Analysis of three important judgements (November 2011 to May 2012)

In the past six months, several decisions of substantial importance to the tax payers have emerged. The Supreme Court decisions in the Vodafone case and also in the section 80-HHC issues are examples of the same. Since these decisions have been widely discussed, they have not been considered in this article to avoid duplication. Apart from these decisions, several decisions of the High Court and the Tribunals on issues of taxation of royalty etc have been nullified by the Government by resorting to retrospective amendments in the recent Finance Bill. These have also not been discussed as their value as legal precedents for the future would be doubtful after these retrospective amendments. The decisions selected in this article are only those which the author felt have analytical value to the readers.

1. AAR decision– selective buy back of shares was held to be distribution of dividend: – [AAR no. P of 2010 dated 22nd March 2012 {www.itatonline.org}] –

In the backdrop of an unsavory Vodafone tax episode, the AAR decision in this case unfolds to us as a preview of the specter looming in the forthcoming GAAR regime.

In the case before the AAR, the Applicant’s shares were held 48.87 % by a US company & 25.06% by a Mauritius company. The rest were held by a Singapore company and the public. The Mauritius company’s shares were ultimately held by another US company. The AAR noted that since 1.4.2003, when the provisions of section 115-O were introduced, the Applicant did not (supposedly to avoid DDT) distribute dividend. Instead, it let its reserves grow and offered a buy-back in the year 2008. The buy-back was accepted only by the Mauritius company, in whose hands the capital gains u/s 46A, were not assessable under the India-Mauritius DTAA. The other shareholders did not accept the offer. A second offer was proposed which also was accepted only by the Mauritius company and not by the other shareholders. The Applicant sought a ruling on whether the gains as a result of the buy-back would be capital gains u/s 46A in the hands of the Mauritius company and exempt under Article 13 of the India-Mauritius DTAA.

The AAR held that though the Applicant was making regular profits, it did not declare any dividends after the introduction of s. 115-O and allowed its reserves to grow. This was only to avoid paying DDT. The buy-back was a “colourable device” devised to avoid tax on distributed profits u/s 115-O because while it would result in repatriation of funds to the Mauritius company, that would constitute “capital gains” in the hands of the recipient, and not be assessable to tax in India under Article 13 of the India-Mauritius DTAA. The fact that the other major shareholders did not accept the buy-back was significant. A buy-back results in a release of accumulated profits which is assessable as “dividend”. The exemption to treat the buy-back proceeds as capital gains is only in respect of a genuine buy-back of shares. As the transaction is colourable, it is not a transaction in the eye of law and has to be ignored and the arrangement has to be treated as a distribution of profits [emphasis supplied in bold underline] by a company to its shareholders which is assessable as dividend in the hands of the recipient.

The issue for consideration of the Readers is whether a payment to single shareholder only [i.e. the Mauritius company] can be considered as a ‘distribution’ of ‘dividend’ u\s 2 [22] {emphasis supplied in bold under line}.

The definition of ‘dividend’ in section 2 [22] is an inclusive one. Whereas, it impliedly includes payments which are regarded as ‘dividends’ in the normal course under the company law, it expressly includes five categories of dividends in clause [a] to [e] of its provisions. Clauses [a] to [d] take in to accounts ‘distributions’ which are considered as dividends under this section. Clause [e] covers  two types of payments made by a company [not substantially owned by the public] of loan or advance to a shareholder having substantial interest etc.- firstly a payment of a loan or advance to such a shareholder and secondly a payment made by the company  on behalf of or for the benefit of such individual shareholder.

It is in face of the above provisions that the Applicant’s case before the AAR has to be tested as to whether there could have been a distribution of profits as ‘dividend resultant from   the shares’ buy-back transaction.

In company law, the concept of ‘dividend’ is twofold. In the first place, it envisages an allocation by the company, as a going concern, of a portion of its profits earned to its shareholders as a reward for committing their investment to its share capital. In the second place, it can connote an allocation by the company, in the course of its winding up, of the realization proceeds of its assets to its capital contributories.

Whatever way one may see it, the common characteristic in both, is that it necessarily involves a ‘distribution’ of its funds to more than beneficiary. The Supreme Court in Punjab Distilling Industries Ltd. vs. CIT [1963] 57 ITR 1, 9 {SC} has noted that a ‘distribution’ involves giving allocated shares to more than persons.

It is this fundamental aspect that distinguishes ‘distribution’ from a mere ‘payment’. Whereas distribution should essentially involve more than one beneficiaries, a payment can be to even a single beneficiary. {CIT vs. Jamnadas Srininwas Pvt. Limited [1970] 76 ITR 656 {Cal} and CIT vs. Bombay Mineral Supply Co. Pvt. Ltd. [1978] 112 ITR {Guj}.

It is in the above legal matrix, that the Readers may appraise the AAR decision.  The AAR has here specifically held that the case before it involved a ‘distribution’ amounting to payment of dividend u\s 2 [22]. The Readers may therefore consider whether the selective buy back in favour of only one beneficiary shareholder can amount to a ‘distribution’? If, per chance, it cannot be considered as a distribution in first place, then question of evasion of DDT should also not arise.

2. Assessment of a joint venture – Difference between an Association of Persons for earning income and that merely for obtaining a tender. – Vizag Tribunal decision.

When two or more persons join in coalition to undertake an enterprise, they would certainly form an Association of Persons in law. But, in the context of the Income Tax Act, since the subject matter is  taxation of ‘income’, one more ingredient is essential to subject an entity to tax as an  Association of Persons and that is –  the constituents of the association must have joined together with the purpose to earning ‘income’ together. [N.V. Shanmugham & Co vs. CIT [1971] 81 ITR 310 {SC}].

Therefore,  where  a joint venture has been set up merely to obtain a  government tender under a common banner and the work involved in the tender was agreed in the joint venture agreement to be independently executed by its constituents in mutually exclusive portions with an understanding that the profits relating to each portion would also accrue to the respective constituents only, then the  income should logically not be taxed in the hands of the joint venture  as an AOP, but in the hands of the individual constituents based on the work handled by it. This should be understandable because the association is formed only to obtain the tender and not to share its profits amongst themselves.

Such principle can be sighted in the decision of the Vizag Tribunal in the case of Transsitoy {I} Pvt. Ltd. vs. ITO [2012] 134 ITD 269 {Vishakhapatnam}{Trib}.

In this case, the assessee company, formed a joint venture named “Navayuga Transtoy (JV)” which bid for the contract. The Irrigation Department of Andhra Pradesh awarded the contract to the JV. As per the terms of the JV, the assessee was to execute 40% of the work in Navayuga, the other constituent partner was to execute 60% of the works. Assessee was to execute work worth Rs. 265.80 crores, out of which works valued at Rs.18.12 crores were executed during the A.Y. 2006-07. Both the partners raised bills on JV for quantity of work as certified by technical consultant appointed by the State Government. In turn, the JV raised a consolidated bill on the Irrigation Department without making any additions. Payments were made to the JV, which shared the payment in accordance with the bills raised by each partner. JV filed its return without claiming any deduction u/s 80IA(4). Assessee also formed a consortium along with one M/s „CT‟ Moscow, with an understanding that the assessee would execute 100% of the works which were awarded to the consortium. Assessee executed works valued worth Rs.31.09 crores and claimed deduction u/s 80IA(4) on the profits derived out of the aforesaid works. AO disallowed the claim stating that the work was not awarded to the assessee. In appeal before CIT (A), the assessee contended that the JV or the consortium was formed only with an object to obtain a contract from the Government but in fact the work was executed by the constituents of the JV i.e. the assessee and the other constituent. Deduction was to be allowed to those enterprises, which were engaged in the business of developing, maintaining and operating any infrastructure facility. Therefore, the assessee was entitled for deductions on profit earned from the aforesaid activities. However, CIT (A) confirmed the disallowance made by the AO.

The Tribunal held as under :-[relevant portions]

“Undisputedly the joint venture or the consortium was formed only to obtain the contract from the Government bodies. At the time of execution of the joint venture or the consortium, it has been made clear that work/project awarded to the joint venture would be executed by the joint venturers or the constituents. As per mutually agreed terms and conditions between them, it was also agreed that each party shall be responsible for the provisions of without limitation on resources required for the purpose of fulfilment of the scope and also solely responsible for the performance of its scope of work and shall bear all technical, commercial and facing risk involved in performing its scope of work. It was also agreed that none of the party shall assign its rights and obligations to any other party without written consent of other party. It is evidently clear that the joint venture and the consortium was formed only with an object to bid contract. Once the project or contract is awarded to the joint venture or the consortium, it is to be executed by its constituents or the joint ventures in a ratio agreed upon by the parties. The assessee was entitled to execute the 40% of total work awarded to the joint venture and in case of a consortium it was agreed that the entire work is to be executed by the assessee itself. Therefore for all practical purposes, it was the assessee who executed the work contract or the project awarded to the joint venture. No doubt the joint venture is an independent identity and has filed its return of income and was also assessed to tax but it did not offer any profit or income earned on this project/works awarded to it nor did he claim any exemption/deduction u/s 80IA(4) of the Act. These facts clearly indicates that the joint venture was only a de-jure contractor but in fact the assessee was a de-facto contractor; the benefit of exemption/deduction is to be allowed to any enterprise carrying on business of developing or operating and maintaining or developing, operating, maintaining any infrastructure facility subject to fulfilment of certain conditions. One of the condition is that the enterprise should be owned by a company registered in India or by a consortium of such companies or any other body established or constituted under any centre or any state Act. The other condition is that it has entered into an agreement with the Central Government or a State Government or local authorities or any other statutory body for developing, operating and maintaining or developing, operating & maintaining a new infrastructure facility;

There is no dispute with regard to the fulfilment of other requisite conditions. The dispute was only raised that the contract was awarded only to the joint venture and not to the assessee and therefore assessee is not entitled for deduction. The benefit of deductions is to be given to an enterprise which carry on the aforesaid classified business. The legislature have also used the word consortium of such companies, meaning thereby the legislature was aware about the object of formation of consortium and joint ventures. Generally the joint ventures or consortiums are formed to obtain a contract from the Government body for its execution by its constituents. If the constituents do not want to execute the work, there was no need to form a consortium. Therefore, mere formation of consortium for obtaining a contract should not debar the enterprises who in fact carried on the aforesaid classified business from claiming the deduction or exemption u/s 80IA(4). The joint venture or the consortium was only a paper entity and has not executed any contract by itself. They have also not offered any income out of the work executed by its constituents, nor did they claim any deductions u/s 80IA(4). Therefore, in all practical purposes, the contract was awarded to the constituents of the joint venturers through joint venture and the work was executed by them. As per provisions of section 80IA(4), the benefit of deduction under this section is to be given only to the enterprise which carried on the classified business. Therefore, in the light of this legal proposition, the assessee is entitled for the deductions u/s 80IA(4) on the profit earned from the execution of the work awarded to JV and consortium.”

This decision should clear bring to the light that merely because an agreement has been styled as a ‘joint venture’, it should not automatically follow that the same should be taxed on the income of the venture . If, the intention of the constituents of the joint venture, as manifest from their conduct, was only to obtain work only and not to perform the work together so as to share its profits in common, the joint venture would  fall short as the taxable entity on which  the income of the venture is to be subjected to tax.  In the case before the Vizag Tribunal, there was no interlacing or interdependence observed in the individual jobs performed by each constituent.  Each constituent’s work was therefore a separate source of income qua  constituent. The income was therefore rightly held to be taxable in the hands of the respective constituent assessee and not  the joint venture.

The decision of the Vizag Tribunal therefore appears to me as one rightfully applied.

3. Disallowance u/s 14A – the sequence to be followed by A.O. before applying Rule 8D- Mumbai Tribunal decision

In its decision in the case of Auchtel Products Ltd vs. ACIT [www.itatonline.org], the Mumbai Tribunal has spelt out the sequence to be followed by the Assessing Officer before resorting to Rule 8D in making disallowance u\s 14A.

The facts of the case are that for Assessment Year  2008-09, the assessee claimed that it had not incurred any expenditure in earning dividend income and no disallowance u/s 14A could be made. However, the AO computed disallowance u/s14A & Rule 8D of Rs.12.81 lakhs. This was upheld by the CIT (A).

On appeal to the Mumbai Tribunal has held as under:-

A bare perusal of the above provisions indicates that the AO shall determine the amount disallowable as per Rule 8D, if he, “is not satisfied with the correctness of the claim of the assessee” in respect of such expenditure in relation to exempt income. Even if the assessee claims that no expenditure was incurred in respect of exempt income, the AO is supposed to follow the mandate of Rule 8D if he is not satisfied with the correctness of the assessee’s claim. To put it simply, the further disallowance u/s.14A is called for when the AO is not satisfied with the assessee’s claim of having incurred no expenditure or some amount of expenditure in relation to exempt income. Satisfaction of the AO as to the incorrect claim made by the assessee in this regard is sine qua non for invoking the applicability of Rule 8D. Such satisfaction can be reached and recorded only when the claim of the assessee is verified. If the assessee proves before the AO that it incurred a particular expenditure in respect of earning the exempt income and the AO gets satisfied, then there is no requirement to still proceed with the computation of amount disallowable as per Rule 8D. From the assessment order, it is observed that the AO simply kept the assessee’s submissions on record without appreciating as to whether these were correct or not. He proceeded on the premise as if the disallowance as per Rule 8D is automatic irrespective of the genuineness of the assessee’s claim in respect of expenses incurred in relation to exempt income. It is an incorrect course adopted by the AO. The correct sequence, in our considered opinion, for making any disallowance u/s.14A is to, firstly, examine the assessee’s claim of having incurred some expenditure or no expenditure in relation to exempt income. If the AO gets satisfied with the same, then there is no need to compute disallowance as per Rule 8D. It is only when the AO is not satisfied with the correctness of the claim of the assessee in respect of such expenditure or no expenditure having been incurred in relation to exempt income, that the mandate of Rule 8D will operate. In the instant case, the authorities below have directly gone to the second stage of computing disallowance u/s.14A as per Rule 8D without rendering any opinion on the correctness or otherwise of the assessee’s claim in this regard. We, therefore, set aside the impugned order on this issue and restore the matter to the file of AO to re-compute disallowance, if any, in accordance with our above observations after duly examining the assessee’s claim in this regard.”

In the present scenario, where  the Income Tax Department is blindly applying the provisions of Rule  8D without even considering the correctness of the claims made by the assessee, the decision of the Mumbai Tribunal spelling out the above guidelines should augur as a welcome correction in the right direction. This is because the ‘satisfaction’ about the incorrectness of the claim made by an assessee should be seen as a ‘jurisdictional requirement’ to be complied by the Assessing Officer before applying the provisions of Rule 8D.  It is a mandatory requirement and should not be dispensed in a farcical manner. It is only on reaching this stage of ‘satisfaction’ that the Assessing Officer becomes seized with the legal authority to apply Rule 8D and not otherwise.  

The only proposition, I wish to venture, is whether the above guidelines set by the Tribunal can be advanced a bit further? The language in section 14A [2] is clear to the effect that the ‘correctness of the claim’ made by the assessee has to be tested ‘having regard to the accounts of the assessee’. The words ‘having regard to the accounts of the assessee’ are therefore pertinent. If the accounts of the assessee are reliable and from the same, a working of the disallowance can be derived by any reasonable and scientific basis, then even if the Assessing Officer is not satisfied about the claim put forth by the assessee, he must work out the disallowance on  the basis of the accounts itself and not as per the provisions of Rule 8D. This is because if the Assessing Officer is taking a stand that the claim of the assessee is not correct ‘having regard to the accounts’, it implies that he must be having in his mind an own idea as to what should be the correct claim ‘having regard to the accounts’. Otherwise, on what basis does he say that the claim of the assessee is not correct ‘having regard to the accounts’ ? It thus follows that if the Assessing Officer doubts the veracity of the claim made by the assessee, he must calculate the disallowance scientifically correctly on the basis of the accounts itself. It is only if the accounts are simply unreliable and incapable of generating a scientific calculation of the disallowance, he should resort to the provisions of Rule 8D. The above interpretation, I feel, will accord due proper  weightage to the words ‘having regards to the accounts’ in the language of section 14A.

Readers are requested to apply their minds in this regard.