Arbitrariness And Income Tax

Advocate Dharan V. Gandhi has deliberated on the interesting topic of what is “arbitrariness” in a legislation and the extent to which it can make a legislation vulnerable to challenge under Article 14 of the Constitution. He has referred to several provisions in the Income-tax Act, 1961, such as sections 50CA, 56(2)(x), Rule 11UA, 194N, and explained why they suffer from the vice of arbitrariness and stand a risk of being declared invalid

“From a positivistic point of view, equality is antithetic to arbitrariness. In fact equality and arbitrariness are sworn enemies; one belongs to the rule of law in a republic while the other, to the whim and caprice of an absolute monarch. Where an act is arbitrary it is implicit in it that it is unequal both according to political logic and constitutional law and is therefore violative of Art. 14”. These were the famous words of Justice Bhagwati in the case of E.P. Royappa v. State of T.N., (1974) 4 SCC 3, which laid the foundation stone of the doctrine of arbitrariness. This doctrine of arbitrariness has had its fair share of ups and down.

Before delving into the controversy, let us first understand the meaning of the term ‘arbitrary’. The Courts have held that there cannot be any exact definition of the term arbitrariness. The term arbitrary describes a course of action or a decision that is not based on reason or judgment but on personal will or discretion without regard to rules or standards. The Courts have described arbitrary as one that is irrational and not based on sound reason and one that is unreasonable (See Om Kumar and Ors. vs. UOI (2001) 2 SCC 386).

Arbitrariness and Article 14

Article 14 of the Constitution of India deals with “Equality before law” and it states that “The State shall not deny to any person equality before the law or the equal protection of the laws within the territory of India”. Prior to Justice Bhagwati’s disposition in the Royappas case, to test whether any provision is falling foul of Article 14, the Apex Court had initially laid down the test of reasonable classification. Under this test, if unequal treatment was provided to different persons or things, based on some intelligible differentia or reasonable classification, then the same was not considered as unconstitutional. Though there were some judicial voices which had spoken against this being the only basis. In 1974, Justice Bhagwati laid down this theory of arbitrariness which had the concurrence of Justice Y. V. Chandrachud and Justice Krishna Iyer. This theory was further concretised in the judgement Maneka Gandhi v. UOI, (1978) 1 SCC 248, wherein J. Bhagwati had laid down “Article 14 strikes at arbitrariness in State action and ensures fairness and equality of treatment. The principle of reasonableness, which legally as well as philosophically, is an essential element of equality or non-arbitrariness pervades Article 14 like a brooding omnipresence and the procedure contemplated by Article 21 must answer the test of reasonableness in order to be in conformity with Article 14.” This view of J. Bhagwati had concurrence of five other judges. Further, this principle was once again reiterated in Ajay Hasiya vs. Khalid Mujib 1981 (2) SCR 79.

The only confusion which remained was whether this doctrine of arbitrariness or reasonableness was in itself sufficient to answer the question of validity under Article 14 or it was only an added argument to the classification theory. This was essential because, critics of this doctrine were wary of the fact that this theory would confer subjective powers in the judiciary to deal with the issue of legislative competence of the Parliament. However, this confusion is now no longer res integra, being answered by majority judges in a five bench judgment in case of Shayara Bano vs. UOI (the triple talaq case) reported in 2017 (9) SCC 1. In this judgment, Justice R. F. Nariman speaking for himself and Justice U. U. Lalit and having concurrence of Justice Kurian Joseph, quashed the practice of triple talaq on the ground of it being arbitrary and therefore violative of Article 14. Further, it may be noted that this was the only ground based on which the judgment was delivered.

The above discussion drives home the point that any provision of law which is arbitrary in nature, will not satisfy the requirements of Article 14 and therefore, would be quashed as being unconstitutional. How far does the above principle apply in so far as tax laws are concerned?

Constitutionality of tax laws

When one comes to the constitutional validity of tax laws, it is deciphered that the Courts are cautious before striking down any provisions of tax law on the ground of unconstitutionality. The Apex Court in case of R K Garg vs. UOI [133 ITR 239 (SC)] has held that “Another rule of equal importance is that laws relating to economic activities should be viewed with greater latitude than laws touching civil rights such as freedom of speech, religion etc.” In para 18, while dealing with the aspect of morality, the Court also held that “the test in every such case would be not whether the provisions of the statute offend against morality but whether they are arbitrary and irrational having regard to all the facts and circumstances of the case”.

Thus, tax laws enjoy greater flexibility when it comes to its constitutional validity, though, the Court can strike down a law if the same is found to be arbitrary and irrational. Further, after the judgment in the triple talaq case, one can always argue that any law which is proved to be arbitrary would run afoul of Article 14 and therefore, be struck down, including tax laws. However, because of greater latitude granted by the Apex Court in case of R. K. Garg, it appears that standards to determine whether the tax law is arbitrary or irrational would be much more stringent. We have witnessed the same in context of section 50C, Rule 8D etc. Nevertheless, if a person is able to demonstrate that a particular provision is arbitrary then, the Courts can interfere with the same by either striking it down or reading it down.

Instances under the Income-tax Act, 1961 which can be termed as arbitrary

Let us understand, some instances under the Income-tax Act, 1961, wherein there is a scope to argue arbitrariness.

1. Section 50CA provides that where the consideration received or accruing on transfer of a capital asset, being unquoted share of a company, is less than the fair market value (FMV) of such share determined in such manner as may be prescribed, then such FMV shall be deemed to be the full value of consideration. There are no exceptions to this section. Thus, where the unquoted shares are transferred at less than the fair market value, there is an automatic addition of difference between the FMV and the actual consideration. There may be varied reasons for getting consideration less than the prescribed FMV, however, without factoring such reasons, straightaway the FMV is taken as full value of consideration. There is not even an opportunity available to assessee to explain the reasons or to justify his consideration. Shouldn’t such a provision fall within the ambit of ‘arbitrariness’? 
2. Similarly, section 56(2)(x) taxes receipt of any immovable or movable property either without consideration or for inadequate consideration as compared to the FMV or receipt of any sum of money without consideration. The whole purpose behind this section is to tackle the bogus capital building and money laundering transactions. However, the wordings of section 56(2)(x) are so open-ended that such purpose is nowhere getting reflected and even the genuine transactions are getting caught within its ambit. There are certain exceptions provided for in the section though the same are in no manner sufficient to take care of genuine transactions. Most importantly, there is no opportunity either to the assessee or any requirement on the part of the Department to prove whether any transaction is genuine or bogus. Isn’t this ‘arbitrary’? Merely because there is a difference between the actual consideration and FMV does not call for an addition by treating the same to be bogus transaction. It may not be out of context to mention that the Courts have held that the Legislature has wide ancillary powers particularly dealing with black money.  However, in my humble understanding, under the guise of such wide powers, Legislature cannot enact arbitrary provisions. Therefore, even the purpose behind insertion of a provision is noble in as much as the same is to get hold of undisclosed income, the same cannot be arbitrary by putting the taxpayer in a position so as to be defenceless and that any presumption that may be made by the Legislature should be a rebuttable one. 
3. The common thread running between section 56(2)(x) and 50CA is the valuation method prescribed to derive the FMV i.e. Rule 11UA. In so far as unquoted equity shares are concerned, a method is prescribed in Rule 11UA(1)(c)(b) to determine the FMV. Such method is the only method prescribed and there are no other methods which can be followed by the assessee. This itself is arbitrary. If one refers to section 56(2)(viib) which deals with taxability in the hands of company, the Legislature itself has prescribed three methods for valuation of unquoted equity shares. Also, the method prescribed by Rule 11UA(1)(c)(b) is not even a recognized method under any other law or used or applied by any institute or any recognized valuer for finding out value of equity shares and such unrecognised method is used to judge the bonafide of a transaction. To top it, no opportunity is granted to the assessee to justify its consideration as against the arbitrary method prescribed under Rule 11UA. A classic example of ‘arbitrariness’? Should it be declared unconstitutional?
4. Notification No. 87/2016 issued by the Central Board of Direct Taxes (‘CBDT’) prescribed Income Computation and Disclosure Standards (‘ICDS’). ICDS IX deals with borrowing cost to be capitalised as a part of qualifying asset. Para 6 of this ICDS prescribes a formula for determining the borrowing cost on general borrowings which can be attributed to a qualifying asset. This formula is the only method which an assessee is compelled to follow coupled with the fact that there are number of issues arising as a result of application of this formula. Another instance of arbitrary provision?
5. When one comes of the recent amendments brought out by Finance Act, 2020, deduction of tax at source on cash withdrawal u/s 194N of the Act smells of arbitrariness. TDS is a mechanism to ensure tax in advance to the Government as well as tracking of income earned by any person. The sine qua non for TDS to apply is that the payment should constitute or should be in the nature of income. Section 199 provides credit of TDS to the person in the year in which the corresponding income is offered to tax. Cash withdrawal from one’s own account does not constitute income in any sense and therefore, applying TDS provision is certainly arbitrary. To keep a track on cash withdrawals, the Legislature can ask the Banks to file a report of all cash withdrawals above a particular limit.  On similar logic, levy of TCS on transfer of money under Liberalised Remittance Scheme of the Foreign Exchange Regulations appears to be arbitrary as there is no link of tax collected and the income earned by the remitter.

The above instances points toward arbitrariness either on the ground that the provision has no real connection with the purpose behind the insertion or on the ground that an adhoc method has been prescribed without any opportunity to contend otherwise, etc. It may be noted that merely because the provisions are inequitable or that the provisions tax something which is not income cannot be a ground to treat such provisions as arbitrary and therefore, unconstitutional. The powers of Legislature in this regard are held to be wide by Courts. However, if such provisions are proved to be otherwise arbitrary and vague then the Courts can interfere. 

Constitutional validity of a provision under tax law can be challenged on various reasons, but in the present article only the aspect of arbitrariness and Article 14 has been dealt with. The point which is sought to be conveyed is that if a particular provision can be demonstrated to be arbitrary then that itself should be sufficient to invalidate a particular provision.