Analysis Of Penalty Provisions On Undisclosed Income Unearthed During Search Proceedings In The Light Of Some Landmarks Verdicts

CA Nidhi Surana has explained the entire law relating to the levy of penalty on undisclosed income unearthed during search proceedings as contained in sections 271AAA and 271AAB of the Income-tax Act, 1961. She has also pin-pointed the numerous controversies that have arisen under these provisions. She has also referred to all the important judgements on the subject and explained their nuances

1. Introduction:

Concept of penalty in Ancient Times:

Indian lawmaker Manu in Manusmriti said that in case the King fails to punish  the offender, the powerful will persecute the weaker. Manu further says that it is only the fear of punishment that keeps a man within four corners of law and compels him to obey the law. Some slokas from Manusmriti (English translation by Maitreyee Deshpande) are reproduced hereunder:-

Men are dominated by the fear of punishment, rare is the man who is moral for the sake of morality; it is the terror of punishment that enables all men to enjoy their earnings or possessions.

Even gods, and demons, Gandharvas, Rakshas, and celestial serpents and birds, dominated by the fear of divine retribution, tend to discharge the irrespective duties (for the advancement of the universe).

Modern Times:

The lawmaker has meticulously drafted provisions relating to search and seizure under the Income Tax Act, 1961 (hereinafter abbreviated as "the Act") to unearth the undisclosed income of any person represented by any money, bullion, jewellery or other valuable article or thing or any entry in any documents, etc.

In recent times, the Government has changed Penalty provisions frequentlyin respect of undisclosed income or assets unearthed during search. Current Penalty provisions as it stands are very stringent and levied up to 200% of Tax payable or 60% of undisclosed income as the case may be. Let’s dig deeper into it:

2. The Framework of Penalty in case of Search:
The operation of various sections of the Act wherein penalty will be levied, could be understood from the following example:

Income Tax Department has carried out Search at the residential premises of Mr. A on 15/12/2019. Now, as per Section 153B of the Act, AO will conduct Assessment u/s 153A of 7 years. 7 years consist of  the year of search i.e. AY 2020-21 and Six years immediately prior to  the year of Search i.e. AY 2014-15 to AY 2019-20. Most probably, looking to the trend adopted by Revenue Officers, it can safely be expected that AO will make additions/disallowances in all the Seven years as mentioned above.

3. Penalty in the year of Search [Analysis of Section 271AAA and Section 271AAB

3.1. In the course of Search operations, generally the Assessee declares his undisclosed income in the statement recorded u/s 132(4) under the impression that if the disclosure of undisclosed income is made then penalty shall not be initiated / levied. However, fact of matter is, penalty still will be levied mandatorily at 10% or 30% of undisclosed income depending upon the year of search.

3.2. Most Assessees are unaware that once the disclosure of additional/ undisclosed income is made and unaccounted income is admitted in the statement u/s 132(4) of the Act, then same shall be the minimum binding threshold commitment made by him to the department with respect to his unaccounted income, which could not and should not be retracted subsequently. Mere act of retraction on part of the Assessee shall not serve the purpose and the department can still proceed on the basis of the statement so recorded and corroborative evidences collected during the search. Therefore, the Assessee must be cautious and well aware as to the commitment he is making by admitting the additional undisclosed income in the statement u/s 132(4) of the Act.

3.3. Vide Taxation Laws (Second Amendment) Bill, 2016 (effective from AY 2017-18), Government has inserted new Section 271AAB(1A) and increased the penalty from 10% to 30% in case the unaccounted income is admitted by the assessee during the search and seizure operation.

3.4. It is relevant to mention here that Taxation Laws (Second Amendment) Bill, 2016 was tabled by the Finance Minister in Parliament on 28/11/2016 and received the assent of the President on 15/12/2016.Hence, rate of penalty was increased retrospectively so far as A.Y. 17-18 is concerned.

3.5. Whether the rate of penalty could be increased retrospectively as a valid piece of legislation?

Above question will definitely be tested in the legal battle. But in our opinion, following case laws are relevant.

National Agricultural Co-operative Marketing Federation of India Ltd v. UOI (i) it was held that,

“The legislative power either to introduce enactments for the first time or to amend the enacted law with retrospective effect is not only subject to the question of competence but is also subject to several judicially recognized limitations. The first is the requirement that the words used must expressly provide or clearly imply retrospective operation. The second is that the retrospectivity must be reasonable and not excessive or harsh, otherwise it runs the risk of being struck down as unconstitutional. The third is apposite where the legislation is introduced to overcome a judicial decision. The power cannot be used to subvert the decision without removing the statutory basis of the decision.

D. Cawasji And Co. Mysore vs The State of Mysore And Anr (ii) Hon’ble Supreme Court held that,

It was contended on behalf of the    appellant thatthe Amending Act doesnot seek  to rectify or remove the defect or lacuna on the basis of which the collection of the excess sales tax had been set aside by the High Court, and  that the increase in the rate of sales tax from 61/2% to45% with retrospective effect is clearly arbitrary and  unreasonable for if, any particular provision of thestatute is  for some lacuna or defect in the statute declared unconstitutional  or invalid,it is  open  tothe Legislature topass aValidating  Actwith  retrospective effect so  that the  State may not be saddled with liability of refund or other consequences which may arise as a result of the particular provision being declared invalid.

In case of Tata Motors v. State of Maharashtra (iii) , Hon’ble Supreme Court held that,

There should be reasonably and rationale behind retrospective amendment, otherwise liable to be struck down. An action taken by the State cannot be so irrational and so arbitrary so as to introduce one set of rules for one period and another set of rules for another period by amending the law in such a manner as to withdraw the benefit that has been given earlier resulting in higher burden without any reason.

Taxing statute is not immune from challenge under Article 14, State of Kerala v. Haji K. Kutty (iv) ; Ayurveda Pharmacy v. State of Tamil Nadu (v)

In case of J.K Synthetics Ltd. vs Commercial Taxes Officer (vi) , Hon’ble Supreme Court held that,

Charging sections are to be strictly construed. Even machinery provisions are to be construed as would effectuate the object and purpose of the statute and not defeat the same. Therefore, fresh inclusion of a circumstance in penalty provisions and increase in rate of tax, even if construed as forming part of the machinery provisions are to be considered as substantive law which cannot be construed retrospectively.

3.6. The Penalty provisions discussed in preceding paras are summarised as under:

 3.7. Whether the period of two years would be covered within the meaning of the Specified years?

Yes, it is possible that even two years can be specified years. For instance, if search was conducted on 07/04/2019 then AY 2020-21 is the specified year as Search is conducted in that year and AY 2019-20 is also the specified year as due date of filing return u/s 139(1) is not expired yet.

3.8. What if the additions were made in specified year under Section 68, 69, 69A, 69B, 69C or 69D?

Vide Taxation Laws (Second Amendment) Bill, 2016, Government has inserted new provision Section 271AAC for additions made Section 68, 69, 69A, 69B, 69C or 69D. However, in specified year even additions made Section 68, 69, 69A, 69B, 69C or 69D, penalty will be levied u/s 271AAB(1A), as Section 271AAC does not override the provisions Section 271AAB(1A).

3.9. “Substantiates the manner in which the undisclosed income was derived” is the real obstacle:

To get the benefit of concessional rate penalty of 10% or 30% as the case may be, one needs to substantiate the manner in which the undisclosed income was derived, while recording the statement u/s 132(4). Followings case laws will be useful in this regard:

In case of CIT v. Radha Kishan Goel (vii) (This ruling is related to old law,but findings are still relevant), Hon’ble Allahabad High Court held that,

Under section 132(4) unless the authorised officer puts a specific question with regard to the manner in which income has been derived, it is not expected from the person to make a statement in that regard and in case in the statement the manner in which income has been derived has not been stated but has been stated subsequently, that amounts to compliance with Explanation 5(2). In case there is nothing to the contrary in the statement recorded under section 132(4) in the absence of any specific statement about the manner in which such income has been derived, it can be inferred that such undisclosed income was derived from the business which he was carrying on or from other sources. The object of the provision is achieved by making the statement admitting the non-disclosure of money, bullion, jewellery, etc. Thus, much importance should not be attached to the statement about the manner in which such income has been derived. It can be inferred on the facts and circumstances of the case, in the absence of anything to the contrary. Therefore, mere non-statement about the manner in which such income was derived would not make Explanation 5(2) to section 271(1)(c) inapplicable.

In case of CIT v. Mahendra C Shah (viii) (This ruling is related to old law,but findings are still relevant), Hon’ble Gujarat High Court held that,

Regarding the manner in which such income has been derived, suffice it to state that when the statement is being recorded by the authorized officer it is incumbent upon the authorized officer to explain the provisions of Explanation 5 in entirety to the assessee concerned and the authorized officer cannot stop short at a particular stage so as to permit the revenue to take advantage of such a lapse in the statement. The reason is not far to seek. In the first instance, the statement is being recorded in the question and answer form and there would be no occasion for an assessee to state and make averments in the exact format stipulated by the provisions considering the setting in which such statement is being recorded, as noted by Allahabad High Court in case of Radha Kishan Goel (supra). Secondly, considering the social environment it is not possible to expect from an assessee, whether literate or illiterate, to be specific and to the point regarding the conditions stipulated by Exception No. 2 while making statement under section 132(4) of the Act. The view taken by the Tribunal as well as Allahabad High Court to the effect that even if the statement does not specify the manner in which the income is derived, if the income is declared and tax thereon paid, there would be substantial compliance not warranting any further denial of the benefit under Exception No. 2 in Explanation 5 is commendable.

3.10. When show cause notice does not contain specific satisfaction for offence as specified in the section:

In case of Shri Vivek Chugh v. ACIT (ix) , Hon’ble Indore ITAT held that

Where the Act provides for two different rates under different two provisions of law [i.e. Section 271AAB(1)(a) and Section 271AAB(1)(b)] in our considered view, the assessee ought to have been given an opportunity of hearing on this aspect. However, in the present case at the very inception notice initiating penalty is not in accordance with mandates of law. Moreover, it is settled position of law that such defect is not curable u/s 292BB of the Act. Therefore, we hereby quash the penalty order.

3.11. “Undisclosed income” to be constructed strictly:
For the ease of reference, definition of Undisclosed income as defined under Explanation (c) below Section 271AAB is reproduced herewith:  

In the definition of undisclosed income, where it talks about “income by way of any entry in the books of account or other documents or transactions found in the course of a search under section 132”, what perhaps has been envisaged by the legislature is an inflow of funds in the hands of the assessee which has been found recorded by way of any entry in the books of accounts or other documents, and which has not been recorded before the date of search in the books of accounts or other documents maintained by the assessee in the normal course. In light of the same, the undisclosed investment by way of advance for purchase of land can be subject matter of addition in the quantum proceedings, as the same has been surrendered during the course of search in the statement recorded u/s 132(4) and offered in the return of income, however the same cannot be said to qualify as an undisclosed income in the context of section 271AAB read with the explanation thereto and penalty so levied thereon deserved to be set-aside.Above was so held in case of Silver & Art Palace vs DCIT (x) .

In case of DCIT v. Manish Agarwala (xi) , it was held that,

From the facts and circumstances described above, since the assessee is not engaged in business or profession, he does not require to maintain the books of account as per sec. 44AA or sec. 44AA(2) of the Act, therefore, the assessee’s case falls in the second limb i.e. "or other documents" as stipulated u/s. 271AAB Explanation (c) (supra) which describes undisclosed income for the purposes of this section which is very important to adjudicate this issue. Therefore, the question is when the search took place, the assessee’s transactions (in this case, the speculative transaction) has been found to be recorded in the "other documents" which is (retrieved from the assessee’s accountant’s drawer) and based on that the assessee declared Rs. 3 cr. during search and later returned income of Rs. 3 cr. as income under the head "Income from Other Sources" which was accepted by the AO in toto. We note that since the income under question (Rs. 3 cr.) was in fact entered in the "other documents" maintained in the normal course relating to the AY 2013-14, which document was retrieved during search, hence, the amount of Rs. 3 cr. offered by the assessee does not fall in the ken of "undisclosed income" defined in Sec. 271AAB of the Act. So, Rs. 3 cr. which was commodity profit recorded in the other document maintained by the assessee which was retrieved during search cannot be termed as "undisclosed Income" in the definition given u/s. 271AAB of the Act. Since Rs. 3 cr. cannot be termed as "Undisclosed Income" as per sec. 271AAB of the Act, no penalty can be levied against the assessee. Therefore, we uphold the order of the Ld. CIT(A) on the aforesaid reasoning rendered by us.

Similarly, in case of Shri Gauri Shankar Kandoi v. DCIT (xii) , Jaipur Tribunal held that,

Deeming fiction u/s 69B cannot be extended and applied automatically in the context of section 271AAB of the Act. Further, the fact that the transaction so found recorded in a document has not been disputed by the Revenue. Given that the assessee is a salaried person who is not required to maintain any books of accounts and there is no mechanism to report the investment in the tax return, the said investment cannot be held as undisclosed investment and more so, undisclosed income so defined in section 271AAB of the Act. In light of the same, the investment of Rs. 17,16,594/- so found in purchase of Villa at Suncity Township at Sikar Road, Jaipur cannot be termed as undisclosed income within the meaning of “undisclosed income” as so defined u/s 271 AAB of the Act and penalty levied thereon is liable to be set aside.

3.12. Whether penalty u/s. 271AAB can be levied merely on the basis of surrender of income made in the statement u/s. 132(4)?

From the definition of "undisclosed income" u/s. 271AAA or 271AAB, it appears that, unless undisclosed valuable assets are found in the search or unless an entry or expenditure is recorded in a secret document found in the search, mere statement u/s. 132(4) disclosing additional income, not specifically supported/ represented by secret document/book and unless a finding is given by AO that it is not recorded in the regular books of account, additional income declared u/s. 132(4) cannot fall in the definition of "undisclosed income". Therefore, initiation of penalty u/s. 271AAA merely on the basis of surrender of additional income in the statement u/s. 132(4) will not be sustainable.Refer DilipKedia v. Asstt. CIT (Hyd. ITAT) (xiii) Asstt. CIT v. Ajit Singh (JP. ITAT) (xiv)

Thus, mere description of a transaction in a statement u/s. 132(4) without being supported by material evidence found in the search will also not be sufficient to levy penalty. In Smt. Aparna Agrawal v. Dy. CIT (xv) , it is held that "disclosure of income in statement recorded under section 132(4) would not ipso facto be regarded as undisclosed income unless and until it is tested as per definition provided in Explanation to section 271AAB."

4. Explanation 5A below Section 271(1)(c) of the Act:

For your ease of reference, Explanation 5A below Section 271(1)(c) is reproduced herewith:

4.2. In case a when additional income is offered in revised return or belated return:

Please note that in limb (a), it is mentioned that “return of income for such previous year has been furnished before the said date”, and not due date as per Section 139(1). That means if income in declared in return u/s 139(4) or 139(5) then also deeming fiction of Explanation 5A will not be applicable.

In this regards, in case of ITO v. Gope M. Rochlani (xvi) , Hon’ble Mumbai ITAT held that,

In the aforesaid Explanation 5A, the legislature has not specified the due date as provided in section 139(1) but has merely envisaged the words ‘due date’. This ‘due date’ can be very well-inferred as due date of the filing of return of income filed under section 139, which includes section 139(4). Where the legislature has provided the consequences of filing of the return of income under section 139(4), then the same has also been specifically provided. For e.g., section 139(3), provides that for the purpose of carry forward losses under sections 72 to 74A, the return of income should be filed within the time-limit provided under section 139(1), otherwise losses cannot be set-off. In absence of such a restriction, the limitation of time of ‘due date’ cannot be strictly reckoned with section 139(1). Thus, the meaning of the words ‘due date’, sans any limitation or restriction as given in clause (b) of Explanation 5A, cannot be read as ‘due date’ as provided in section 139(1). The words ‘due date’ therefore, can also mean date of filing of the return of income under section 139(4).

Once the legislature has not specified the ‘due date’ as provided in section 139(1) in Explanation 5A, then by implication, it has to be taken as the date extended under section 139(4). In view of the above, it is held that the assessee gets the benefit /immunity under clause (b) of Explanation to section 271(1)(c) because the assessee has filed its return of income within the ‘due date’ and, therefore, the penalty levied by the Assessing Officer cannot be sustained on this ground

4.2. In a case when the additional income is offered in return u/s 153A:

Above question is controversial, but following are few favourable rulings, which may be useful:

In case of Prem Arora v. DCIT (xvii) , Hon’ble Delhi ITAT held that,

Further, in case of search initiated after 1-6-2003 a return of income is always filed on issue of notice under section 153A. As held above the penalty under section 271(1)(c ) is imposable when there is variation in assessed and returned income. If there is no variation, there will be no concealment. When there is no concealment, question of levy of penalty under section 271(1)(c) will not arise. This is settled position of law. The concept of voluntary return of income may be important in penalty proceedings initiated in course of normal assessment proceedings made under section 143(3) or 147 but not under section 153A. From above discussion it follows that where retuned income filed under section 153A is accepted by the Assessing Officer, there will be no concealment of income and, consequently, penalty under section 271(1)(c) cannot be imposed.

Further in case of Alok Bhandari &Anr. v. ACIT (xviii), Delhi ITAT held that,

Even otherwise, it is further submitted that presumption raised by the Explanations to section 271(1)(c) are rebuttable and does not, ispo facto, result in automatic imposition of penalty. In the present case, the fact that the entire ‘undisclosed income’ was declared by the appellant in the statement recorded during search and the same was also disclosed in the return filed pursuant to notice issued under section 153A, clearly goes to show the bona fides of the appellant, not warranting imposition of penalty under section 271 (1)(c) of the Act.

4.3. Language of Explanation 5A of Section 271(1)(c) to be construed strictly:
Above explanation has two limbs (i)it speaks about Assets acquired by utilising unaccounted income and (ii) and speaks about income and starts with “any income based on any entry in any books of account or other documents or transactions”.

If during the Search addition was made on account of bogus purchases, then one may argue, it will not fall under any of above limb and ratio of Silver & Art Palace vs DCIT (xix) , still holds good in this case.

4.4. When show cause notice does not specify the offence namely inaccurate particulars of income or concealment of income:

In case of Sanjog Tarachand Lodha v. ITO (xx) ,a search u/s. 132 was conducted at the premises of the assessee on 21-05-2009. Consequent to search action, a notice u/s. 153A was issued to the assessee for the impugned assessment years. In response to the notice, assessee filed returns of income by showing undisclosed income declared during the search. The returns filed by the assessee u/s. 153A were accepted by the AO without making any further addition. Penalty proceedings u/s. 271(1)(c) were initiated against the assessee. Penalty was levied u/s. 271(1)(c) vide separate orders. The CIT (Appeals) invoked the provisions of Explanation 5A to section 271(1)(c) of the Act and upheld the findings of AO in levy of penalty u/s. 271(1)(c) of the Act.

Hon’ble Pune ITAT held that,

Furnishing of inaccurate particulars of income and concealing of income are two different expressions having different connotations. For initiating penalty proceedings, the Assessing Officer has to be very specific for the reasons of levying penalty, Whether it is for furnishing of inaccurate particulars of income or concealing of income or for both. In the present case, a perusal of notice issued u/s. 271(1)(c) r.w.s. 274 shows that the Assessing Officer has not specified the reasons for levying of penalty i.e. whether it is for furnishing of inaccurate particulars or concealment of income or both. Further, a bare perusal of the order levying penalty would show that the Assessing Officer is not clear whether the penalty is levied for concealment of income or furnishing of inaccurate particulars of income or both.Thus, in the facts of the case and documents on record, we are of the considered view that the notice issued u/s. 271(1)(c) r.w.s. 274 is invalid and thus, the subsequent penalty proceedings arising there from are vitiated.

5. Section 270A:

5.1. During the six assessment years immediately preceding the assessment year relevant to the previous year in which such search is conducted or requisition is made penalty u/s 271(1)(c) or 270A of the Act is levied. If any of such six assessment years consists of A.Y. 2017-18 and afterwards, penal provisions as per section 270A of the Act shall be applicable. With effect from A.Y. 2017-18, section 270A has completely revamped the pre-existing penalty provisions u/s 271(1)(c) of the Act which were part of the statute books since incorporation of the Act.

5.2. Finance Minister has in his budget speech while presenting the Finance Bill 2016 explained the reason for recasting the penalty provisions afresh in following words;

5.3. Memorandum of Finance Bill, 2016 that describes the amendments made in Finance Bill has clarified the rationale behind incorporation of new penal provision u/s 270A in following manner.

“In order to rationalize and bring objectivity, certainty and clarity in the penalty provisions, it is proposed that section 271 shall not apply to and in relation to any assessment for the assessment year commencing on or after the 1stday of April, 2017 and subsequent assessment years and penalty be levied under the newly inserted section 270A with effect from 1stApril, 2017. The new section 270A provides for levy of penalty in cases of under reporting and misreporting of income.”

Accordingly, such provision has been inserted to bring objectivity, certainty and clarity in the penalty provisions and to remove ambiguities and unnecessary litigation created by section 271(1)(c) of the Act. The charging mechanism has been shifted from concealment of particulars of income or furnishing inaccurate particulars of income to Underreporting and Misreporting of Income.

5.4. Underreporting and Misreporting of Income:

Due to difference in quantum of penalty and restrictive option to avail immunity, it is imperative to understand the difference between what is construed as Underreporting and what is considered as Misreporting u/s 270A.

In simple terms, Underreporting of income is said to have been committed where assessed income is higher than returned or earlier assessed income or maximum amount not chargeable to tax if return of income was not filed or would not have been filed. It is more particularly defined as follows;

(a) the assessed income is greater than the income determined u/s 143 (1)(a);

(b) the assessed income is greater than the maximum amount not chargeable to tax, where no return of income has been furnished or where return has been furnished for the first time u/s 148;

(c) the income reassessed is greater than the income assessed or reassessed immediately before such reassessment;

(d) the assessed or reassessed deemed total income under MAT Provisions, is greater than the deemed total income determined u/s 143(1)(a);

(e) the assessed deemed total income under MAT Provisions, is greater than the maximum amount not chargeable to tax, where no return of income has been furnished or where return has been furnished for the first time under section 148;

(f) the reassessed deemed total income under MAT Provisions, is greater than the deemed total income assessed or reassessed immediately before such reassessment;

(g) the income assessed or reassessed has the effect of reducing the loss or converting such loss into income.

5.5. Misreporting of Income:

Misreporting of Income is defined to include underreporting of income due to any of the following:

a) misrepresentation or suppression of facts;

b) failure to record investments in the books of account;

c) claim of expenditure not substantiated by any evidence;

d) recording of any false entry in the books of account;

e) failure to record any receipt in books of account having a bearing on total income; and

f) failure to report any international transaction or any transaction deemed to be an international transaction or any specified domestic transaction, to which the provisions of Chapter X apply.

5.6. Quantum of Penalty:

The section envisages levy of penalty to the extent of 50% of Tax Payable on Underreported Income whereas in case of Misreporting the amount of penalty will be 200% of Tax Payable on such Misreported Income.

5.7. Immunity from imposition of penalty & prosecution as per section 270AA:

Where proceedings for penalty has been initiated for underreporting of income not consequent to misreporting thereof, then assessee shall be granted immunity from imposition of penalty and prosecution if assessee has accepted the assessment or reassessment order and paid the tax alongwith with interest payable as per the assessment or reassessment order under section 143(3) or under section 147 as the case may be, within a specified period and appeal against such assessment order has not been filed.

5.8. Penalty under Search & Seizure:

Like explanation 5A of section 271(1)(c), there is no specific provision u/s 270A that governs imposition of penalty on undisclosed income consequent to search and seizure operation. Penalty in case of Search and Seizure is governed by normal provisions i.e. underreporting of income & misreporting of income.

To levy penalty under the provision of Section 271AAB(1A) & Explanation 5A of Section 271(1)(c), it must fall within the definition of "undisclosed Income" that means, there must be discovery in the search (initiated against the assessee), of money, bullion, jewellery or other valuable article or thing in respect of which an addition is made u/s. 69/69A. However, to levy penalty u/s 270A of the Act, there is no requirement to unearth undisclosed income, but rather it must fall under the definition of Underreporting or Misreporting of income.

Disclosure of income in case of search is almost always on account of suppression or misrepresentation of the facts and considering the quantum of penalty, assessing officer will always want to levy penalty u/s 270A(9) of the Act i.e. for Misreporting Income. We shall try to correlate the common additions made in case of search with the penalty leviable u/s 270A of the Act.

6. Other Immunitie9s available under the Act

Following are the immunities available under the Act: