Education Cess As A Deduction – Certain Deceptive Facets

Advocate Fenil Bhatt has submitted that the prevalent judicial view that ‘education cess’ is not affected by the bar in section 40(a)(ii) of the Income-tax Act, 1961 and is allowable as a deduction requires reconsideration. He has argued that education cess is nothing but the State’s right in the profits of the Assessee, akin to income tax, is in the nature of distribution of income, and is not eligible for deduction

Much water has flown under the bridge in relation to allowability of education cess as a deduction. We have the benefit of two High Court decisions elucidating as to why education cess can be claimed as a deduction, being the recent decision of the Bombay High Court in the case of Sesa Goa Ltd. vs. JCIT (117 taxmann.com 96) and the decision of the Rajasthan High Court in the case of Chambal Fertilisers and Chemicals Ltd. vs. CIT (ITA No. 52/2018 dated July 31, 2018). There are a catena of Tribunal decisions as well allowing education cess as a deduction, to refer to few:

• Voltas Ltd. vs. ACIT (ITA No. 6612/Mum/2018 dated June 30, 2020) – Mum. Trib.
• Aditya Birla Nuvo Ltd. vs. Add. CIT (ITA No. 4220/Mum/2015 dated February 24, 2020) – Mum. Trib.
• Reckitt Benckiser I Pvt. Ltd. vs. DCIT (117 taxmann.com 519) – Kol. Trib.
• The Peerless General Finance & Investment Co. Ltd. vs. DCIT (ITA No. 937/Kol/2018 dated April 24, 2019)
• P. N. Gadgil Jewellers P. Ltd. vs. ACIT (113 taxmann.com 354) – Pun. Trib.
• Symantic Software India P. Ltd. vs. DCIT (114 taxmann.com 435) – Pun. Trib.

Limited point of this discussion is to highlight that there are certain aspects which, in my opinion, entail further deliberations on the issue of allowability of education cess. The first being greater analysis of what is the nature of education cess. Second would be whether it is an expenditure or is it a distribution of profits / application of income.

We all are conversant with the controversy at hand and brief reference to the decision of the Bombay High Court in the case of Sesa Goa Ltd. (supra) would be sufficient for recapitulating the issue. The Assessee, in this case raised for the first time, the claim of deduction of education cess before the CIT(A). The CIT(A) as well as the Tribunal decided the issue against the Assessee. The Assessee then took the matter before the High Court. The High Court negated the contention of the Revenue that cess is nothing but a tax and, therefore, it would be hit by section 40(a)(ii) of the Income-tax Act, 1961 (‘the Act’). The Court ruled that even though cess may be collected as a part of income tax, that does not render cess as either a “rate or tax”, as referred to in section 40(a)(ii) of the Act. The mode of collection is really not determinative of the nature. The Court further held that section 40(a)(ii) of the Act uses the term “any rate or tax levied” and there is no reference to the term “cess”. If the legislature intended to prohibit the deduction of amount paid by the Assessee towards “cess”, it could have easily included reference to the word “cess” in section 40(a)(ii) of the Act. The Court also observed that section 10(4) of the Income-tax Act, 1922 specifically referred to the word “cess”, however, the same did not find any mention in the current Act. The fact that legislature has not done so means that it did not intend to prevent the deduction of amount paid by an Assessee towards “cess”. The Court also referred to CBDT Circular No. 91/58/66-ITJ(19) dated May 18, 1967, which stated that omission of the word “cess” from clause (ii) of section 40(a) of the Act after the opinion of the Select Committee, meant that only taxes paid are to be disallowed for the assessment year 1962-63 and onwards, and held that circular is binding on the income tax authorities and also that circular is quite consistent with the principles of interpretation of taxing statute. In view of the aforesaid, the Court allowed deduction of education cess so paid by the Assessee. Also, another contention in support of the view that it was never the intention of the legislature to include “cess” under section 40(a)(ii) of the Act is that wherever legislature so desired to specifically include “cess”, it has done so. For instance, reference can be made to the language employed in section 43B of the Act

“(a) any sum payable by the assessee by way of tax, duty, cess or fee, by whatever name called, under any law for the time being in force,.”

Also, Explanation 2 to section 115JB states that

“For the purposes of clause (a) of Explanation 1, the amount of income-tax shall include –

………….

(iv)       Education Cess on income-tax, if any, as levied by the Central Acts form time to time; and

(v)        Secondary and Higher Education Cess on income-tax, if any, levied by the Central Act from time to time.”

Having appreciated the rationale behind allowing deduction of education cess, as explained by the Bombay High Court, it would be apposite to appreciate the two aspects referred above which, in my opinion, require deeper deliberation.In connection with the first aspect, as to what would be the nature of education cess, the principle laid down by the Constitution Bench of the Supreme Court in the case of State of West Bengal vs. Kesoram Industries Ltd. (266 ITR 721) has to be kept in mind. The Constitution Bench held that the term “Cess”is commonly employed to connote tax with a purpose or a tax allocated for a particular thing. Depending on the context and purpose of levy, cess may not be tax; it may be collected even as a fee.  Therefore, keeping in view the above dictum we would have to appreciate first the nature and purpose of the levy of cess. We all are aware that the Act does not provide for levy of education cess, the relevant Finance Act provides for its levy. Education Cess was brought in for the first time by Finance Act, 2004. For our discussion, it would be sufficient to refer to Finance Act, 2004 and section 2(11) and (12) of Finance Act, 2020,wherein levy of Education cess, in its new label being “Health and Education Cess”, is provided for. Relevant extracts are reproduced hereunder, respectively:

“(11) The amount of income-tax as specified in sub-sections (4) to (10) and as increased by a surcharge for purposes of the Union calculated in the manner provided therein, shall be further increased by an additional surcharge for purposes of the Union, to be called the “Education Cess on income-tax”, so as to fulfil the commitment of the Government to provide and finance universa lised quality basic education, calculated at the rate of two per cent of such income-tax and surcharge.”

 “(11) The amount of income-tax as specified in sub-sections (1) to (3) and as increased by the applicable surcharge, for the purposes of the Union, calculated in the manner provided therein, shall be further increased by an additional surcharge, for the purposes of the Union, to be called the "Health and Education Cess on income-tax", calculated at the rate of four per cent of such income-tax and surcharge so as to fulfil the commitment of the Government to provide and finance quality health services and universalised quality basic education and secondary and higher education.

(12) The amount of income-tax as specified in sub-sections (4) to (10) and as increased by the applicable surcharge, for the purposes of the Union, calculated in the manner provided therein, shall be further increased by an additional surcharge, for the purposes of the Union, to be called the "Health and Education Cess on income-tax", calculated at the rate of four per cent of such income-tax and surcharge so as to fulfil the commitment of the Government to provide and finance quality health services and universalised quality basic education and secondary and higher education:

Provided that nothing contained in this sub-section shall apply to cases in which tax is to be deducted or collected under the sections of the Income-tax Act mentioned in sub-sections (5), (6), (7) and (8), if the income subjected to deduction of tax at source or collection of tax at source is paid to a domestic company and any other person who is resident in India.”

From the aforesaid extract, it is amply clear that cess has been levied as an additional surcharge for the purposes of the Union, so as to fulfil commitment of the Centre to provide and finance quality health services and education. It has only been termed as a cess.

Reference can be made to the decisions of the Tribunal, wherein the issue had arisen that should education cess be added over the tax rates prescribed under the various tax treaties entered into by India with other contracting states? The Tribunal in the case of DIC Asia Pacific Pte. Ltd. vs. Ass. DIT (IT) (52 SOT 447), while dealing with India- Singapore treaty, held that education cess, as introduced by Finance Act, 2004, was in the nature of additional surcharge. The Finance Act only describes it as such while introducing it.  Article 2(1) defines tax as ‘income tax’ including any surcharge thereon. Education cess would form part of Article 2 and, therefore, it would be covered within definition of tax prescribed under the Treaty.Since treaty provisions would override the Act, the rate of tax provided under the treaty has to be taken, which would be inclusive of basic tax and surcharge, and education cess need not be added over and above the tax so calculated. The aforesaid decision has been, inter alia, followed in the case of DDIT vs. BOC Group Ltd. (156 ITD 402)(India UK Treaty), JC Decaux S.A. vs. ACIT (116 taxmann.com 408) (India-France Treaty) and R.A.K. Ceramics vs. DCIT (176 ITD 294) (India – UAE Treaty).

It is pertinent to note that the Rajasthan High Court in Chambal Fertilisers (supra) reversed the order of the Tribunal wherein it was held by the Tribunal that cess is nothing but an additional surcharge by relying upon the language used in the Finance Act. The Court relied upon the CBDT Circular referred (supra) and alsoheld that cess is not a tax without providing any reasoning to the argument that Finance Act has levied additional surcharge terming it to be cess. The Court simply held that it is not a tax by rejecting the contention that it is an additional surcharge. There cannot be any doubt about the proposition that if cess is held to be as a surcharge then it would be tantamount to a tax. The Supreme Court in the case of CIT vs. K. Srinivasan (83 ITR 346) elucidated the concept of surcharge and equated it with an additional tax. The Court observed that Article 270(1) of the Constitution of India (“the Constitution”) provides that taxes levied and collected by the Union has to be distributed between the Union and the States in the manner provided in clause 2 of Article 270. The Court also observed that Article 271 of the Constitution provides that the Parliament, notwithstanding anything contained in Article 269 and 270, may at any time increase, inter alia, taxes referred to in such articles with a surcharge for the purposes of the Union and whole proceeds of it would form part of the Consolidated Fund of India, meaning thereby that the proceeds of surcharge are wholly assigned to the Union, which the Finance Acts also provides expressly. The Court thereafter referred to the dictionary meaning of the word “surcharge” to mean that “to charge too much or in addition” and also “additional tax”. The Court, thereafter, held that income tax is to be charged in four different ways- basic charge, surcharge, special surcharge and additional surcharge. Therefore, even additional charges form part of income tax and surtax.

It is pertinent to observe that the Bombay High Court in Sesa Goa (supra) expressly rejected the argument of the Revenue that cess is nothing but a tax and, therefore, section 40(a)(ii) of the Act would be applicable disallowing the deduction of the same. Attention of the Court was not brought to the language used in Finance Act. It is my submission that a further consideration is required on the argument that cess is an additional surcharge only and would not be allowed as a deduction. Keeping in mind the clear language used in Finance Act equating cess with an additional surcharge and the aforesaid decision of the Supreme Court in the K. Srinivasan (supra) which holds that surcharge is nothing but an additional tax, the contention raised that cess is nothing but a tax, in my opinion, requires a deeper consideration.

Second aspect, and a larger point in my opinion, which can be explored is whether payment of amount of education cess is an expenditure in the first place, as is it nothing but distribution of profits / application of income, without getting into the controversy as to whether it would fall within the ambit of section 40(a)(ii) of the Act. To appreciate the distinction between expenditure incurred for the purpose of earning income and application of that income, reference can be made to the decision of the Supreme Court in the case of CIT vs. Travancore Sugars & Chemicals Ltd. (88 ITR 1).The Court was concerned with the issue whether payment to the Governmentunder a contract for taking over another Company by the Assessee Company would be eligible for deduction or not. The Assessee before the Court had entered into a contract, inter alia, with a condition that the Government would be entitled to twenty percent of net profits of the Assessee Company for every year,subject to a maximum of Rs. 40,000. The Contract also stipulated the manner in which net profit was to be calculated. After laying down that the expenditure so incurred was revenue in nature, the Court went ahead to deal with the issue that when payment is, computed with reference to profits, whether the same would be a mere division of profits or is it an item of expenditure. The Court observed that the amount paid by reference to profits can either be that it is paid after the profits became divisible or distributable or that the amount is payable prior to such distribution or division, to be computed by a reference to notional or an apparent net profit. The Court ruled that in the former instance, it will certainly be a distribution of profits and not deductible as an expenditure incurred in running the business and in the latter, after considering the facts of the case and nature of obligation under the instrument, it would be possible to contend that expenditure was incurred as a contribution to profit-earning apparatus or expended wholly and exclusively for the purposes of business. Thereafter, the Court ruled in favour of the Assessee holding that the Assessee is eligible for deduction of the payment so made. Classic example to the latter part which the Court referred to would be payment of Remuneration to Directors, which is determined on the basis of Net Profits of the Company. However, in the present case,the question is whether cess would form part of first category or second category. In view of the decision discussed above, it is possible to contend that cess is an item falling in the first category and therefore not allowable as deduction.

Reference can also be made to the decision of the Calcutta High Court in the case of Molins of India Ltd. vs. CIT (144 ITR 317),wherein the Court was dealing with the issue as to whether surtax paid would be allowable as a deduction under section 37 of the Act or not. The Court rejected the contention of the Assessee that surtax is a statutory charge on the income and, therefore, income of the Company has been statutorily diverted at source qua the surtax liability by holding that charge of surtax presupposes existence of income of the Assessee, it does not prevent accrual of income in the hands of the Assessee by diverting a portion of income to the Revenue at source. The Court, thereafter, dealt with the second contention of the Assessee and held that surtax would fall within the mischief of section 40(a)(ii) of the Act. The Court, thereafter, went ahead to hold that payment of surtax would not evenbe eligible for deduction under section 37 of the Act. The Court placed reliance on decision of House of Lords in the case of IRC vs. Dowdall O’ Mahoney & Co. Ltd. (33 TC 259), wherein it was held that foreign income-tax and excess profit tax are not paid for the purposes of earning profits of the trade, they are applications of those profits. The Court further placed reliance upon the decision of Supreme Court in the case of Indian Aluminium Co. Ltd. vs. CIT (84 ITR 735), the Supreme Court while dealing with the issue whether wealth tax paid on business assets would be allowable as a deduction or not observed that where profits, the net gains of business determined after making all deductions, are taxed, the disbursements to meet such taxes cannot be deducted. However, the Supreme Court observed, that where the tax was levied, on capital assets used for the purpose of earning profits, it was a permissible deduction. The High Court relying upon the Supreme Court decision, consequently, held that surtax is of the same character as that of income tax and similar treatment would follow for surtax too and, therefore, it cannot be held that it is incurred wholly and exclusively for the purpose of business.  Similar view has been taken by the Gujarat High Court in the case of S.L.M Maneklal Industries Ltd. vs. CIT (172 ITR 176), wherein it was held that the question of payment of surtax would arise only after the profit or income is earned. It is an event which takes places after the income is earned, meaning thereby that payment of surtax is an application of the profits after they are earned. It is pertinent to note here that when the matters from various High Courts travelled to the Supreme Court, the Court in the case of Smith Kline & French India Ltd. vs. CIT (219 ITR 581) affirmed the aforesaid two decisions on the point that surtax paid would be hit by section 40(a)(ii) of the Act. Though the Supreme Court did not specifically deal with the other reasoning given by the Calcutta High Court and the Gujarat High Court, its reasoning, discussed above, stands.

Keeping in view the mechanism by which “education cess” is levied by charging it over and above income tax and surcharge and the dictum of the aforementioned judicial pronouncements, de hors section 40(a)(ii) of the Act, it can be contended that education cess so paid, is a payment in the nature of distribution of income, it is nothing but the State’s right in the profits of the Assessee, akin to income tax. As observed above, the question of levy of cess would arise only after profits are determined and are available for distribution, which the Supreme Court in the case of Travancore Sugars (supra) stated would not be eligible for deduction. Once the aforesaid contentions are deliberated and adjudicated upon, the law with respect to deduction of education cess would present a much definite picture.