Analysis of six important judgements (July to November 2010)

It is true that the law is attired in the language used in the statute. But, it would be sheer folly to assume that this law is bound or self contained in the language only. Law, in its natural state, has a dimension that extends beyond the language used in the statutory provisions. It has capabilities to overflow in to the realm of the unwritten law i.e. the principles of law and its interpretations. Whereas the language used in a statutory provision constitutes the ‘express law’, the legal principles constitute the “implied law.”

The logical end point of every law should be delivery of justice. It is here that the implied law operates as the unseen force supplementing the express law towards this objective. Ultimately, it is the manner in which the law is administered in a State that determines how progressive its society is.

In this article, popularly reported decisions have been avoided as they have been amply covered in articles written by other authors A few decisions have been handpicked by the author where the judiciary has endeavored to read the law beyond the language it is couched and interpret the same on the basis of the implied law, it felt, was sighted within. The readers are advised to form their own opinions on the same.

Indo-UK DTAA – When Treaty benefits available ?- Fiscal Domicile –Meaning :-

The Mumbai Tribunal’s decision in the case of Linklaters LLP vs. ITO as reported in [2010] 40 SOT 51 {Mum} has thrown up an interesting legal proposition.

The assessee, in this case was an UK based law firm, which did not have an office in India. It rendered services in India through its partners and employees who visited India for this purpose. The Tribunal found that its income from these services were taxable in India by virtue of section 9 [1] of the Income Tax Act, 1961. The next consequential issue to be decided was whether the assessee firm could an avail the benefits of the provisions of the Indo-UK DTAA. This is because if the benefits of the DTAA were available to it and it is also found that it had no permanent establishment or fixed base in India through which these services were rendered, then its income from services would not be taxable in India [Article 7, paragraph 1 – ‘Business Profits’]

Now, the benefits of the DTAA are available only to a ‘person’ who is ‘resident’ in either of the Contracting States.{emphasis supplied in bold underline}. Under the tax regime prevailing in UK, a partnership firm is treated as a transparent entity and ignored for purposes of taxation. The partners of the firm are taxed instead. This is in contrast to the situation in India, where a partnership firm is taxed as the fiscal entity.

The Tribunal found that a partnership firm is recognized as a ‘person’ in paragraph 2 of Article 3 {General definition} of the DTAA. But, in order to avail of the benefits of the DTAA, a further condition was required to be satisfied and i.e. this partnership firm must be shown to be ‘resident’ in UK. Under the provisions of paragraph 1 of Article 4 {Fiscal Domicile }of the DTAA, the term ‘resident’ of a Contracting State means any person who, under the law of that State, is liable to taxation by reason of his domicile, residence, place of management or other criterion of a similar nature. In short, unless the partnership firm is shown to be ‘liable to taxation’ in UK on the basis of its location, it cannot access the DTTA in India as a resident. And the difficulty here is that in UK, the assessee partnership firm is not taxed, but its partners are subjected to taxation.

The Tribunal noted that the head note of the Article 4 is “Fiscal Domicile’. Drawing inspiration from this, it held that as long as all the partners of the assessee firm are liable to taxation in UK as residents, the assessee firm can be treated as a resident in terms of the DTAA in India. In short, what the Tribunal proposed is that the test of residence must be satisfied by qualifying to be ‘fiscal domiciled’ and if the all the partners were assessable to tax in UK as residents, it amounts to, in substance, to the same thing as the firm being ‘fiscally domiciled’ person in UK’.

In my opinion, the real test of efficacy of this decision will be in situation in which income of a partnership firm is doubly taxed both in India and UK and the issue of grant of tax credit is involved. The problem is often vexed due to the mismatch in the legal perceptions in these countries about whether a partnership firm is a fiscal entity or not. Whereas in India, the firm is subjected to tax, in UK the partners are taxed and not the firm. Tax credit is given in the State of residence only when the same entity is taxed on the same income in both the States- which phenomenon may not be perceived in the circumstances because in one State, the firm is taxed and in the other, its partners.

Suppose, by way of example, an enterprise of an Indian partnership firm carries on business in UK through a permanent establishment {PE}. The partnership firm will, in the first place, be taxed in India on its business profits on the basis of its residence. UK will also subject its profits attributable to the PE to tax, but in hands of the partners of the firm. The issue for consideration of the readers is whether, on the basis of the Mumbai Tribunal’s interpretation of the expression ‘fiscal domicile’[Article 4- Indo UK DTAA} in its decision in the case of Linklaters discussed above, the tax regime in India will grant tax credit to the partnership firm for the taxes paid by its partners in UK ? This, in my opinion, will be the acid test set out for the Linklaters’ decision in the coming future.

Accrual of income must be factual and not merely contractual…

The decision of the Delhi High Court in the case of CIT vs. Vasisth Chay Vypari in ITA nos. 552/2005 and others dated 29-11-2010 {courtesy – www.itatonline.org] presents an opportunity for dynamic thinking.

The assessee, a NBFC, advanced Inter Corporate Deposits (ICD) to Shaw Wallace. As the interest was not received by the assessee for more than six months in view of the adverse financial position of the borrower, the assessee treated the ICD as a Non Performing Asset (NPA) in terms of the directions of the RBI and did not account for the interest. However, the AO held that as the assessee was following the mercantile system of accounting, the interest had “accrued” even if it was not actually realized. This was confirmed by the CIT (A) though reversed by the Tribunal.

On appeal by the department, the High Court held dismissing the appeal in the following manner:-

[i] U/s 45Q of the RBI Act read with the NBFCs Prudential Norms (Reserve Bank) Directions 1998, it was mandatory on the part of the assessee not to recognize the interest on the ICD as it had become a NPA.

[ii]The assessee was bound to compute income having regard to the recognized accounting principles set out in Accounting Standard AS-9. AS-9 provides that if there are uncertainties as to recognition of revenue, the revenue should not be recognized.

[iii] Accordingly, the argument of the revenue that the interest on the NPA can be said to have accrued despite it being a NPA is not acceptable.

{Here, the decision of the Supreme Court in Southern Technologies vs. JCIT 320 ITR 577 (SC) relied by the Revenue was distinguished by the High Court on the ground that there the interest was admittedly accrued, but its realization was doubtful for which a provisions was made in the accounts and whereas in the instant case before it, the interest income was not booked in the accounts by the assessee because its very realization was questionable at inception itself}.

Readers may examine whether the issue before the Delhi High Court could have also been approached from another example.

The law, as on date, is fairly well settled to the effect that income can be said to have accrued to an assessee if he acquires the right to receive it [CIT vs. Shri Goverdhan Ltd {1968} 69 ITR 675 {SC}]. The income should become a debt in favour of the assessee [E.D. Sasson and Co. Ltd. {1954} 26 ITR 27 {SC}]. In short, if a right to receive the income has contractually vested in a person, then the income is accrued to him for tax purposes.

At the same time, it may be noted that the above principle of accrual of income is intricately linked to the principle of ‘ real income’. The decision of the Supreme Court in the case of State Bank of Travancore vs. CIT {1986} 158 ITR 102 {SC} is testimony to this proposition. The Apex Court has held that whether an accrual has taken place or not must, in appropriate cases, be judged on the principles of ‘real income’ theory. If, in the reality of a situation, the very accrual of income is prevented, then no tax can be levied on the income. On the other hand, if after the income has accrued, it is subsequently found to be non realizable, then the accrual having already occasioned cannot be defeated due to any subsequent non realization of the income.

By analogy, if you have a contractual right to draw water from a well and the well is dried at the time of your proposed drawing, is not your right to draw this water illusory ?

In summary, if the uncertainty of realization of income precedes its accrual, then the event of its accrual is defeated at the roots itself. It is this principle, which I propose that the readers may apply in the context of the Delhi High Court case of Vasisth Chay Vyapar discussed above. From the facts of the case, it appears that the chances of realization of interest by the assessee from its customer was far from remote even before the event of accrual of interest taking place. In such circumstances, can it not be said that interest had ‘not factually accrued’? Cannot the principle of ‘real income’ be applied here? These are the queries which I wish that the readers should ponder over.

Penalty u/s 271 [1][c] not leviable – when no provision in statute for penalizing alleged offence

A penalty is a creature of the Statute. Unless there is a specific provision in the Act providing for levy of penalty, the same cannot be levied. Further, even if there is an overall provision, but the machinery in the provision is not adequate to deal with alleged offence, the penalty becomes unworkable. The decision of the Delhi High Court in the case of CIT vs. Nalwa Sons Investments Ltd as reported in [2010] 327 ITR 543 {Del} is an illustration of such an instance.

Here, the assessee initially filed its return declaring a loss of Rs. 43.47 crores. Thereafter, it filed a revised return declaring an income of Rs. 3,86,82,128 being book profits u\s 115JB of the Income Tax Act. In assessment u\s 143 [3] of the Income Tax Act, the loss was assessed at Rs. 36.95 crores as per the normal provisions and the book profits as the total income assessed at Rs. 4,01,63, 180. An issue for consideration before the High Court was whether penalty u\s 271 [1][c] is leviable in respect of the disallowances made in the income assessed under the normal provisions {The loss assessed under normal provisions was reduced due to some disallowances}.

The High Court held as under :-

“ Under the scheme of the Income Tax Act, 1961, the total income of the assessee is first computed under the normal provisions of the Act and the tax payable on such profits is compared with the prescribed percentage of the book profits computed under section 115JB of the Act. The higher of the two amounts is regarded as total income and tax is payable with reference to such total income. If the tax payable under the normal provisions is higher, such amount is the total income of the assessee, otherwise, the book profits are deemed as the total income of the assessee in terms of section 115JB of the Act. Where the total income computed in accordance with the normal procedure is less than the income determined by the legal fiction, namely, the book profits under section 115JB of the Act and not under the normal provisions, the tax is paid on the income assessed under section 115JB of the Act. Concealment of income would have no role to play and would not lead to tax evasion. Therefore, penalty cannot be imposed on the basis of disallowance or additions made under the regular provisions.”

Readers may also note that the computation of penalty u\s 271 [1][c] is also with reference to “the amount of tax sought to be evaded”, which expression has been defined in Explanation 4. Under this Explanation, the tax on the additions which constitute concealed income is treated as the amount of tax evaded. In short, the additions made in the assessed income are compared with returned income for determining the tax sought to be evaded. In the instant case before the Delhi High Court, the allegation of concealment was with respect to the income assessable under the normal provisions and not regarding the book profits u\s 115JB returned as the total income and later assessed.

Dismissal of a SLP by Supreme Court –consequential effects

The order of the Supreme Court in the case of CIT vs. CIT vs. GlaxoSmithKiline {Asia} – SLP {Civil} {No (s) 18121 /2007 dated 26-10-2010 – {Courtesy :- www.itatonline.org} should be understood as a dismissal of a SLP and not a dismissal of an appeal. The consequential effect of lack of any precedent in this order can then be appreciated.

The Supreme Court had dismissed the SLP filed by the Income Tax Department as under :-

“The assessee did not have any employee other than a company secretary and all administrative services relating to marketing, finance, HR etc were provided by Glaxo Smith Kline Consumer Healthcare Ltd (“GSKCH”) pursuant to an agreement under which the assessee agreed to reimburse the costs incurred by GSKCH for providing the various services plus 5%. The costs towards services provided to the assessee were allocated on the basis suggested by a firm of CAs. The AO disallowed a part of the charges reimbursed on the ground that they were excessive and not for business purposes which was upheld by the CIT (A). However, the Tribunal deleted the disallowance on the ground that there was provision to disallow expenditure on the ground that it was excessive or unreasonable unless the case of the assessee fell within the scope of s. 40A (2). It was held that as it was not the case of the Department that s. 40A (2) was attracted, the disallowance could not be made (see 290 ITR 35 (Del) for facts). The department challenged the deletion. HELD dismissing the SLP:

(i) The Authorities below have recorded a concurrent finding that the said two Companies are not related Companies under s. 40A (2). As far as this SLP is concerned, no interference is called for as the entire exercise is a revenue neutral exercise. Hence, the SLP stands dismissed. For other years, the authorities must examine whether there is any loss of revenue. If the Authorities find that the exercise is a revenue neutral exercise, then the matter may be decided accordingly;

(ii) The larger issue is whether Transfer Pricing Regulations should be limited to cross-border transactions or whether the Transfer Pricing Regulations be extended to domestic transactions. In domestic transactions, the under-invoicing of sales and over-invoicing of expenses ordinarily will be revenue neutral in nature, except in two circumstances having tax arbitrage such as where one of the related entities is (i) loss making or (ii) liable to pay tax at a lower rate and the profits are shifted to such entity;

(iii) Complications arise in cases where the fair market value is required to be assigned to transactions between related parties u/s 40A(2). The CBDT should examine whether Transfer Pricing Regulations can be applied to domestic transactions between related parties u/s 40A(2) by making amendments to the Act. The AO can be empowered to make adjustments to the income declared by the assessee having regard to the fair market value of the transactions between the related parties and can apply any of the generally accepted methods of determination of arm’s length price, including the methods provided under Transfer Pricing Regulations. The law can also be amended to make it compulsory for the taxpayer to maintain Books of Accounts and other documents on the lines prescribed in Rule 10D and obtain an audit report from his CA that proper documents are maintained;

(iv) Though the Court normally does not make recommendations or suggestions, in order to reduce litigation occurring in complicated matters, the question of extending Transfer Pricing regulations to domestic transactions require expeditious consideration by the Ministry of Finance and the CBDT may also consider issuing appropriate instructions in that regard.”

A dismissal of a SLP merely means that the Supreme Court is not inclined to admit the SLP as an appeal and hear it. It means that the Supreme Court does not consider the matter fit for exercise of its jurisdiction under Article 131 of the Constitution. It does not amount to affirmation of the decision of the High Court. This is more particularly so when it does not comment on the correctness of the decision of the High Court. It is only when the SLP is allowed that it is converted in to an appeal. When the order is passed in appeal by the Supreme Court, the decision of the High Court merges in to it and what subsists operatively thereafter is only the order of the Supreme Court as the final word. If such an order passed in appeal by the Supreme Court involves an answer by it on a question of law, the answer amount to a law declared by it and therefore a binding precedent on the lower courts and authorities. This is my perception of the law regarding SLPs which I want to share with the readers.

The order of the Supreme Court dismissing the Department’s SLP in the GlaxoSmithKline {Asia} may therefore be viewed by the readers from the above angle. It should not be read as a decision which says the provisions of section 40A [2] are not to be applied if the transaction between related parties is ‘ revenue neutral’. In fact, it is quite possible that the issue of application of the provision of section 40A [2] may not even be involved before the Supreme Court. While the order of the Supreme Court recaptures the facts of the case and gives its decision declining the SLP, as to what was the question to be answered by the Supreme Court does not find mention in the order. But, from the facts cited in the order, the issue could have been more probably, whether a disallowance can be made of the expenditure on grounds of excessiveness when the payer and payee are not related as per the provisions of section 40A [2] and when the Department had never invoked the provisions of section 40A [2] in the first place. This order should also not be construed as the Supreme Court saying that if an expenditure transaction is tax neutral between the parties, no disallowance can be made for excessiveness. I also clarify that it is also not my case that such a disallowance is permissible in absence of a provision authorizing it. According to me, the Supreme Court meant that since the SLP is filed by the Revenue, the Court is not considering it fit for exercise of jurisdiction under Article 131 as no effective prejudice is caused to the Department because the issue is revenue neutral. {There is no monetary loss to the Department from a revenue neutral transaction and issue is therefore not significant enough for the Supreme Court to intervene}

Since this order is being widely reported, I thought I should share my views with the Readers.

Levy of interest – How much mandatory?

As a general rule, levy of penal interest u\s 234-A, u\s234-B and u\s 234-C for alleged delay in depositing taxes has held to be mandatory by the Supreme Court in the case of CIT vs. Anjum M.H. Ghaswala [2001] 252 ITR 1 {SC}. Unless there is no express power granted by the statute to waive the same, the taxing authority would not have any discretion in the matter of levy of the same.

At the same, time, when the assessee is visited with the interest liability either because of impossibility in depositing the tax [where the liability to pay the tax has arisen because of a retrospective amendment} or due to the fault of the Department only, judicial authorities have intervened to redeem the assessee in this situation.

In the case of JSW Steel Ltd vs. ACIT [2010] 5 ITR {Trib} 31{Bangalore}, the assessee was found liable in assessment for interest u\s 234-B on book profits assessed as the total income u/s 115JB of the Income Tax Act. It was the assessee’s case that this liability had arisen because of a provision brought subsequently with retrospective effect that deferred tax has to be added back in computation of the book profits. The Tribunal found that it was impossible for the assessee to have paid the advance tax when at the due dates for paying the advance tax, this provision was not on the statute book. It accordingly deleted the interest levied.

In another case, the Delhi High Court in the case of CIT vs. Mesco Airlines Ltd [2010] 327 ITR 554 {Del} has ruled that the assessee should not be burdened with interest u\s 158BFA [1] for delayed filing of the block assessment return for the period of delay occasioned by the time taken by the Department to supply copies of documents seized by the Department, which documents were necessary for compiling the income to be returned.

Taking a cue from the above decisions, two legal principles come to my mind. Firstly, the law does not compel any one to perform the impossible ( lex non ogit ad impossibilia). Secondly, no person should be allowed to take advantage of one’s own default [and that too at the cost of the other and even when the defaulter is an authority himself]. It is time that these principles should be read in to the law by our tax courts in cases where charging of penal interest is otherwise mandatory, where the assessee is not at fault.

With these remarks, I shall take leave of the readers.