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Is Exempt Income Really Taxable Under MAT?

CA Ankit Shah

Is Exempt Income Really Taxable Under MAT?

CA Ankit Virendra Sudha Shah

After extensive research, the author makes out a strong case to contend that exempt income was never intended to fall within the concept of “book profits” in s. 115JB. He argues with convixtion that the judgement of the Special Bench of the Tribunal in Rain Commodities 41 DTR 449 which holds to the contrary requires reconsideration

Come year 2011 and the MAT provisions under the Income-tax Act, 1961 (‘the Act’) shall complete around two decades of its existence in various forms and with most recent one being Section 115JB of the Act. However, controversies surrounding the interpretation of said provisions fail to die down. Further, with preference of investment-linked deductions to profit-linked incentives, it is envisaged that more and more corporate will be subject to MAT provisions in near future. Out of the tax controversies so created, this Article seeks to discuss about the meaning and scope of ‘net profit’ under MAT provisions of the Act.

Explanation 1 to Section 115JB of the Act defines the word ‘book profit’ to mean ‘net profit’ as shown in the profit and loss account prepared as per Section 115JB(2) of the Act, and as further increased by the amount(s) mentioned in clauses (a) to (i) [Upward Adjustments] and as reduced by amount(s) covered under clauses (i) to (viii) to said Explanation 1 [Downward Adjustments].

One may argue that the rationale in introducing the proviso to Section 10(38) of the Act was to allay fears and bring out explicitly that income by way of long-term capital gains of a company exempt under Section 10(38) of the Act, should be considered in computation of book profit. However, the said argument may fail for want of following reasons

Section 115JB(2) of the Act, requires every assessee which is a company, to prepare its profit and loss account for the relevant previous year in accordance with Parts II and III of Schedule VI to the Companies Act, 1956 (‘the Companies Act’). Further, Section 115JB(2) also houses two provisos which require accounts including said profit and loss account to be prepared with

– the accounting policies,

– accounting standards and

– the method and rates of depreciation

as have been adopted while preparing the accounts including profit and loss account laid before the company at its annual general meeting (‘AGM’) in accordance with Section 210 of the Companies Act. The aforesaid requirements also apply when the company adopts a financial year different from the previous year under the Act.

On a careful consideration of construction of Section 115JB(2), one would notice that provisions of Parts II and III of Schedule VI to the Companies Act are legislatively incorporated. ‘Legislation by incorporation’ is a legislative device under which provisions of an act are referred to in some other act in order to avoid verbatim reproduction, whereby the said provisions so incorporated become part and parcel of the latter act, as if they have been ‘bodily transposed into it’.

The following decisions and commentaries on the subject of legislation by incorporation, comprehensively explain the principle of legislation by incorporation, some of which are discussed below after listing of decisions:

– Onkarlal Nandlal vs State of Rajasthan (1985) (4 SCC 404);

– Bolani Ores Ltd vs State of Orissa (AIR 1975 SC 17);

– Mahindra and Mahindra Ltd. Vs UOI (49 Company cases 419) (SC);

– Dynamic Orthopedics (P) Ltd vs CIT (321 ITR 300) (SC) – Matter referred to Larger Bench;

– Secretary of State for India vs. Hindustan Co-operative Insurance Society Ltd. (AIR 1931 PC 149);

– Shamrao V. Parulekar vs District Magistrate, Thana (AIR 1951 SC 324); and

– Justice G.P. Singh on Principles of Statutory Interpretation (2006 Edn) – (pg no. 308 to 309)

Principles emerging out of legislative device of ‘legislation by incorporation’

– Parts II and III of Schedule VI to the Companies Act shall be incorporated as if the provision is made in the enactment under Section 115JB;

– Post incorporation, Parts II and III of Schedule VI under the Companies Act, 1956 and as incorporated in s.115JB of the Income-tax Act, 1961 remain different and distinct, and each is to be judged with reference to its own source;

– Only the provision which is incorporated into another enactment should be referred to and it shall not be permissible to refer to other parts of the earlier statute which are not incorporated, unless such reference is for limited purpose to understand the meaning or intention of the provisions incorporated; and

– For the purpose of interpretation of aforesaid incorporated provisions, it may sometime require variation of details in the context of the incorporating Act.

Further, the Apex Court in the case of J.K.Industries Ltd. Vs Union of India (297 ITR 176), explained the construction of Parts II and III of Schedule VI to the Companies Act, as under:

– Part II of Schedule VI, in particular, prescribes the particulars which must be furnished in the profit and loss account and does not prescribes a proforma of profit and loss account;

– Part II of Schedule VI lays down the manner in which the presentation of various items of income and expense in the profit and loss account should be made, but it nowhere lays down as to how and when income or expenditure should be recognized and/ or measured/ computed;

– Part II of Schedule VI sets out the income and expenditure under different heads separately. It requires the profit and loss account to show the income from the manufacturing operations [clause 3(ii)(a)], amount of income from investments, distinguishing between trade investment and other investment [clause 3(xi)(a)], other income by way of interest specifying the nature of income [clause 3(xi)(b)], profit and loss in respect of transactions of a kind not usually undertaken by the company or undertaken in circumstances of an exceptional or non-recurring nature, it is also provided that the profit and loss account shall also separately show the net profits [clause 3(xii)(b)], etc; and

– Part III of Schedule VI to the Companies Act provides interpretation of expressions such as “provision”, “reserve”, “capital reserve”.

In light of the aforesaid observations of the Apex Court and the principle of legislation by incorporation as enunciated under Section 115JB(2), one finds that Parts II and III of Schedule VI to the Companies Act merely prescribe the presentation of profit and loss account and the real principles as regard to recognition, measurement and disclosure requirements of profit and loss items are prescribed by accounting standards governing the respective assessee companies. In other words, it is the provisos to Section 115JB(2) which actually provide the basis for the computation of net profit, which then subjected to upward and downward adjustments determine ‘book profits’.

After having considered the meaning of ‘net profit’, it then brings us to discuss other controversy relating to the scope of ‘net profit’ for computation of book profits.

Recently, the Special Bench of Hyderabad Tribunal in the case of Rain Commodities Ltd vs Dy CIT (41 DTR 449) while adjudicating upon the subject of scope of ‘net profit’ under Section 115JB of the Act, held that income by way of capital gains (irrespective of whether the impugned gains are exempt or otherwise under the normal provisions of the Act) shall be included in computation of net profit. Some of the relevant observations as made by the Special Bench, are reproduced below:

– Assessee claimed exclusion of long term capital gains arising on transfer of shares from the book profit by virtue of the said capital gains being exempt under the normal provisions of the Act [ie Section 47(iv)];

– The impugned capital gain in question is exempt under Section 47(iv) of the Act ie under normal provisions of computation but the same is not covered by any of the downward adjustments provided under (i) to (viii) of Explanation 1 to Section 115JB of the Act; and

– Character for exemption granted under Section 47(iv), Section 47(v) and Section 50 are not total exemption section but exemption in the nature of deferment.

However, one finds that the said Special Bench decision and the decisions relied thereunder, may have not consider the following arguments:

– Construction of Section 115JB and Section 10(38) of the Act;

– Construction of Section 115JB and Section 10(23G) of the Act as existing; and

– Intention of the Legislature with respect to applicability of MAT provisions

Construction of Section 115JB and Section 10(38) of the Act

Section 10(38) of the Act provides for exemption of income arising from transfer of long term capital asset, being an equity share in a company or a unit of an equity oriented fund. The Legislature vide Finance Act, 2006 amended clause (ii) and (f) of Explanation 1 to Section 115JB and also Section 10(38) of the Act to include income referred in Section 10(38) of the Act as part of book profit.
The amendments so made in Section 115JB and Section 10(38) read as under:

Amendment in Section 115JB:

“Explanation 1 to Section 115JB – ………, “book profit” means the net profit as shown in the profit and loss account ……….……………………

……………………as reduced by,

…….(ii) the amount of income to which any of the provisions of Section 10 (other than the provisions contained in clause (38) thereof) or ………apply, if any such amount is credited to the profit and loss account”

Amendment in Section 10(38) vide insertion of proviso:

“Provided that the income by way of long-term capital gain of a company shall be taken into account in computing the book profit and income-tax payable under Section 115JB.”

if the ratio of Special Bench in Rain Commodities case and decision relied therein as regard to scope of net profit is upheld, then a situation may arise whereby income referred in Section 10(23G) and Section 10(38) shall be subject to twice inclusion in computation of book profit

The Special Bench in Rain Commodities case (supra) has held that net profit as shown in the profit and loss account of a company shall also include income from sale of investments. However, then one fails to understand the consequence of introducing a proviso to Section 10(38) of the Act because the impugned proviso in effect specifically provides for inclusion of income by way of long-term capital gain in computation of book profits, which as discussed above, is already part of net profits. The intention of the legislature was never to consider the impugned income under Section 10(38) twice for the purpose of computation of book profit.

In addition to above, kindly note, what has been sought to be included in book profit is income by way of long-term capital gains of the company. Section 2(29B) of the Act defines long-term capital gains as capital gain arising from the transfer of a long term capital asset. However, the profit and loss account of a company neither requires nor recognises profit and loss on transfer of capital assets under the classification of long term capital assets and short term capital assets.

One may argue that the rationale in introducing the proviso to Section 10(38) of the Act was to allay fears and bring out explicitly that income by way of long-term capital gains of a company exempt under Section 10(38) of the Act, should be considered in computation of book profit. However, the said argument may fail for want of following reasons:

– Vide the proviso, the Legislature has sought to include income by way of long-term capital gains and not income from sale of investments, which as discussed above is neither required or recognised in the profit and loss account prepared under the legislatively incorporated provisions of Companies Act;

– Secondly, the Legislature while introducing the amendment in Section 10(38) and similar amendment in Section 10(23G), had an intention of rationalizing the said exempt provisions, since the exempt incomes were excluded from the computation of total income. Therefore, the intention of the Legislature was to specifically include the said income while computing the book profits

− In light of the intention of the Legislature and language used in effecting such amendment, one may suggest that manner in which the desired results is sought to be achieved, gives the understanding of the Legislature about the scope of ‘net profit’ of not including income by way of long term capital gains;

− Amendment was brought in to trim down the effect of exempt provision of Section 10 in computation of book profit and consequential amendment was effected in Section 115JB

− Further, after considering the language used in simultaneously amending clause (ii) and (f) of Explanation 1 to Section 115JB of the Act, one may argue that this consequential amendment was brought to allay fears and provide explicitly the mode of computation of book profit as against argument of insertion of proviso to exempt provision to allay fears

− On the contrary, it acts as a substantive provision in computation of book profit for Section 115JB of the Act

– Thirdly, if proper attention is given to the External aids to construction ie Notes of clauses and Memorandum explaining the provisions amending Section 10(38), Section 10(23G) and Section 115JB and similar aids which included the income referred in Section 10A and Section 10B in computation of book profit under Section 115JB, a subtle difference can be observed in the manner in which said incomes are sought to be included in the computation of book profit

− In the case of amendments relating to Section 10(38), Section 10(23G) and Section 115JB of the Act, as discussed above, the legislature has given the reason of rationalisation of exempt provisions and thereby have included incomes by way of inserting a proviso to said exempt provisions. The mechanism and manner in which the amendments are carried out suggests the following methodology in computation of book profit, which can also be read in light of principles of harmonious interpretation of all the provisions of the Act under consideration:

– Net profit does not include income by way of long-term capital gains;

– Section 10(38) of the Act also denies the consideration of aforesaid income for computation of book profit, since it is specifically excluded from the total income;

– In order to trim down the exempt provision of Section 10(38) and include the said income in computation of book profit, a proviso is inserted to Section 10(38) and simultaneously references to Section 10(38) are excluded from the Clause (f) and (ii) of Explanation 1 to Section 115JB for computation of book profit; and

– Amendments are carried out in Section 115JB of the Act in order to explicitly bring out the mode of computation of book profit to include the exempt income, which are otherwise not included in the scope of ‘net profit’, as substantiates the intention of the Legislature

− Whereas, while including the income referred to in Section 10A and Section 10B in computation of book profit, only Section 115JB is amended as against the mechanism of inserting a proviso to exempt provisions, since the said income are understood by Legislature to be already part of net profit.

In light of the aforesaid observations, one may argue that an irrefutable presumption which one may arrive is that the Legislature also envisaged that net profit could not include such long term capital gains. The decision of Kolkata High Court in the case of CWT vs Sun Jute Press (P) Ltd. (203 ITR 350) also comes to the rescue of the assessee companies, wherein the Court while setting aside the matter on the question of allowability of exemption contemplated under Section 40A(3)(vi) of the Finance Act, 1983 observed that the construction of a statutory provision particularly in the context of a situation not foreseen by the law-makers should not be overtly literal but should be purpose-seeking. The reading of the legislature intention is very important especially where the law as framed leaves a void for the judiciary to fill in, in the total setting of the law.

Construction of Section 115JB and Section 10(23G) of the Act as existing

Further, Section 10(23G) of the Act (as existing) provided for exemption of income by way of dividends (other than dividend referred to in Section 115-O), interest or long term capital gains of an infrastructure company. The Legislature vide Finance (No. 2) Act, 2004 simultaneously amended clause (ii) of Explanation 1 to Section 115JB and Section 10(23G) of the Act to include income referred in Section 10(23G) of the Act as part of book profit. The language of proviso to Section 10(23G) is similar to proviso to Section 10(38) of the Act. Therefore, arguments as made above w.r.t. Section 115JB and Section 10(38) of the Act shall also hold good for the purpose of this section to conclude that net profit as shown in the profit and loss account prepared in accordance with Parts II and III of Schedule VI to the Companies Act should not be read to include income referred in Section 10(23G) of the Act.

Intention of the Legislature with respect to applicability of MAT provisions to tea companies

The CBDT Circular No. 495 dated 22 September 1987 on Explanatory Notes on the provisions of Finance Act, 1987 explained the applicability of provisions of Section 115J (predecessor to Section 115JB) to tea companies. It was provided that out of the income derived from the sale of tea grown and manufactured by the seller, only 40% of such income is liable to tax under Rule 8 of the 1962 Rules. Further, it provided that in the case of tea companies, the book profit should be computed by making all the adjustments referred to in the Explanation to Section 115J, except for aforesaid adjustment of 40%. In other words, the Legislature provided for apportionment of 40% of the book profit of tea companies in accordance with Rule 8 of the 1962 Rules.

It would be relevant to note that no such mechanism of apportionment of profits can be specifically be read, in the language of MAT provisions, but such basis of adjustment is well provided for computing total income of tea companies under normal provisions of the Act. Further, Rule 8 of the 1962 Rules, provides that the income derived from the sale of tea grown and manufactured by the seller in India shall be computed as if it were income derived from business and 40% of such income shall be deemed to be income liable to tax under the Act.

In light of the aforesaid considerations, following questions could then arise as a consequential effect of considerations:

What was then intention of the Legislature as regard to scope of “net profit” for Section 115JB of the Act, when it used the expression “as shown in the profit and loss account prepared as per the legislatively incorporated provisions of the Companies Act.”

AND/ OR

Based on the aforesaid consideration and though stretching the conclusion, can one argue that long term capital gains of companies not exempt under Section 10 and interest income, dividend income of companies other than infrastructure companies, which are not exempt under Section 10 of the Act can be included in computation of net profit

A possible answer, though inconclusive, could be found by looking at the formula of computation of book profit, ie the upward and downward adjustments which are subjected to net profit. The downward and upward adjustments applied to said net profit are items found generally in relation to determine true working result of business profits. Further, the said answer also gets support from the considerations as discussed above w.r.t. specific inclusions of other incomes such as long term capital gains, dividend, interest and directions w.r.t. scope of book profit, could also suggest that net profit for the purpose of book profit under Section 115JB was understood by the Legislature as restricted to business profits of the company.

The aforesaid situation of such inconclusiveness, highlights the major demerit of the legislative device of legislative by incorporation, for which it has received criticisms from various English Courts, who have also found similar difficulties in application of this mode of legislation.

A possible solution to aforesaid problem lies in one of the principle of legislative of incorporation, which has been reproduced above of “for interpretation of aforesaid incorporated provisions, it may sometime require variation of details in the context of the incorporating Act”. Therefore, Courts may in light of aforesaid considerations as discussed above, could be called in to vary the details or interpret the scope of “net profit” to business profits of the assessee company for the purposes of Section 115JB of the Act.

However, if the ratio of Special Bench in Rain Commodities case and decision relied therein as regard to scope of net profit is upheld, then a situation may arise whereby income referred in Section 10(23G) and Section 10(38) shall be subject to twice inclusion in computation of book profit.

In addition and without prejudice to aforesaid arguments, for want of following reasons, one may contend that capital gains exempt under Section 47 of the Act shall not form part of net profit.

Section 2(24)(vi) of the Act defines the word ‘income’ to include any capital gains chargeable under Section 45 of the Act. Section 45 of the Act vide legal fiction recognises any profit and gains on transfer of capital asset as income and subjects the said income to tax in the year of transfer. In other words, capital gains vide legal fiction is defined to mean income under the Act.

Further, Section 47 of the Act provides that “Nothing contained in Section 45 shall apply to transfers of Section 47”. In other words, all transactions referred in Section 47 of the Act shall be exempt from being regarded as income under the Act and also shall not be subject to tax under Section 45 of the Act.

Taking a cue from the exposition of CBDT in Circular No. 13 of 2001 dated 9 November 2001 on scope of Section 115JB of the Act, one may conclude that for want of following reasons the capital gains which are exempt under Section 47 of the Act cannot be considered as part of net profit for the purpose of computation of book profit under Section 115JB of the Act:

– Sections 2(24)(vi), 45 r.w.s. 47 provides that any profit and gains arising from a transaction falling under Section 47 shall be exempt from tax and also shall not be regarded as income under the Act;

– The provisions of definition and charge under the Act are not overridden by the provisions of Section 115JB of the Act. Therefore, once a transaction fails to satisfy the definition of income under the Act, then consequently the gains arising from the transaction can neither form part of total income nor book profit for the purpose of Section 115JB; and

– It may be indicated that Section 47 and Section 115JB are mutually exclusive of each other for the purpose of “total income” and “book profit” and Section 5 of the Act is rendered neutral, being subject to provisions of the Act

Therefore, even though one does not find a specific downward adjustment in computation of book profit under Section 115JB w.r.t. capital gains exempt under Section 47 of the Act, still the impugned gains cannot be included in the computation, since it does not qualify to be income under the Act.

Alternatively, and without prejudice to aforesaid considerations, the argument of non-inclusion of exempt capital gains provided under Section 47 of the Act in computation of book profit for Section 115JB, could also find support on the touchstone of the intention of Legislature to introduce MAT provisions in the Statute, which has received explanation in the following cases dealing with constitutional validity of MAT provisions, are reproduced below after listing of decisions:

– Karimtharuvi Tea Estates Ltd & Anr vs DCIT (247 ITR 22) (Ker.);

– Suryalatha Spinning Mills Ltd and Anr vs Union of India and Anr. (223 ITR 713) (AP); and

– National Thermal vs Union of India (192 ITR 187) (Del.)

Some of the key findings of the aforesaid decisions are reproduced below:

– Object of MAT provisions were to tax “zero tax” companies, ie those companies which make huge profits and declare substantial dividends, but manage their affairs in such a manner that they avoid paying taxes, on account of various tax concessions and incentives.

– What the legislature has actually done vide MAT provisions is limit the allowances, deductions so that “zero tax” companies can pay some tax and therefore, has considered book profit as the taxation base which is not a fictional or hypothetical income.

– Legislature in its wisdom has curtailed or restricted such deductions, allowances, concessions by introducing MAT provisions under an independent Chapter XII-B in the Act

Therefore, based on above findings, one may argue that intention of legislature was never to tax the capital gains which were exempt under the Act, and on the contrary the MAT provisions were brought on statute to restrict the deductions, allowances and concessions which were in the nature of investment linked deductions, depreciation, etc ie deductions available with regard to activities relating to business of the assessee company.

In law, the following aspects and aforesaid considerations were not raised and/ or considered by the Special Bench in the case of Rain Commodities Ltd. (supra) and therefore, it may require reconsideration:

– Construction of Section 115JB and Section 10(23G) of the Act as existing;

– Construction of Section 115JB and Section 10(38) of the Act;

– Intention of the Legislature with respect to applicability of MAT provisions to tea companies;

– Without prejudice, construction of Section 2(24)(vi), 45, 47 r.w.s. 115JB of the Act; and

– On the touchstone of intention of Legislature in insertion of MAT provisions

Disclaimer: The contents of this document are solely for informational purpose. It does not constitute professional advice or a formal recommendation. While due care has been taken in preparing this document, the existence of mistakes and omissions herein is not ruled out. Neither the author nor itatonline.org and its affiliates accepts any liabilities for any loss or damage of any kind arising out of any inaccurate or incomplete information in this document nor for any actions taken in reliance thereon. No part of this document should be distributed or copied (except for personal, non-commercial use) without express written permission of itatonline.org.

2 comments on “Is Exempt Income Really Taxable Under MAT?
  1. G S Gandhi says:

    I’m a private limited company have an agricultural land in Haryana some part of the land government is acquiring for widening road.is capital gains tax or MAT payable or exemption on the amount paid by the government
    Please guide

  2. CA. PRADIPTA says:

    Thanks dear for a wonderful article

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