIT v. Oman International Bank. This was then approved by the Bombay High Court in DIT v. Oman International Bank, with the caveat that the entry in the books of account must be bona fide. The issue was then considered in CIT v. Kohli Brothers by the Allahabad High Court. As ITAT online reports in a summary of that case, the High Court held that “The effect of the amendment to s. 36 (1) (vii) is that it is not necessary for the assessee to establish that the debt had become bad in the previous year and mere writing of the debt as irrecoverable is sufficient. However, the said entry of write off of the bad debt in the books of accounts is not conclusive and the AO is not precluded from making inquiries as to whether the entries are genuine and not imaginary or fanciful. The AO has the power u/s 143(2) to see that the entries are not mere paper work or fake…” Thus, while the entries in the books of account are enough to suggest that prima facie there is a bad debt; the AO can go behind those entries to see if the debts are actually bad. One reading of the Allahabad High Court would be to suggest that the High Court held that the 1989 amendment only shifted the burden of proof; and did not change the position substantively. The Bombay High Court’s judgment in Oman seems to support this reading, as the Court has stated that after the 1989 amendment, the burden is not on the assessee to show the debt is “bad”. In order to disallow the deduction, the AO must show that the decision of the assessee was not bona fide. Again, this can be treated as going to the issue of burden of proof.

In TRF Ltd. v. CIT, the Supreme Court seems to have rejected this reading. The Court has clarified, “After 1^st April, 1989, it is not necessary for the assessee to establish that the debt, in fact, has become irrecoverable. It is enough if the bad debt is written off as irrecoverable in the accounts of the assessee.” Arguably, even an enquiry into the reasons behind the entry is not to be undertaken after the Supreme Court decision. This is because the decision to treat a debt as bad or not is a purely subjective commercial decision for the assessee in question to take. The fact that no further enquiries are to be made gets further support as the matter was remanded by the Supreme Court to the AO to consider solely whether the requisite entry appeared in the books of account. The Court has not left open the possibility to the AO to go behind the entry to ascertain the genuineness thereof. In the words of the Court, “… in the present case, the Assessing Officer has not examined whether the debt has, in fact, been written off in accounts of the assessee. When bad debt occurs, the bad debt account is debited and the customer's account is credited, thus, closing the account of the customer. In the case of Companies, the provision is deducted from Sundry Debtors. As stated above, the Assessing Officer has not examined whether, in fact, the bad debt or part thereof is written off in the accounts of the assessee. This exercise has not been undertaken by the Assessing Officer. Hence, the matter is remitted to the Assessing Officer for de novo consideration of the above-mentioned aspect only and that too only to the extent of the write off.”

For another reading of Kohli Brothers, reconciling it with Oman, see this post on Indian Corporate Law. Following the Supreme Court judgment, Kohli Brothers must be restricted to this reading or must be considered as being impliedly overruled. If Kohli Brothers is given a restricted scope, the position then would be, as noted in the above post, “Oman and Kohli Brothers can be reconciled on the basis that the first allowed the deduction since the persons with respect to whom the debt was written off were known, while Kohli Brothers did not because the assessee furnished no information whatsoever as to the identity of the persons involved. This is also consistent with the principle that commercial judgment is relevant in determining when a debt is considered “bad”, not in determining whether there exists a person who owes a debt.” This harmonious reading would not be affected by the Supreme Court decision in TRF; as the Court is quite clear that the identity of the debtor should be evident in the books (this is clear from references to “the customer’s account”). In other words, the entry can be treated as not being bona fide only if even the identity of the alleged debtor is not shown in the books of account. If the identity is shown, the entry would be bona fide and the decision to treat the debt as bad would be a matter left for commercial judgment.

In sum, the judgment of the Supreme Court in TRF clarifies that the decision to treat a debt as bad is a commercial decision to be taken by the assessee; and the scope for interference with the judgment is almost non-existent.

Secretary of State v. Neufeld: The Corporate Veil Revisited

Issues relating to the ‘corporate veil’ and concepts such as lifting the corporate veil have been previously discussed here. The Court of Appeal has in a recent decision reiterated the sanctity of the corporate form. The decision, Secretary of State v. Neufeld, is available here; and V. Niranjan has posted a note on the case on Indian Corporate Law, accessible here.

The issue in Neufeld arose in the context of employment-related legislation; and the Court was required to determine the status of a controlling shareholder who also had a contract of employment with the company. The Court observed after reviewing the authorities on the corporate veil, “There is also no reason in principle why someone whose shareholding in the company gives him control of it—even total control (as in Lee's case)—cannot be an employee. In short, a person whose economic interest in a company and its business means that he is in practice properly to be regarded as their “owner” can also be an employee of the company…” The only exception to this is when the contract is a sham as a matter of law. As Niranjan explains in his note, “… ‘sham’ is a legal, not economic, concept and only requires the Court to determine whether the legal substance of the relationship between the parties is what it purports to be. For example, if A and B enter into an agreement that is called a “Licence Agreement”, a Court is bound to examine whether the terms of the agreement are characteristic of a licence. However, the Court cannot look to whether in “economic reality” the party acquires something other than the rights of a licensee. In this instance, if the court finds that the contract is neither a sham and is a valid or true contract of employment, the employment legislation will apply…”

The strength of the observations of Neufeld – that what matters is the legal and not the economic substance – have arguably been watered down in a later decision. In Agahi v. Department of Employment, the Industrial Tribunal analysed the facts by saying, “Mr Agahi also took considerably reduced sums by way of salary during other periods.  It is difficult to conceive of genuine employees accepting such an arrangement on a prolonged basis.  The fact that some payments were being made to the claimants out of other loans to the company also seems to me to be inconsistent with employee status. The provisions relating to holidays and holiday pay again did not reflect the reality of the situation.  Mr Agahi regarded himself as entitled to time-off in lieu, for which there was no express provision…”

It is submitted that the Industrial Tribunal in this later case has not paid due regard to the distinction between ‘legal’ reality and ‘economic’ reality – what Neufeld (and the other authorities on point allow) is for the Court to look into the former; not the latter.

TDS u/s 195: Samsung Electronics in the Supreme Court

We have discussed the issue of TDS several times on this blog; and have also discussed a recent judgment of the Karnataka High Court in Samsung Electronics, which holds that deduction must be made u/s 195 of the Income Tax Act, 1961, on all sums paid to a non-resident, irrespective of the chargeability of the sum. As was argued in the earlier posts, this view merits reconsideration and seems to be based on a questionable reading of the statute, as well as of the Supreme Court decision in Transmission Corporation. In a development which will give some hope to taxpayers, the Supreme Court has issued notice to the Department on the SLP filed by Samsung Electronics. However, the Bench of Justice Kapadia and Justice Swatanter Kumar has not stayed the judgment of the High Court at this juncture. Final hearings in the matter are scheduled in August 2010. The order of the Supreme Court can be downloaded from this link.

Service Tax and Works Contracts

A recent decision of the Punjab and Haryana High Court Commissioner of Central Excise v. Vahoo Colour Lab clarifies the scope of service tax in the context of works contracts. Issues around works contracts have been controversial in relation to income tax as well as sales tax. The controversy in income tax law (in relation to TDS under Section 194C) has been discussed here; and the issue of sales and service tax on software has been discussed here. Insofar as sales tax is concerned, the controversy has been over legislative competence. Certain contracts – works contracts being one such example – have elements of transfer of property as well as service. Are they to be taxed, then, as a sale of goods or as a rendering of services? The difficulty arises because the States have the competence to tax sales of goods; while the Union has the competence to tax services.

The issue was discussed by the Supreme Court elaborately in the context of building contracts, in State of Madras v. Gannon Dunkerley, AIR 1958 SC 560. The Court held that the concept of ‘sale’ must be given its legal understanding for the purposes of ascertaining legislative competence; and involved three elements – (a) the objective existence of goods; (b) the intention of the parties to transfer title in those goods; (c) actual transfer of title in furtherance of that intention, supported by consideration. It was held that a tax on an alleged sale of goods in building contracts would be outside the legislative competence of states. In an elaborate judgment, Justice Venkatrama Aiyar said, “We are… of opinion that on the true interpretation of the expression "sale of goods" there must be an agreement between the parties for the sale of the very goods in which eventually property passes. In a building contract, the agreement between the parties is that the contractor should construct a building according to the specifications contained in the agreement, and in consideration therefore receive payment as provided therein… there is in such an agreement neither a contract to sell the materials used in the construction, nor does property pass therein as movables. It is therefore impossible to maintain that there is implicit in a building contract a sale of materials as understood in law…” Applying this logic, a typical works contract would not involve a sale of goods.

Subsequent to the decision, Article 366(29A) was inserted into the Constitution of India, which laid down several categories of ‘deemed’ sales. It was provided that a “tax on the sale or purchase of goods” would include inter alia a “tax on the transfer of property in goods (whether as goods or in some other form) involved in the execution of a works contract.” To this extent, then, the decision in Gannon Dunkerley was overridden. It must be stressed, however, that the principle of Gannon Dunkerley would continue to apply outside of the specific categories mentioned in Article 366(29A). As Justice Ruma Pal stated in BSNL v. Union of India, “Gannon Dunkerley survived the 46^th Constitutional Amendment in two respects. First with regard to the definition of 'sale' for the purposes of the Constitution in general and for the purposes of Entry 54 of List II in particular except to the extent that the clauses in Article 366(29A) operate. By introducing separate categories of 'deemed sales', the meaning of the word 'goods' was not altered. Thus the definitions of the composite elements of a sale such as intention of the parties, goods, delivery etc. would continue to be defined according to known legal connotations…” The only change is where the amendment specifically includes the concept of deemed sales. Works contracts are one such element; and states do have the competence to levy sales tax on works contracts. The extent of taxability was again discussed by the Supreme Court in Imagic Creative, (2008) 2 SCC 614.

Imagic dealt with whether the charges collected towards the services for evolution of a certain design, on which service tax had been paid under the relevant provisions of the Finance Act, 1994 were also liable to tax under the Karnataka Value Added Tax Act, 2003. The Court held, “Payments of service tax as also the VAT are mutually exclusive. Therefore, they should be held to be applicable having regard to the respective parameters of service tax and the sales tax as envisaged in a composite contract as contradistinguished from an indivisible contract. It may consist of different elements providing for attracting different nature of levy. It is, therefore, difficult to hold that in a case of this nature, sales tax would be payable on the value of the entire contract; irrespective of the element of service provided.” Thus, the Court held that sales tax would not be payable on the entire value of the contract – the service element must be calculated; and sales tax would be payable on the remainder.

Before the Punjab and Haryana High Court, the question was similar – except that here, the Court had to determine the extent to which service tax would be payable (as opposed to the extent of sales tax as in Imagic). The case involved the question of “whether the assessee is liable to pay the service tax on the value of goods/material consumed, during the course of processing of photography or not…” The Court began by noting that the photography contract was to be treated as a works contract [this is settled law now, but earlier there was a controversy – see Rainbow Colour Labs, 118 STC 9 (SC) and Associated Cement v. Commissioner of Customs, 2001 JT (2) SC 141]. Next, it interpreted BSNL as having laid down the principle that “if the nature of transaction involved is composite contract, of service and sale and if the components of sale element are discernible, then both the components cannot be re-mixed for the purpose of relevant tax.” Consequently, a result analogous to Imagic was reached; and the Court held that service tax and sales tax operate in two different spheres; and service tax would be payable only on the service component and not the whole amount of the consideration.

The decision illustrates that as a matter of law, the confusion in this area is on its way to being cleared. Nonetheless, there might still be several difficulties in ascertaining what part of the consideration is to be attributed to the service element and what part is to be attributed to the sale element. Hopefully, these difficulties will be cleared by the comprehensive Goods and Services Tax.

Clarifying the law on the Liability of Auditors

The issue of the liability of auditors for negligence has been debated heavily in recent times; with the decision of the House of Lords in Moore Stephens being among the more recent pronouncements on the issue. The decision has been discussed in posts on this blog and elsewhere. In short, in Moore Stephens, the House of Lords restricted the liability of auditors, by allowing them to rely on the ex turpi causa principle in a claim by the company. Effectively, their Lordships held that when a company is guilty of a fraud, then it can bring no claim against auditors for negligence even if the very thing which the auditors were supposed to do was detect that fraud.

But when will a company be guilty of fraud? When will it have the mental state required for a person to act fraudulently? The short answer is that the knowledge of the company’s directing mind will be attributed to the company. The fraud of the directing mind would then be the fraud of the company. But what about the fraud of an agent? Would that fraud also be attributed to the company on grounds of agency? A possibility arises for some confusion in this regard. This is so because the House of Lords in Moore Stephens discussed in great detail cases relating to the attribution of an agent’s knowledge (for instance, the Hampshire Land line of cases; which properly deal with agents). Did Moore Stephens then intend to leave open the possibility for attribution of an agent’s knowledge also? A reading of the speeches of their Lordships does suggest that this is not so. This issue has now been specifically clarified in Safeway Stores v. Simon John Tigger. The Court explained, “There are essentially three different bases of liability of a company: (i) primary liability, through the application of the primary rules of attribution; (ii) liability through the application of the normal principles of agency or of vicarious liability (the general rules of attribution) and (iii) liability imposed for the purposes of a particular legislative intent (a special rule of attribution)…” The Court has clarified that for the purpose of applying the ex turpi causa defence, the attribution must be primary – that is of category (1) listed above. Thus, attribution of (say) a director’s acts through principles of agency will not allow negligent auditors to escape liability through ex turpi causa.

As stated by the Court, Moore Stephens does not detract from this – indeed, Moore Stephens affirms this position. Thus, Safeway Stores summarizes the correct legal position by saying that before the ex turpi causa defence can apply, “the company must be under a personal liability for the relevant wrongdoing. In other words, the rule does not apply where the company is only liable for the acts of its employees or agents either by virtue of the application of the doctrine of vicarious liability or where the act or conduct of an employee or agent is attributed to the company under the general principles of the law of agency. In neither of those cases is the liability of the company personal or primary or direct, nor can it be said that the company is guilty of turpitude.”

Thus, Moore Stephens cannot be used by auditors in every case where a company’s agents have acted fraudulently. This does not, however, detract from the position that the auditor’s liability is in general a limited one. Auditors may be liable for deceit, or for negligent misstatement. Insofar as liability for negligent misstatement is concerned, such liability can be fastened on the defendant only when there is an “assumption of responsibility” by the defendant coupled with detrimental reliance by the plaintiff. While this position continues with respect to auditors as well, another recent English decision highlights the need for special principles to govern the liability of auditors: Sky Subscriber Services v. HP Enterprise Services. 

In Sky Subscriber, the Court held, “in considering whether a contractual provision affects the existence or the scope or extent of a duty of care, the test is whether the parties having so structured their relationship that it is inconsistent with any such assumption of responsibility or with it being fair, just and reasonable to impose liability. In particular, a duty of care should not be permitted to circumvent or escape a contractual exclusion or limitation of liability for the act or omission that would constitute the tort…” Thus, the duty of care owed by the auditor to the company as a matter of tort law will be conditioned by the contractual clauses between the two parties. This statement was made by the Court in the context of the general law on negligent misstatement. This cannot, however, be the statement of law in relation to auditors.

The special position of auditors under company law casts upon them a statutory duty to certify accounts as true and fair. The principle in Sky Subscriber cannot automatically be applied to auditors; as auditors cannot be allowed to contract out of their statutory obligation. The danger arises because content of the statutory duty of the auditor is often framed in terms which are identical to a duty in tort – “The auditor must exercise such reasonable care as would satisfy a man that the accounts are genuine, assuming that there is nothing to arouse his suspicion and if he does that he fulfils his duty; if his suspicion is aroused, his duty is to 'probe the thing to the bottom'…” (ICAI v. P.K. Mukherji, AIR 1968 SC 1104). Prior to Sky Services, there need not have been any distinction drawn between the auditor and other professionals for the purposes of liability for negligent misstatement and for ascertaining the content of the duty of care. However, given the statutory basis behind the auditor’s duties, it appears that there is now reason for drawing that distinction. The content of the duty of care owed by one party to another may ordinarily depend on the contractual terms; in the case of the duty owed by the auditor to the company, it must depend on the construction of statutory obligations. These obligations would, in turn, depend on the meaning to be assigned to terms such as the “true and fair” view – a matter discussed here and here.

Retrospective Tax Legislation: Challenges to Section 80(IA) of the Income Tax Act

In this post, I had discussed some of the principles of law applicable to retrospective tax statutes. The issue assumes greater relevance, with the retrospective amendment to Section 80(IA) of the Income Tax Act being challenged before several High Courts. The Gujarat High Court in Ketan Construction v. Union of India had earlier ordered stay of recovery pending final disposal. The Bombay High Court in Patel Engineering v. ACIT, W.P. No. 210 of 2010, has today admitted a petition challenging the retrospective amendment; and the matter is listed for final hearing on March 15th, 2010. More details are available here.

Section 92: Suits against Public Trusts - Part II

(Part I of the post is available here)

On the question of whether if an application to revoke leave is rejected the defendant is entitled to apply for rejection of the plaint, it has been held that he is not so entitled. This is because the questions which the Court will go into in order to determine the two applications are essentially the same. Accordingly, allowing the defendant to pursue both courses of action would only lead to wastage of judicial time. The Supreme Court has in fact held once leave was granted, the question of rejection of plaint under Order VII, Rule 11 of the CPC does not arise at all. Thus, after having lost their opposition to the grant of leave, it is not open to the defendants to apply for rejection of the plaint under Order VII, Rule 11 of CPC (Sudhir Angur v. M. Sanjeev, AIR 2006 SC 351.).

Finally one may turn to a peculiar issue which might arise given the nature of the provisions. Let us assume a hypothetical situation where the Court refuses to grant leave to the plaintiff. The order refusing to grant leave being an appealable order under the provisions of the CPC, the plaintiff prefers an appeal to the appellate Court. The appellate Court reverses the impugned order and grants the plaintiff leave to sue. Accordingly, the suit commences in the Court of first instance. Now, the defendant files an application for revocation of leave. Considering that the leave has been granted to the appellate Court, can the Court of first instance adjudicate on whether the leave should be revoked? There does not seem to be any case-law specifically dealing with the issue under Section 92 of the CPC. However, one may seek to draw an analogy with a similar provision under the Income Tax Act. Under that enactment, there was originally a provision for registration of partnership firms by the Income tax Officer. It was held that when the Officer refuses to grant a certificate of registration, but a Court overturns his decision and decides to grant the certificate, it was no longer open to the Officer to consider any application for cancellation of the certificate (CIT v. Deokinandan Om Prakash, 276 ITR 497 (All)). The rationale behind the decision was that the judicial hierarchy must be respected, and a lower authority cannot sit in appeal over a higher Court’s decision. By analogy, the same should extend to the case of grant of leave. Accordingly, there is a strong case that the Court of first instance should not hear the application for revocation. As submitted earlier, ordinarily, the Court should hear the defendant before deciding whether to grant leave or not. The same must be true of an appellate Court as well. Thus, the appellate Court’s decision would be based on hearing both the parties and would be conclusive of the matter as to the lower Court.

On the other hand, there may be an exceptional case where the defendant has not been heard by the appellate Court before the decision to grant leave. In such a case, there would be no difference; as an ex-parte order would be entitled to as much respect as an order passed after hearing both parties. It is submitted that the only exceptional situation is where new facts come to light, which were not (and could not have reasonably be) placed before the appellate Court. In such a situation, the Court of first instance may be able to decide the application for revocation of leave on merits. Such an approach would not engender disrespect for the higher judicial authority, as it would be taken only on the basis of new facts which could not have reasonably be placed before the appellate Court. The case in which this is most likely to arise is where the appellate Court has heard the matter ex-parte without hearing the defendant. In such a case, on the basis of new facts which were not and could not reasonably be before the appellate Court, it may be possible for the application of revocation of leave to be considered.

Of course, these questions still remain unsettled; perhaps, the pending cases on the point will serve to settle the debate on the interpretation of Section 92.

Section 92: Suits against Public Trusts - Part I

Section 92 of the Code of Civil Procedure deals with suits in respect of public trusts. In order for Section 92 of the CPC to be applicable, the following conditions must be satisfied:

1. There is a trust created for public purposes of charitable or religious nature.

2. There is an alleged breach of such trust, or the direction of the Court is necessary for the administration of such trust.

3. The suit is instituted in accordance with the procedure and by the persons mentioned in the Section

4. The suit is representative in character, instituted on behalf of the public, for a vindication of the public interest and not merely a private interest. It is filed by the Advocate General or by two or more persons having an interest in the trust and having obtained the leave of the Court

Unless these requirements are strictly followed, the suit cannot be said to be one instituted under Section 92 (Syed Moinuddin v. Tamil Nadu Wakf Board, AIR 1998 Mad 129). Several issues may arise in this regard. There have been a couple of decisions on the interpretation of the Section in the past few weeks, primarily in relation to maintainability and jurisdiction. The Supreme Court has ruled on jurisdiction under Section 92 here in Sri Jeyaram Educational Trust; the Calcutta High Court has explained some of the locus standi requirements here in Mridula Sodhani.

Several other issues also arise – some of them settled; others still pending a conclusive answer. First, what must the Court consider in deciding whether to grant leave or not? Secondly, is the defendant entitled to being heard before leave is granted? Thirdly, assuming the defendant’s application to revoke leave is dismissed, does the defendant still have the right to move an application for rejection of the plaint? Fourthly, if the Court refuses leave but on appeal the appellate Court grants leave without hearing the defendant, can the defendant move a application before the Court of first instance to revoke leave? If not, what other remedy would the defendant have in such a case?

The question of what should be considered by the Court in deciding whether to grant leave is important because an answer to this question will determine whether or not the Court’s function is purely mechanical in this regard. The provision in this regard has been amended – earlier, leave of the Advocate General was required; now, leave of the Court is required. It has been held that the order granting or refusing leave must be a reasoned order (Gurdwara Prabandhak Committee v. Amarjit Singh, AIR 1984 Del 39). An appeal has been provided against such an order in Section 104(1)(ffa), CPC. All these factors indicate that the Court’s function is not purely a mechanical one but a judicial one. It is submitted that prior to deciding the question, the Court must look at whether the procedural requirements of the Section have at least prima facie been satisfied. This would involve looking at the question – at a prima facie level – of whether the conditions mentioned at the beginning of this post have been fulfilled. Once there is such prima facie fulfillment, leave must be granted.

Prior to the amendment, there existed a conflict between the High Courts as to whether the Advocate General’s functions in deciding whether to grant leave or not were purely administrative (Abu Backer v. Advocate General, AIR 1954 Tr&C 331; Shantanand v. Advocate General, AIR 1955 All 372). A Full Bench of the Kerala High Court finally held that the function was an administrative one and not a judicial one (A.K. Bhasker v. Advocate General, AIR 1962 Ker 90). It is submitted that the nature of the amendments – changing the required leave to that of the Court instead of that of the Advocate General) reveals that the process is intended to be a judicial one. No other reason would justify the amendment. The factors mentioned in the beginning of this paragraph support this view.

A learned author comments that the Court’s function is purely administrative and non-judicial, because there is no requirement that the defendant must be heard (Mulla, The Code of Civil Procedure, p. 983 [2001 edition]). It is submitted that the position of law is that ordinarily, the defendant must be heard. Only in exceptional situations will the Court be justified in proceeding without hearing the defendants (B.S. Adityan v. B. Adityan, (2004) 9 SCC 720). And in such cases also, it is open to the defendants to apply for revocation of leave (Chettiar v. Chettiar, AIR 1991 SC 221).Furthermore, the fact that in exceptional situations the defendant is not heard is not sufficient to conclude that the function is non-judicial in its entirety. Even in granting ad-interim injunctions, at times, a Court will do so ex-parte. That does not mean that the Court is not sitting as a judicial body. Accordingly, it is submitted that the function is a judicial one; although the Court will grant leave based on its prima facie satisfaction. As such, the Court is required to look at its prima facie satisfaction as to the establishment of the requirements of Section 92. “Prima facie” in this context would mean that the maintainability of a suit under the Section depends on the allegations in the plaint. Assuming that the allegations are true, would a case be established such that all the ingredients of the Section are met? That is the question which the Court is required to ask at this stage (Charan Singh v. Darshan Singh, AIR 1975 SC 371; Kabul Singh v. Ram Singh, AIR 1986 All 75). The logic behind this appears to be that a full-fledged trial would be necessary to check the veracity of the allegations. That is not possible at this stage, and would defeat the purposes of the Section. By adopting the test stated above, the Courts can weed out frivolous and vexatious claims, thereby carrying out the legislative mandate behind the Section. Thus, while Section 92 does not require issuance of notice to the defendants before granting leave, since proceedings for granting leave are judicial proceedings, it is ordinarily proper to pass orders after hearing the defendants. In other words, the order granting or refusing the leave should be reasoned order after giving opportunity to trustees to oppose it. However, this is not a hard and fast rule, as explained in by the Supreme Court (B.S. Adityan v. B. Adityan, (2004) 9 SCC 720):

“Although as a rule of caution, court should normally give notice to the defendants before granting leave under the said Section to institute a suit, the court is not bound to do so. If a suit is instituted on the basis of such leave, granted without notice to the defendants, the suit would not thereby be rendered bad in law or non- maintainable. Grant of leave cannot be regarded as defeating or even seriously prejudicing any right of the proposed defendants because it is always open to them to file an application for revocation of the leave which can be considered on merits and according to law or even in the course of suit which may be established that the suit does not fall within the scope of Section 92 CPC.”

(To be continued in Part II)

Moore Stephens: The Attribution of Fraud

An earlier post had discussed the ex turpi causa arising in a recent House of Lords judgment – Stone & Rolls v. Moore Stephens. Another post had stated on the second issue (attribution), “It was held that a directing mind’s fraud will be attributed to the company in all cases, except where the fraud was played directly on the company. If the company is a vehicle of the fraud, as opposed to the victim of the fraud, the directing mind’s fraud will be attributed to the company. This would mean that the fraud of the directing mind is, in law, the fraud of the company. Once such attribution occurs, the principle of ex turpi causa would apply. The auditors were appointed for the very thing of detecting the fraud. Yet, when the company brings a claim against them for negligence in failing to detect the fraud, they can rely on the ex turpi causa rule to prevent the company from pursuing the claim. The only exception to this is if the company shows that it was the direct and primary victim of the fraud. In other words, if a company’s directing mind has committed a fraud using the company as a vehicle, then the company cannot bring a claim in negligence against the auditors for failing to detect the fraud.” This post considers the general law on attribution; and on the fraud exception to attribution.

In certain situations, acts of certain individuals can be attributed directly to the company, instead of vicariously through doctrines of agency. Thus, a company (although acting through the mechanism of individuals) can have certain acts attributed directly to it (Per Lord Hoffman, Meridian Global Funds Management (Asia) Ltd. v. Securities Commission, [1995] 2 AC 500, 506. Acts of the companies “directing mind and will” will be acts of the company itself. (Hence, the issue in Moore Stephens – is the fraud of the directing mind also the fraud of the company, or is there a fraud exception to attribution.) This “directing mind and will” theory can be traced to Viscount Haldane’s words in Lennard’s Carrying Co. Ltd. v. Asiatic Petroleum Co. Ltd., [1914-15] All ER Rep. 280, “… a corporation is an abstraction. It has no mind of its own any more than a body of its own; its active and directing will must consequently be sought in the person of somebody who for some purposes may be called an agent, but who is really the directing mind and will of the corporation, the very ego and centre of the personality of the corporation.”

The Supreme Court of India considered this theory in JK Industries v. Chief Inspector of Factories and Boilers, (1996) 6 SCC 665. The Supreme Court cited and specifically approved of Lennard’s case. It then stated that where the “directing mind and will” test is use, vicarious liability come into play to fasten liability on the company of the acts of the directing mind. With respect, this approach requires a slight clarification. The acts of the “directing mind and will” or the “alter ego” of the company are directly attributed to the company, not vicariously (Tesco Supermarkets Ltd. v. Nattrass, [1972] AC 153). The position on the point is clarified in the leading judgment of Lord Hoffman in the Meridian case. In Lord Hoffman’s view, “Any proposition about a company necessarily involves a reference to a set of rules. A company exists because there is a rule (usually in a statute) which says that a persona ficta shall be deemed to exist and to have certain of the powers, rights and duties of a natural person. But there would be little sense in deeming such a persona ficta to exist unless there were also rules to tell one what acts were to count as acts of the company. It is therefore a necessary part of corporate personality that there should be rules by which acts are attributed to the company. These may be called ‘the rules of attribution’. The company’s primary rules of attribution will generally be found in its constitution, typically the articles of association, and will say things such as ‘for the purpose of appointing members of the board, a majority vote of the shareholders shall be a decision of the company’ or ‘the decisions of the board in managing the company’s business shall be the decisions of the company’. There are also primary rules of attribution which are not expressly stated in the articles but implied by company law…”

The question which arises then, is – once a directing mind is identified, are all acts/knowledge of the directing mind to be attributed to the company? Is the fraud of the directing mind to be treated as the fraud of the company? In Moore Stephens, the House of Lords accepted that there was a fraud exception. In doing so, the Court relied on In re Hampshire Land Company, [1896] 2 Ch 743. I have elaborated on these points in an article forthcoming in the Journal of Business Law. Briefly, Hampshire Land is an agency-case. It deals with when the knowledge of an agent will not be attributed vicariously to the principal. Other cases on the point include Belmont Finance Corporation Ltd v Williams Furniture Ltd., [1979] Ch 250 and Canadian Dredge and Dock v. The Queen, [1985] 1 SCR 662. But, the Hampshire Land line of cases deals not with a directing mind’s knowledge; but with attribution of an agent’s knowledge. They are thus cases of exceptions to vicarious liability. The rationale behind Hampshire Land is restricted to agency; it does not apply to directing minds. The typical explanation for the Hampshire Land exception is, “…general principles of imputation are based on a presumption that there has in fact been communication between agent and principal, a presumption that must be rebutted by the agent's fraud on his principal, since no fraudster will tell his principal information that will reveal his fraud…” (Peter Watts, “Imputed Knowledge in Agency Law – Excising the Fraud Exception”, [2001] 117 Law Quarterly Review 300). But, when dealing with directing minds and wills, the general principles of imputation are not based on any such presumption of communication, they are based on the legal rule that the directing mind “is an embodiment of the company or, one could say, he hears and speaks through the persona of the company, within his appropriate sphere, and his mind is the mind of the company…” Once it is found that ‘X’ is acting as the directing mind, that finding is in itself is sufficient for attribution; no further presumption of any communication is needed. Hence, the Hampshire Land exception – premised as it is on the rationale of communication – is not apposite to cases of the directing mind and will.

There might be an independent fraud exception to attribution of the directing mind’s acts to the company. The Supreme Court of Canada has reached explained a possible basis for this exception: “The identification theory ceases to operate when the directing mind intentionally defrauds the corporation and when his wrongful actions form the substantial part of the regular activities of his office. In such a case, where his entire energies are directed to the destruction of the undertaking of the corporation, the manager cannot realistically be considered to be the directing mind of the corporation.” (emphasis added) See: Canadian Dredge v. The Queen, [1985] 1 SCR 662. This is quite different from the communication rationale of Hampshire Land. With respect, the House of Lords may have reached the right result by applying the Hampshire Land exception; it however adopted reasoning which can be made stronger if one recognises that it is not the Hampshire Land exception, but an independent fraud exception which applies the cases of the directing mind and will. Treating the two exceptions separately will avoid the confusion which is likely from the application of cases from one principle to facts pertaining to the other.