DIRECT TAX

 Income Tax Act [IT Act]. Wealth Tax Act is also there, but it is not much relevant for us.
Government is planning to bring a Direct Tax Code which merges the Income Tax and
Wealth Tax Acts.

We cannot define tax in a restrictive manner. It is a compulsory levy imposed by organ of the
government for public purpose. Thus, three essential characteristics:

i. Compulsory levy.
ii. Imposed by government or an organ of the government.
iii. For a public purpose.

There is no quid pro quo or service in exchange for the fees involved in tax. We cannot ask for a
specific benefit in return. The definition of public purpose is given by the State. Article 265 of
the Constitution – no tax shall be levied or collected except by authority of law. Thus, levy and
collection should come from the authority of law only. For instance, there is Income Tax Act,
etc. as well as enabling powers under the Union/State/Concurrent list. Enabling power for IT Act
is Entry 82 of Union List. It provides for tax on income except agricultural income.

Power to tax – constitution only limits the power under Article 265, and does not grant the
power to tax. However, the power comes from the sovereign itself. Limitation is through subject
matter under various Lists, Article 265, etc. Entry 97 of Union List is residuary entry, and a
number of taxation statues have been brought under the residuary entry. Wealth Tax Act is still
part of residuary entry. Before GST, service tax was also part of residuary entry.

Public purpose – there is a consolidated fund controlled by Parliament where all tax collections
go. The government defines what is public purpose.

DIRECT AND INDIRECT TAX

Taxes are divided into – Direct and indirect tax. We decide it based on the nature of the tax. In
Mafatlala Industries v. Union of India, SC in 1997 has laid down what is direct and indirect
tax. taxes are either direct or indirect. Direct taxes are demanded from the very person who is
intended to pay it. Indirect taxes are demanded from 1 person with the intention that he shall
indemnify for the expenses from another. Thus, when levy of tax and incidence of levy is on
same person, then direct tax. while when liability of tax and incidence of tax are on different
person, then it is indirect tax. In indirect tax, liability is on manufacturer, seller, etc., but
incidence is on the consumer. While in income tax, the same person is liable to pay, as well as
bears the burden of tax.

SC has quoted a US Court judgment to define tax. Taxation is the power where the government
enforces or enacts some law and levies taxes for general revenue purposes.

Venkat Subbarao v. State of Andhra Pradesh, AIR 1965 SC 1773 – constitutional validity of
tax. SC held that a levy would not constitute tax unless it is a compulsory extraction. Tax is an
imposition made for public purpose without any consideration or direct benefit for the taxpayer.
There is no special benefit to be provided to the taxpayer. If the levy is in exchange for the
services rendered to the payer, then it is contradictory to the very nature of tax. The tax is for a
common benefit, and no direct or specific benefit is there. Primary objective of tax is to raise the
revenue.

Characteristics of tax:

i. It is not a voluntary payment. It is an enforced contribution pursuant to legislative

authority in the exercise of its taxing powers.
ii. It is a contribution, being of proportionate character, payable in money. It may be tax
on income, services, entertainment, import, etc. But whatever the tax, it is
proportionate.
iii. It is imposed, levied and collected for the purpose of raising revenue.
iv. It is used for public/government purpose and not for payment of any special benefit.

Taxes have been imposed since ancient times. It finds mention in Kautilya’s Arthashastra also.
He has mentioned various kinds of taxes:

i. Rajbhaga – king’s share of produce.

ii. Bali – villagers’ cess over the rajbhaga.
iii. Kara – tax on property.
iv. Vivita – levy on pastures.
v. Rajju – survey and settlement cess for land, etc.
 vi. Chora rajju – police cess.

In Arthashastra, it was mentioned that King was only a trustee of the land, and his duty was to
protect it and make it more and more productive, so that its income could be protected. It was the
King’s sacred duty to protect his subjects in return for the tax. If King failed in this duty, it was
the right of the citizen to stop paying taxes, and demand refund of taxes.

PURPOSES OF TAXATION

There are 3 types of taxation – progressive, regressive and degressive. The first type of taxation
is based on 1st principle of Adam Smith regarding ability to pay. Income tax is considered
progressive because of the slab system. Based on the ability of person to pay taxes, the slabs and
rates of taxes are determined. Lesser income earner has to pay lower tax, while high income
earner has to pay higher taxes.

In regressive taxation, the lower income groups and higher income groups are charged with the
same rate of tax.

In some indirect taxes also, slab system is there – for essential commodities, 5% tax, and higher
taxes for luxury goods. Some categories are exempted also (such as milk, farm produce, etc).
Thus, it is also indirectly progressive. Within a slab also, say in automobiles, based on the
models, the lower end models and lower segment cars are levied with lesser taxes as compared to
high end models.

Thus, indirect tax can be said to be regressive, but in various categories, it is progressive as well.

In degressive taxation, the higher income groups pay less percentage of tax as compared to lower
income groups. This is because the amount of contribution from a high-income earner is
anyways high. This is not present in India. But higher income groups advocate it because this
will encourage the people to earn more and happily pay taxes.

Purposes of taxation:

i. Primary purpose of taxation is to raise revenue for government expenditures. There

are various other purposes, but they are secondary.
ii. Redistribution of income and wealth.
 iii. Control of the economy – there are various measures taken through the taxation
regime to control the economy. In indirect taxes, this is a common purpose. For
instance, in custom duties, if price of onion is increasing, the government bans the
export, or imposes a high export duty on it. If price goes down due to excess import,
then high import duty is put on that good. Sometimes, tax exemption is used as an
incentive to domestic industries and start-ups.
iv. Protection of environment – green tax, carbon tax, environmental cess, etc. are
imposed for the betterment of environment and to control pollution, as part of
sustainable development goal.
v. Tool for social control – for instance, if government wants to restrict the use of any
item, it is taxed heavily. For instance, sin goods like tobacco and alcohol.

CLASSIC PRINCIPLES OF TAXATION

Adam Smith, in 1776, discussed 4 principles:

1. Ability to pay – discussion regarding progressive taxation. It is followed in income tax

for individuals and HUFs, but not for companies. For companies, there is a flat tax rate
system. Whether a company is small or big, they have to pay the same rate of tax.
However, based on the threshold, some kind of benefit is being provided, which is
indirectly progressive taxation. Thus, government is aiming to bring progressive taxation
wherever possible and practical. For indirect tax as well, by putting slab system
(essential, semi-essential, standard and luxury – 5, 12, 18, and 28%), government has
tried to bring in progressive taxation indirectly. Thus, we have followed this principle.
2. Benefit approach – it proceeds on the presumption to equate tax with fees. In fees, there
is some quid pro quo i.e., some special benefit attributable to the individual is provided.
But in tax, so such direct or specific benefit is provided.
3. Certainty – whether the tax is certain or not. Tax law should be certain. The subject ought
to know the tax payable to the sovereign. In our Income Tax Act, although there are
predetermined slabs, but there are various retrospective amendments imposing liability
on individuals. This makes the tax uncertain. Otherwise, we know in advance the
liabilities, exemptions, etc. Thus, IT Act is certain, but not completely. While indirect tax
is completely uncertain as only a notification is required to bring change.
Horizontal and vertical equity – horizontal equity refers to taxation of equals equally. Vertical
equity means that if equals are to be taxed equally, unequals can be taxed unequally.

Suppose there is an amendment in IT Act promising certain exemptions for startups for 10 years.
A person starts his business, makes various investments, and enjoys exemptions for few years.
However, after 5 years, the amendment was withdrawn. Such withdrawal cannot be challenged.
This makes the IT Act uncertain. However, for income tax – the amendments are always through
Finance Act which comes at the time of budget every year, thus granting security for at least 1
year. But in indirect tax, the amendments can come any time of the year as only a gazette
notification is required. For instance, in the first week of January, a notification came which
provided exemption for mobile phone imports. An importer placed order, but before the order
could clear customs, another notification came charging tax on imports.

Thus, although income tax is certain to some extent (as security is there for at least 1 year),
indirect taxes are uncertain as they can be changed through a notification in the gazette.

In 1958 Sitalwad committee was constituted to bring IT Act and it gave a slogan of SSS –
income tax should be safe, simple and stable. This principle has not been followed in IT Act. By
2010, when a direct tax code bill was brought to replace the IT Act, there were 19000
amendments in the IT Act. They did not simplify, rather complicated the IT Act. For instance,
there is a provision, then a proviso, then an explanation to proviso, then proviso to the
explanation. There is tussle between the legislature and judiciary also. Many amendments are
brought to nullify the effects of judgment.

4. Administrative convenience – to both the taxpayer and the collector. Many committees
such as Chouksey committee, Kelkar committee, Ishwar committee, etc. have been
constituted by government for administrative reforms in taxation. Kautilya has said that
tax is as good as the ease with which it is collected. Administrative convenience should
be for both taxpayer and collector.

For instance, the provision of TDS ensures administrative convenience as it is easy to collect at
the source itself. However, convenience is for the collector only. As for taxpayer, it can be that in
TDS, tax deducted is 30%, and at the year end while filing return, it is found that tax payable is
20%, then for an entire year, the benefit of interest on the additional amount paid as tax would be
enjoyed by the government. As tax is already collected, and TDS is generally on the higher side
only (i.e., more than the liability), the benefit of interest is enjoyed by government and not the
taxpayer. Also, another negative aspect is that payer is liable to deduct taxes at source, and if he
fails to do so, he would be liable, and not the person who is taxed.

At least for procedural things, we have aimed at administrative convenience. We have digitalized
the procedure under GST and IT Act. In Finance Act, 2021, there is cashless assessment. Earlier,
we had to go to bank and make a challan, but now, everything is online and challan, etc. are done
through e-filing portal.

5. Modern principle – compatibility of taxation regime with international obligations. How

we apply income tax in a cross-border scenario is important. We have to make our laws
compliant with international obligations if we want to compete globally.

All investment decisions are influenced by tax policy of a country. A lot of incomes are earned
cross border. India is considered as a source country (capital import country) and not a resident
country. Countries like OECD countries want to bring resident-based taxation. However, our
position is in between resident and source. Therefore, our double taxation avoidance agreements
[DTAAs] are a mix of OECD and UN model convention. DTAA is a beneficial provision.
General anti-avoidance rules [GAAR] – we made certain transactions impermissible. In 2016, we
came with concept of equalization levy to tax service transactions. We also implemented action
plan I of BEPS – base erosion policy. We also brought significant economic presence under this
– if a company’s source and residence is outside India, still it can be taxed (such as Netflix).
Digital service tax (2020 Amendment) also is there. Global minimum tax is also part of that only.
Multilateral agreement of 2020 is also part of this process. Multilateral agreements provide
benefit to country – without looking into bilateral agreements (DTAA is a bilateral agreement),
i.e., if both parties are part of multilateral agreement, there is no need to amend the bilateral
agreement between them. For instance, to revoke 1 benefit (exemption from capital gains tax to
resident companies of Mauritius) in the treaty (DTAA) between Indian and Mauritius, it took
around 8-9 years. Benefit was provided to attract investments in India.

There are mutual legal assistance treaties between countries for tax matters, which ensures
international compatibility.
Thus, compatibility with international obligations is important.

Another principle of tax is cost effectiveness – this is from the perspective of recovery of taxes.
There are various departments – income tax departments, customs department, revenue
department. If the recovery of taxes is more effective than the collection of taxes itself, then the
tax regime cannot be said to be cost effective. For instance, for a tax of 5 lakh rupees, the tax
authority enters into litigation, and it goes till Supreme Court, the cost incurred to recover the tax
is more than the tax collection itself. This is also called tax terrorism – unnecessary litigation i.e.,
on a settled position of law, authorities go to courts. Also, for search and seizure, huge cost is
incurred, which is not cost-effective. There is a circular issued putting a monetary limit for tax –
up to what limit of tax, authority can go to court, to high court, to Supreme Court, etc.
Ultimately, it is the taxpayers’ money which is wasted. Thus, cost effectiveness comes within
administrative reforms only.

INCOME TAX ACT

For any form of tax, and whatever the reason for its adoption, there are three things/elements
which need to be identified:

i. Identification of tax base – tax base has to be identified.

ii. Identification of incidence of tax – the incidence/burden of tax, including the rates.
iii. Identification of person liable to pay tax – the taxpayer i.e., the person liable to pay.

Tax base means the thing/transaction/amount on which the tax is raised. The base can be the
person, income, wealth, transaction, service, good itself, manufacturing, sale, etc. If income is
the tax base, we need to see what is income. Even within income, is it salary income, house
property income, business income, income from profession, capital gain, etc. All heads are
mutually exclusion to each other. As for each head, various exemptions, benefits, charges are
involved. Just to identify the tax base, these things need to be determined. After that, the
incidence of tax is seen. All taxing statutes have these three elements.

The origin of IT through legislation is in Great Britain in 1799. The tax was introduced as a war
tax. In relation to India, the first income tax Act came in 1860. British wanted to compensate the
expenditure incurred in the mutiny of 1857, therefore they came with IT Act of 1860. Then a
new Act came in 1866, and another new Act in 1896, then in 1906 and finally the Indian Income
Tax Act in 1922. Before 1922 Act, even agricultural income was not exempted. The 1922 Act
was comprehensive and included employment, business, etc. This was the last pre-independence
Act. After independence, 1922 Act continued. Then government constituted Setalwad and Tyagi
committee and based on their recommendation, 1961 IT Act came, and was made applicable
from 1962. It continues till today. It was sought to be replaced with Direct Tax Code in 2010, but
it didn’t happen.

1961 Act has had a lot of amendments till date. Every year, there are amendments on many
provisions. The motto of committee to make it safe, simple and stable is effectively not possible
for any fiscal legislation due to problems from both taxpayers’ and tax department’s sides.
Another reason is that government is not agreeing with judicial interpretation, and hence amends
the Act to nullify the effect of judicial interpretation. Some procedural amendments are required
with time as well to make it more convenient.

In 2020 also, a committee has been constituted to see whether the direct tax code can be
reintroduced in a different form.

Section 4 of IT Act provides for charge of tax. Section 4(1) states that where any Central Act
enacts that income-tax shall be charged for any assessment year at any rate or rates, income-tax
at that rate or those rates shall be charged for that year in accordance with, and subject to the
provisions including provisions for the levy of additional income-tax of, this Act in respect of the
total income of the previous year of every person. Provided that where by virtue of any provision
of this Act income-tax is to be charged in respect of the income of a period other than the
previous year, income-tax shall be charged accordingly.

Assessment year is the year of charging. And it is charged on the total income earned in the
previous year i.e., the year of earning. And it is charged on the person. Thus, 4 important things –
assessment year, previous year, total income and person.

Total income – various heads of income.

Section 2(31) defines person and gives an inclusive definition. As per it, person includes:

i. Individual.
 ii. Hindu undivided family.
iii. Company.
iv. Firm.
v. An association of persons (such as JV), or a body of individuals (cooperative
societies, etc.), whether incorporated or not.
vi. Local authority.
vii. If any category is not covered in any of the above clauses, they would be considered
artificial juridical person. Such as university, UGC, etc.

Explanation provides that for the purposes of this clause, an association of persons or a body of
individuals or a local authority or an artificial juridical person shall be deemed to be a person,
whether or not such person or body or authority or juridical person was formed or established or
incorporated with the object of deriving income, profits or gains. Thus, even if motive is not to
earn income or profit, they would be called person under IT Act.

In this manner, every kind of entity is covered under person.

An inclusive provision is better from the perspective of revenue collection.

There are two things with respect to assesse – liable to tax, and subject to tax. First we determine
liability, and after that we see whether he is subject to tax or not, as the liability to tax is subject
to many provisions. Assesse is the person who is subject to tax.

Every assesse is a person, but every person is not an assesse.

Section 2(7) defines assesse – as a person by whom any tax or any other sum of money is
payable under this Act, and includes—

a. every person in respect of whom any proceeding under this Act has been taken for the
assessment of his income or assessment of fringe benefits or of the income of any other
person in respect of which he is assessable, or of the loss sustained by him or by such
other person, or of the amount of refund due to him or to such other person;
b. every person who is deemed to be an assessee under any provision of this Act;
c. every person who is deemed to be an assessee in default under any provision of this Act.
Thus, assesse is a term used in restrictive sense for the income tax proceedings – who files any
return, against whom any proceeding is there, etc.

Just by virtue of being a person, one is liable to pay. However, assesse is used in a restrictive
sense. Therefore, to widen the liability, the IT Act uses the term ‘person’ for section 4. For
chargeability, we only have to see whether there is a ‘person’. Payment of tax is a different thing,
and chargeability is different.

Assessment year is defined under section 2(9) as meaning the period of 12 months commencing
on the 1st day of April every year.

Section 3 defines previous year as the financial year immediately preceding the assessment
year.

Suppose assessment year is April 1, 2021 to March 31, 2022, then previous year would be April
1, 2020 to March 31, 2021.

Previous year is the year of earning and payment of tax and assessment of year is limited to filing
of return and assessment by department. You can file return, declare income, claim refund, etc.
in the assessment year.

There are some exceptions under section 172, 173, 174A, 175 and 176, where same year is
previous year and assessment year. For instance, where there is dissolution of business, we
cannot wait for another year, as the entity would not be in existence anymore. Then same year is
assessment year and previous year.

Income is another important aspect. Entry 82 of List I also defines income tax as tax on income
except agricultural income. Section 2(24) defines income but provides an inclusive definition.
The income has not been defined under the IT Act by the legislature intentionally so as to
include as many receipts as possible within its ambit.

CIT v. Shaw Wallace and Co. AIR 1932 PC 138. Here, the Privy Council tried to define
income. They defined it as “income connotes a periodical, monetary return which comes with
some sort of regularity or expected regularity from a definite source”. In IT Act however,
regularity is not required to tax any income. Definite source is also not required, as windfall
gains and casual incomes are taxable. 1972 Amendment included under section 224 casual
incomes and windfall games from activities like betting, lottery, gambling, etc.

In another case, Maharaj Kumar Gopal Saran Narayana Singh v. CIT, 1935 3 ITR 237 Privy
Council. Here, Court said that income under the IT Act is wide and vague in scope. It is a
word of elastic export. Every receipt can be defined as income unless it is expressly excluded.
There is nothing to represent that source should be recognized under law. Thus, source being
illegal is not an exemption. Everything taxable under IT Act is income, unless it is exempted
under IT Act.

Kamakhya Narayana Singh v. CIT, 1943 11 ITR 513 Privy Council – income is a word difficult
and perhaps impossible to define in any precise general formula. It is a word of the broadest
connotation. They also said that the wide scope of expression should not be restricted to the
technical conception of income. Thus, we have to look in context what is income. It is the nature
of transaction that is decisive.

There is a saying under IT Act – all revenue receipts are taxable unless it is expressly exempted
under IT Act, and all capital receipts are taxable, unless it is expressly exempted under IT Act.

Even the Court has interpreted income in a manner that is beneficial to revenue collection. There
is a challenge that how you can tax capital under income tax (capital gain). However, it has been
argued that it is not capital which is being taxed, but capital gain.

In this manner, it is not possible to define income, as otherwise many receipts would be
excluded, which is not the objective of the IT Act.

CIT v. GR Kartikeyan AIR 1993 SC 1671 – assessment year concerned is 1974-75. The assesse
was assessed as an individual. He had salary and business income. In the relevant accounting
year, he participated in All India Highway Motor Rally. He was awarded Rs. 20,000 by Indian
Oil Corporation, and 2000 more by the All India Highway Motor Rally. The rally was organized
jointly by automobile association of Eastern India and IOC, and supported by various automobile
association. Length of rally was 7000 km. person had to drive the car from Mumbai, Madras or
Kolkata in anti-clockwise direction and reach the starting point. Personal vehicles had to be used.
Purpose of rally was to test the endurance and reliability of the automobiles and skill of the
driver. Traffic regulations of various states had to be followed. The person with the least penalty
points was declared winner. GR was the winner. Question arose as to the taxability of these Rs.
22,000.

Section 2(24)(9) is involved here, which includes games, gambling, betting, or any other games
etc. as income. It was to be seen whether the rally was a game. Department issued notice saying
that income was taxable. On appeal, the commissioner said that rally was not a game, hence
income is not taxable under section 2(24)(9). The Tribunal, on appeal by revenue, held that rally
was not a game, it was a test of skill and endurance. Hence, it fell outside ambit of income.
Matter went to High Court. The High Court upheld Tribunal’s points, and held that the
expression ‘winnings’ connotes money won by betting or gambling, and therefore, prize money
doesn’t represent winnings, as amount was obtained by participating in rally which involved
assessing the skills of the driver. Legislature used the word ‘winnings’ and not ‘winning’ (which
denotes participating in an event and then winning).

Appeal went to SC, and SC set aside HC verdict. The SC merely said that it is taxable under
section 2(24) and it does not matter under which sub-clause. The expression income must be
construed in its widest sense. It is an inclusive definition, even if receipt does not fall in any
of the sub-clauses, it can still constitute income. Hence, price money won by assesse is
income.

The High Court erred in reading certain sub-clauses as exclusive, even when the definition is
inclusive. It may still be income if it partakes of the nature of income. Intent of section 2(24) is
not to limit, but widen its meaning. Income is of widest amplitude and has to be given its natural
meaning.

Bhagwandas Jain v. Union of India, 1981 was referred. In this case, issue was taxability under IT
Act on a notional basis. Notional income – even no income is an income. Real income – there is
some actual receipt. In notional income – even if there is nothing incoming, it is income. House
property is taxable as notional income only. This is a 1981 case where not even a single property
was exempted from tax (now 2 houses are exempted) – even if person is himself residing there. It
was taxable based on expected rent. Assesse challenged the validity of this provision. Contention
of assesse was he was not deriving any monetary benefit by residing in his own house.
Therefore, no tax should be levied. It was contended that income means realization of monetary
benefit, and without it, the charge of tax as notional income was violative of Entry 82 of Union
List. If there is nothing which comes in, then how can tax be charged.

However, this contention was rejected by SC affirming that income is of widest amplitude and
includes not just what is received or what comes in, but also which can be converted into
income. Not just what is coming, but what is expected to come is also income. Thus, validity
was upheld.

This case was referred in GR, and SC observed that when even notional income is taxable, then
how come an actual income would not be taxed. There is no requirement to find out a suitable
place under any sub-clause of section 2(24). If it partakes the characteristics of an income,
anything can be charged as income under section 2(24).

Also, conversion of a capital asset into stock in trade and vice versa is taxable under IT Act.

In income tax, only income can be taxed, and not capital under any circumstance. Only the
capital gain can be taxed, and not capital itself.

In another case, EL Hotels and Investment Ltd. v. Union of India, 1989 178 ITR 140 SC –
constitutional validity regarding Entry 82 of Union List was challenged. Whether tax at flat rate
of 15% on the gross receipts of hotel business is valid having regard to Entry 82. In 1980, Hotel
receipt Act came into existence wherein hotels were taxable on their gross receipts. If room rent
is more than Rs. 75, then hotel would be covered under that Act.

The assesse challenged validity on grounds of Article 14, 19, Entry 82. Question was whether
gross receipt can be considered income. Act was abolished in 1882 for a different reason.

SC upheld constitutional validity. Income is of elastic import and a very wide meaning should be
given to the entry. To understand the scope of income in Entry 82, any meaning which fails to
comprehend income in all its width and comprehensiveness, must be avoided. Income
encompasses within it every kind of gain either of a revenue or capital nature.

In 2004-05, government came with fringe benefit tax which came in 2004-05 and was abolished
in 2009 (for a different reason). This tax was not on income, but on the benefits/perquisites
provided by the employer to the employees. This tax was a tax on the expenditure incurred by
employer. And SC upheld the constitutionality of this tax holding that income cannot be
confined to its natural income. Even gain, turnover, gross receipt, expenditure can be termed as
income under Entry 82.

In this manner, from judgments of SC, it is clear that whatever receipts are covered in its natural,
ordinary meaning, it would be income. Even income in kind is considered income (some non-
monetary benefits/amenities are also considered income). Income need not only be in money
form.

Recently, through amendment, even subsidy has been considered as income under section 2(24).

Capital gain arises when there is transfer of a capital asset.

Exemption does not mean that it is not income. If any receipt is exempted, the receipt is still
income and liable to tax. However, because it is exempted, it is not subject to tax.

Allahabad High Court has said that income in the constitution cannot be restricted to fiscal
receipt only. Income under Entry 82 relates to every kind of receipt and gain. Therefore, we
cannot limit the understanding to the traditional or accounting meaning of income. Sometimes,
even loss is income, even in accounting terms. As loss is to be set off from profit after being
carried forward next year, so it would be deducted from profits. In this manner, loss is a negative
income. Even for the purpose of being carried forward and setting off, return has to be filed.

Capital receipts – they either reduce the assets or increase the liability i.e., they are liabilities.
While revenue receipt – neither create any liability nor reduce the assets.

To declare a receipt as revenue or capital, whether nature of asset is important or nature of

transaction is important. For instance, for a person, a car is asset, while for an automobile dealer,
a car is inventory (stock in trade), so when he sells the car, it is not a capital receipt. Thus, the
asset is not important, but the nature of transaction is important. We need to see whether the
asset is part of business, or an investment. For instance, shares can be considered investment as
well as trading assets.

When an investment asset is sold, it is capital receipt, but when a trading asset is sold, it is a
revenue receipt. Whether shares held by foreign institutional investors is investment asset or
trading asset. If trading asset, it would be business income, which is taxable. While if investment
asset, it is a capital gain, which is not taxable due to DTAA with Mauritius. This is because
investment is not for profit, but to save the principal. Even if profit is earned, it is other income,
and not business income. While business is done to earn profits.

In 2015, Amendment in IT Act, and section 2(14) inserted a specific provision that these shares
held by FIIs are investment assets.

Thus, for any asset, a single fact cannot decide whether it is a trading asset or investment asset. A
number of facts would have to be seen.

In business, adventure or concern in the nature of trade, even if no continuity and regularity, just
because a person is doing something which looks like an income, it can also be termed as
business.

Thus, there is no precise definition of income. Even accounting standards are not binding on IT
Act. This is because income tax is a self-contained code, and has its own conditions, restrictions
and set of rules for treatment of items. Accounting treatment done by a business would not affect
the income tax calculation.

Also, if receipt is revenue, then it is burden of taxpayer to show why it is not taxable. And if
receipt is capital, then burden is on revenue authority to show why it is taxable.

If a person has a showroom which has stock, and everything is insured, showroom and stock is
damaged and insurance is paid, whether insurance receipt is revenue or capital receipt – as stock
in trade is revenue, while showroom is capital, thus, within the claim, it is both revenue and
capital. The assesse has to apportion how much is revenue and how much is capital receipt. In
this manner, it has to be seen subjectively – nature of insurance, the agreement, etc. has to be
seen. Also, whether insurance covers only the loss of stock, or it covers the loss of all things. If
insurance covers loss of both revenue and capital, then assesse would have to determine how
much is revenue and how much is capital.

Compensation for breach of contract, whether capital or revenue – we have to first ask for what
purpose the compensation is there, whether to restore the profits, or to restore the assets. We
need to see what is the breach, for what purpose the compensation is granted. If compensation is
to restore the profit, then it is revenue, but if to restore the loss of asset, then capital.
Thus, we have to look in entirety to determine whether it is a revenue or capital receipt. It is the
nature of transaction that is decisive.

For instance, if tree and fruits are sold generally, sale of tree would be capital, and sale of fruit
would be revenue. But if a person is dealer of trees, sale of tree would be revenue, while sale of
fruits would be income from other sources.

AGRICULTURAL INCOME

It is exempted from IT Act. Section 10(1) exempts it. As agriculture is a state subject, the state
government has the power to regulate anything related to it. Section 2 (1A) of IT Act defines
agricultural income. Agricultural income includes not just cultivation, but animal husbandry,
dairy activities, etc. Whether sale of agricultural land is also agricultural income has to be seen.

Article 366(1) defines agricultural income as that defined by the Parliament for the purpose of IT
Act. Article 274 of Constitution prohibits any amendment in the definition of agricultural income
unless it is moved in either Houses of Parliament by the President.

Agricultural income includes 3 categories as per section 2 (1A):

a. any rent or revenue derived from land which is situated in India and is used for
agricultural purposes;
b. any income derived from such land by—
(i) agriculture; or
(ii) the performance by a cultivator or receiver of rent-in-kind of any process
ordinarily employed by a cultivator or receiver of rent-in-kind to render the
produce raised or received by him fit to be taken to market; or
(iii) the sale by a cultivator or receiver of rent-in-kind of the produce raised or
received by him, in respect of which no process has been performed other than a
process of the nature described in paragraph (ii) of this sub-clause;
c. any income derived from any building owned and occupied by the receiver of the rent or
revenue of any such land, or occupied by the cultivator or the receiver of rent-in-kind, of
any land with respect to which, or the produce of which, any process mentioned in
paragraphs (ii) and (iii) of sub-clause (b) is carried on.
Sub-clause (a)

In part (a), the first important characteristic is that there should be some rent or revenue, and
such rent or revenue should have a direct nexus with the land. Following ingredients can be seen
in part (a):

i. Any rent or revenue.

ii. Derived from land.
iii. Situated in India.
iv. Used for agricultural purposes.

However, agricultural purpose is not defined in the Act. So it is difficult to determine when land
can be said to be used for agricultural purpose.

Nowhere in the definition it is provided that the land should be agricultural land. Thus, even
commercial land or household land, courtyard, etc. can be used for agricultural purpose.

Traditional meaning of agriculture is cultivation of land. But cultivation of land is a very

restrictive term. It refers to involvement of human skill and labor upon the land, preparation of
the land, etc. After the preparation, there is plantation, sowing seeds, pesticides, etc. When there
is a crop, there is thrashing, etc. to make it suitable for consumption and to sell in the market.
This entire process is considered to be an agricultural process.

In this traditional form of agriculture, animal husbandry, fisheries, dairy farming, etc. should not
be included.

The Courts have given a restrictive definition to agricultural purpose. In a 1957 SC case Raja
Benoy Kumar Sahas Roy v. CIT, 32 ITR 466, the Court has defined agricultural purpose. A
restrictive definition has been given and it is limited to cultivation only. Cultivation is also not
something which is spontaneous and self-grown. Thus, if no involvement of human skill and
labor, then it is not agricultural purpose. The term agricultural purpose is confined. SC has said
that basic operation is a must for fulfilment of agricultural purpose i.e., there should be
preparation of land before cultivation of land. If no basic operation is done, it cannot be
agricultural purpose. Subsequent operation without performing the basic operation (for instance,
to preserve the spontaneous growth) is also not an agricultural purpose.
If land is used for animal husbandry, dairy farming, fisheries, etc. then it is not an agricultural
purpose, and it isn’t included in agricultural income.

The conflict in this case was that in case there is no tilling or cultivation of land, there was
growth of certain spontaneously grown trees. However, the assesse, in order to preserve the trees,
performed certain subsequent operations such as preservation sites. But there was no basic
operation. There was sale of spontaneously grown trees. Assesse claimed that it is agricultural
income only. However, SC said that basic operation is must. Prior to germination, there is
involvement of labor and skill on the land itself, and not just on the growth from the land. Basic
operations involve tilling of land and preparation of land for cultivation.

Subsequent operations – operations which are undertaken after the produce sprouts from the soil,
such as clearing the soil around the sprout, preventing it from pests, etc.

Raising of grains and food products, as well as raising of commercial crops such as tea, coffee,
tobacco, cotton, jute, rubber, etc. are included in agriculture. Even production of mulberry or
eucalyptus leaves is agriculture. Thus, agriculture not only includes food crops, but all kinds of
crops. However, basic operation is mandatory. The assesse has to prove that he performed the
basic operation, and only then, agricultural income can be claimed.

Activities that do not involve any basic operation would not be considered agricultural income
merely because they have connection with the land – such as dairy farming, breeding and raising
of livestock, etc. These are not agricultural income. Although these are also exempted from IT
Act, but under different exemptions, and not as agricultural income. Exemption is not because
they are related to agriculture, but because the legislature wanted to exempt them.

Rent/revenue – usually, landowners give their lands on rent to cultivators who undertakes all
operations related to agriculture. Rent can be taken from such cultivator in cash or kind
(produce). Such rent would also be agricultural income. Income earned by the cultivator given by
the landlord is also agricultural income. Thus, ownership of land is not required.

Some High Courts such as Bombay High Court have considered income from sale of land as
revenue derived from the land. However, an amendment has been made in the definition itself.
Explanation I was added from Amendment Act of 1989 with retrospective effect from 1979. It
states that for the removal of doubts, it is hereby declared that revenue derived from land shall
not include and shall be deemed never to have included any income arising from the transfer of
any land referred to in item (a) or item (b) of sub-clause (iii) of clause (14) of this section.

Thus, transfer of land is always considered income from capital asset (capital gain). Whether it is
taxable or not is discussed in capital gain.

Bacha F. Guzdar v. CIT – Court explained the concept of rent or revenue ‘derived from land’.
The appellant was a shareholder in 2 tea plantation companies and received dividend of Rs.
2,750. Case relates to accounting year 1949-50. Growing and manufacturing tea is partly
agriculture and partly business as industrial process is also involved. It is partly agricultural since
revenue is derived from land, and basic operation is there. But at the same time, it is partly
business as in cutting tea leaves, deriving the tea, etc. involves business activities. Under Rule
7(a) of IT Rules, proper apportionment is made – income from tea is 40% business and 60%
agricultural income.

Question in this case was regarding dividend received from these companies. It was argued by
appellant that since dividend was from tea companies, 60% of this should be exempted, and tax
should be charged on remaining 40% as business income. Court discussed ‘derived from land’.
Cases of Privy Council discussing the concept of income were discussed. One was Kamakhya
Narayana Singh. The question before PC there was whether interest on arrears of rent relating to
the land is agricultural income or not. It is clear that rent is always an agricultural income –
whether at time due, or arrears of rent. Issue was whether interest on arrears of rent would also
be treated as agricultural income.

The rent is derived from land, but interest on arrears is not derived from land, but from the
agreement itself. The Court discussed that for ‘derived’, the source of income will have to be
seen. Inquiry should be stopped as soon as the immediate and effective source is clear. The land
should be immediate and effective source of income. If it is indirect and source of income, then it
is not considered as ‘derived from land’.

Here, SC also discussed that source of dividend is not land, but being a shareholder of the
company. Hence, since land is not immediate and effective source, it is not agricultural income.
As if we make ‘derived from land’ too broad, it would go against the intent of the legislature.

In Gopan Saran Narayan also, the Court interpreted ‘derived from land’ in a similar manner.
The land should be situated in India, otherwise it is not agricultural income.

In DTAA, the tax on immovable property (land) is always charged where the property is located.
Thus, there is requirement of land being situated in India.

Sub-clause (b)

Such land means the land which is part of section 2(1A)(a) – i.e. situated in India and used for
agricultural purpose. In b(ii), the performance is done either by cultivator or receiver of rent-in-
kind.

Any ordinarily employed process – for instance, if paddy is cultivated, then it has to be
converted into rice. This is the ordinarily employed process. (However, if a rice mill owner is
purchasing paddy from farmers and changing that into rice, it is always an industrial process, and
not agricultural process).

Thus, there can be some degree of use of machines to convert the product. However, if there is a
proper industrial activity and business intention involved, then it would not be ordinarily
employed process, and wouldn’t be agricultural income. This would be a case of composite
income. It is the duty of the assesse to find out and make the apportionment. If there is value
addition, we have to see whether it changes the characteristics of the product. And if such a
process is ordinarily employed, it would be agricultural income, however if such conversion and
value addition is an industrial activity with business intention, then it would be a business
income.

For instance, if potato is converted into wafers, it would not be an agricultural income as there is
value addition with business motive. Similarly, up to the stage of production of mulberry leaves,
it is agricultural income. However, changing characteristics of the leaves into silk is an industrial
process and business intent is involved in it.

Suppose sugarcane is cultivated and converted into jaggery and sold in market. Whether it is
ordinarily employed process. It is generally not considered ordinarily employed process.
However, courts have said that we have to look at the market conditions also. If market for
sugarcane is not available nearby, then the farmer would have to convert sugarcane into jaggery
to derive any income. In such case, Courts have considered it agricultural income. But in reality,
if there is no market, then the farmer would not produce it. Regarding market for the product,
even 1 person can create a market.

Thiru Aruran Sugars Ltd. v. CIT, 1997 227 ITR 432 SC – SC stated that market does not mean
there has to be a definite place or mundi for purchase. It merely means availability of buyers that
can be reached by the producer.

Brihan Maharashtra Sugar Syndicate v. CIT, 1946 14 ITR 611, Bombay HC – question of
whether there is a market or not was discussed by Court.

K. Lakshmannan and Co. v. CIT, 1998 9 SCC 537 – Regarding mulberry leaves, Court stated
that there is market for mulberry leaves, and hence, conversion of leaves into silk using industrial
process is not an ordinarily employed process. (See once)

The change in the condition/form/characteristics of the product should only be intended to

make the commodity marketable. For instance, paddy is converted into rice to make it
saleable. So it is an ordinarily employed process. However, if rice is packaged in 5/10/20 kg
packets, a business intent comes, and hence it is not an ordinarily employed process. Similarly,
market for wheat is there. Still, if wheat is converted into flour and then sold, it is not an
agricultural income.

In this manner, assesse will have to apportion what percentage of income is agricultural and
business income.

There are three produce which are specifically apportioned – tea, coffee and rubber. Rules under
IT Rules apportion agricultural and non-agricultural income for these. For income from sale of
tea – 60% agricultural and 40% non-agricultural (Rule 8). As basic operation in preparation of
soil, etc., and plucking of leaves, etc. is mechanical operation.

For coffee (where some ingredients are mixed in coffee), 65% agricultural and 35% business
income. However, if pure coffee, then 75% agricultural and 25% business.

Rubber also 65% agricultural and 35% business income.

In case of fruits, if fruits are sold, then it is agricultural income. However, if pulp is extracted and
juice is sold, it is composite income. Similarly, if medicinal plant is sold, it is agricultural
income, but if medicine is extracted and then sold, it is composite income.
Nowadays the aspect of market has become irrelevant as market is present for all products at all
places, otherwise a person would not produce the product.

For ordinary process, it is generally seen what is the custom and practice followed in relation to
that product. For instance, if for consumption, that process is required and done by all
agriculturalists, then it would be an ordinary process. However, if there is value addition, and not
every producer is undertaking such activity, the it would not be an ordinary process.

Sub-clause (c)

Any income derived from any building owned and occupied by the receiver of the rent or
revenue of any such land, or occupied by the cultivator or the receiver of rent-in-kind, of any
land with respect to which, or the produce of which, any process mentioned in paragraphs (ii)
and (iii) of sub-clause (b) is carried on.

Income from farmhouse or farm building is also considered agricultural income subject to certain
conditions:

1. The farmhouse or building should be in immediate vicinity of such land (situated in India
and used for agricultural purpose).
2. Building should be used/occupied either by receiver of the rent or revenue or the
cultivator, or the receiver of rent-in-kind. Thus, building should be used either by
cultivator or receiver of rent.
3. The building should be used for either of the three purposes – as a dwelling house, or
store-house or other outbuilding.
4. Land is subject to land revenue or local rates (some taxes and charges on land), if it is
situated in urban areas. And if it is situated in rural areas, then no such condition is there.

Suppose if a farm building or farm house is let out for residential purpose to any person other
than cultivator, or is let out for shooting of any movie or series, it is not agricultural income.

Explanation 2 provides that income derived from any building or land referred to in sub-clause
(c) arising from the use of such building or land for any purpose (including letting for residential
purpose or for the purpose of any business or profession) other than agriculture falling under
sub-clause (a) or sub-clause (b) shall not be agricultural income.
INTEGRATION OF AGRICULTURAL INCOME

49th Report of Law Commission on integration of agricultural income with non-agricultural

income. This is a scheme which indirectly taxes agricultural income.

Salary, house property, business, capital gain and other sources – 5 heads of income taxable
under the Act. Thus, if rent or revenue is not from agricultural sources under sub-clause (a), it
would be taxable under other sources. In regard to ordinary process, if income is not from
ordinary process, it would be taxable under business income. For farm building, if it is not
exempted as agricultural income, it would be taxable as income from house property.

There were two questions referred for consideration before Law Commission:

(1) Whether under the Constitution, as it stands now, it is permissible for Parliament to amend
the Income-tax Act, 1961, to provide that “total income” as defined in that Act will include
“agricultural income” for the purpose of computing the rate of tax though no tax will be levied
by the Centre on agricultural income.

(2) If the answer to the first question is in the negative, on what lines the Constitution would
need to be amended to secure for the Parliament, without abridging the taxation powers of the
State legislatures in respect of agricultural income, a limited power to legislate only for the
aggregation of agricultural income with income on which tax is leviable under the Central
Income-tax Act for the purpose of deter mining the appropriate rate of tax on non-agricultural
income.

Thus, the essential question was when we can add agricultural income with the non-agricultural
income of the assesse for the aggregation of tax liability of assesse. Thus, we are not taxing
agricultural income, but merely taking into consideration agricultural income to determine the
rate of taxation (slab) applicable to the assesse.

The Commission stated that assesses used agricultural income as a device to hide the non-
agricultural income in the name of agricultural income. There were many professionals who, not
being agriculturalists, still held agricultural income, and hid their income from other sources in
the name of agricultural income.
Thus, question was that we are not going into the merits of agricultural income. Rather, we will
add agricultural income to the total income, and then determine the tax slab applicable on the
assesse.

Under the 1860 Act, agricultural income was not exempted. The Commission discussed the
historical aspects, constitutional validity and competence to incorporate agricultural income into
non-agricultural income, etc. The Report said that we can refer to presumption in favour of
validity of legislation. Unless the invalidity is clear, every reasonable intendment should be in
favour of validity of enactment. Implementing the proposal does not run a serious risk of being
regarded as an attempt to do indirectly what cannot be done directly. The inclusion of
agricultural income in "total income" assessed under the Central Income-tax Act would not
amount to the imposition of a basic liability to tax on agricultural income, as no tax is actually
required to be paid on it.

The Commission said that it is not a tax on agriculture, but merely considering the agricultural
income also for determining the rate of tax liability. As no tax is actually required to be paid on
agricultural income, it would not be a violation of the constitution.

1. The proposed legislation falls in pith and substance in Entry 82, therefore is within the
power of Parliament.
2. The power to enact a law levying a tax also includes power to enact law for effective
implementation of law.
3. Validity of an enactment should be upheld unless there is express invalidity.

After this Report, in the Finance Act of 1974-75, this integration scheme was started and
continued throughout the years in the Finance Act. Finance Act, 2021 in Chapter II, discusses the
rates of income tax. It states that in the cases to which Paragraph A of Part I of the First Schedule
applies, where the assessee has, in the previous year, any net agricultural income exceeding five
thousand rupees, in addition to total income, and the total income exceeds two lakh fifty
thousand rupees, then,

(a) the net agricultural income shall be taken into account, in the manner provided in clause (b)
[that is to say, as if the net agricultural income were comprised in the total income after the first
two lakh fifty thousand rupees of the total income but without being liable to tax], only for the
purpose of charging income-tax in respect of the total income; and

(b) the income-tax chargeable shall be calculated as follows:

(i) the total income and the net agricultural income shall be aggregated and the amount of
income-tax shall be determined in respect of the aggregate income at the rates specified in the
said Paragraph A, as if such aggregate income were the total income;

(ii) the net agricultural income shall be increased by a sum of two lakh fifty thousand rupees, and
the amount of income-tax shall be determined in respect of the net agricultural income as so
increased at the rates specified in the said Paragraph A, as if the net agricultural income as so
increased were the total income:

(iii) the amount of income-tax determined in accordance with sub-clause (i) shall be reduced by
the amount of income-tax determined in accordance with sub-clause (ii) and the sum so arrived
at shall be the income-tax in respect of the total income:

This scheme is applicable when net agricultural income exceeds 5 thousand rupees.

Suppose assesse is an individual and he has a taxable income from salary after all deductions and
exemptions of 10 lakhs. His net agricultural income is 2 lakhs. Currently, there are 2 slab
systems – old and new. In the new system, the rates of tax are reduced and there are multiple
slabs, however no exemption under IT Act can be claimed. In the old system, the tax rates are
high, and there are only 3 slabs, but all the exemptions are available.

In the old system, up to Rs. 2.5 lakhs, it is completely exempted. From 2.5-5 – 5%, 5-10 – 20%,
and above 10 – 30%.

As per the first step (i), we have to add agricultural income to total income. Thus, 10 + 2 = 12
lakhs. 12 lakhs has to be put in different slabs. For 2.5 to 5, there is 2.5 lakhs. 5% of 2.5 lakhs is
12,500. For 5 to 10, 20%, so liability is 1 lakhs. Now in third slab, 2 lakh is coming. Therefore,
30% of 2 lakhs = 60,000.

Thus, total tax liability= 1,00,000 + 60,000 + 12,500 = 1,72,500.

Second step (ii) states that net agricultural income shall be increased by the threshold which is
exempted i.e., a sum of 2.5 lakhs. Thus, total agricultural income is now 2 + 2.5 = 4.5 lakhs.
Here, 4.5 lakh is considered as total income. Out of this 4.5 lakhs, 2 lakh is taxable i.e. liability is
5% i.e., 10,000.

In step (iii), the amount in (i) is reduced by amount in (ii) i.e., 1,72,500 – 10,000 = 1,62,500.

Without integration scheme, only 1,12,500 had to be paid. But after integration scheme, 50,000
more has to be paid. Thus, essentially, it is a tax on agriculture only.

The Law Commission noted that it has been stated that to the extent the present exclusion of
agricultural income has acted as a loophole in the existing IT Act. There is unaccounted money
being put as agricultural income just to reduce their liability. It was proposed that if we follow
this integration scheme, such devices to hide the income as agricultural income would not be
possible. Thus, a clear-cut objective was there to remove agriculture source as a colourable
device for tax avoidance.

In 2016 also, the CBDT noted that maximum black money is hid by persons under the name of
agricultural income. Moreover, a suggestion is made that agricultural income exemption can be
provided on the basis of landholding. Kelkar committee also recommended that integration
scheme should be followed to prevent tax avoiding by claiming non-agricultural income as
agricultural income.

Also, state has no infrastructure to tax agricultural income, only Centre has the infrastructure to
tax it. So centre should collect it and then revenue can be distributed between centre and state.

APPLICATION OF INCOME AND DIVERSION OF INCOME

Diversion of income is a way of tax avoidance. If one person is receiving income on behalf of
someone else, then the other person has an overriding title over income, and he is the one liable
for tax.

Application of income is where a person purchases something or avails a service, there is an

obligation on the person. In diversion of income also, there is obligation on person.

It is the nature of obligation that is the decisive factor as to whether it is a diversion of income or
application of income.
There are 3 ways of diversion/application of income (if it is not diversion, it is definitely
application of income):

1. Legal obligation – a decree of court or arbitral award. This may be one way of diversion.
2. Statutory obligation – part of a statute. For instance, obligation of creating a general
reserve in Companies Act i.e., statute dictating that income should be diverted in a
particular way.
3. Contractual obligation – parties are involved, and both have to apply their minds.

For instance, whether CSR is a diversion of income, as on the 2% diverted income, tax does not
have to be paid. Explanation to section 37 was added through amendment – CSR expenditure
would not be considered as a business expenditure.

It is under the Company’s control where to utilize the money (under any of the activities in
Schedule VII) for CSR. Hence, it is not considered a diversion of income, as control test is very
important for diversion of income. Who exercise control over the money – if any government
body or any other party has control, then it is diversion of income. However, if the party itself
has control over where to utilize money, it is not a case of diversion of income, but application of
income.

Even under legal obligation, we have to see the nature of decree and the purpose. If decree is
merely to compel a person to fulfil his own obligation, it is not a case of diversion of income, but
application of income. For instance, payment of maintenance to ex-wife. Court has decreed to
pay Rs. 10,000 per month maintenance. This is not a diversion of income.

If it is diversion of income, it is not the person’s income, and hence the person is not liable to pay
tax on it. However, if it is application of income, the person is liable to pay tax.

Suppose a person takes home loan for construction of house. In the agreement, there is a
provision that in case of default on EMI, bank can create a charge on the salary of person. A
person defaults, and created a charge and thus bank started realizing money from the source
itself. Whether it is application or diversion of income – it is application of income, as it was the
person’s obligation in the first place, and through decree/charge, bank just compelled the person
to pay for it.
In case of diversion of income, the income would not be considered as belonging to that person
at all. That diversion would be deducted and then tax would be levied. For instance, arbitration
award is considered a diversion of income.

Contractual obligation as a way of claiming diversion of income is most controversial as it would

always be the case that the person himself created a contractual obligation or accepted the
condition.

CIT v. Sunil J. Kinariwala, 2003 1 SCC 660 – assesse was partner in partnership firm with 10%
share in firm named Kinariwala RJK Industries. He created a trust (Sunil J. Kinariwala Trust) by
a deed of settlement and assigned 50% out of his 10% right, title and interest as a partner which
he had in firm in the favour of trust. Thus, 50% of income attributable to the partner was to be
diverted to the trust. He claimed this as diversion of income. Trust could directly claim it from
the partnership. And for that 50%, the partner was not liable. Therefore, partner claimed that tax
is to be levied only on 50% of income. Whether this claim is correct has to be seen.

There are 3 beneficiaries of trust – assesse’s wife, brother and son.

He claimed that as 50% of the income attributable to him was to be diverted to the trust at
source, it could not be considered total income for computation of tax. Income Tax Officer
rejected this contention. The assesse appealed Assistant Commissioner of Income Tax allowed
the appeal. On appeal by revenue to ITAT, . Question ultimately came before High Court.

Relying on two judgments of SC, it was noted that it is a case of diversion of income. CIT v.
Bhaglakshmi, and Murlidhar v. CIT.

Matter went to SC. SC reversed the order of High Court. The SC discussed issue regarding rights
of assignee and rights of sub-partner under section 29. Right of assignee is below the right of a
sub-partner. Right of assignee is a limited right, and not an unlimited right such as of a sub-
partner. The right of assignee comes after the partners. Assignee has no right to claim it from the
partnership itself. This was the main difference between assignment and partnership. Here, as it
is a case of assignment of rights and interest, it is a right which comes after the partnership.
Hence, it is a case of application of income, and not diversion of income.
CIT v. Sitaldas Tirathdas, 1961 41 ITR 367 – on diversion of income. The test laid down by SC
quoting a Privy Council judgment, to identify diversion and application of income. It is followed
till date. Court stated:

“In our opinion, the true test is whether the amount sought to be deducted, in truth, never reaches
the assessee as his income. Obligations, no doubt, there are in every case, but it is the nature of
the obligation which is the decisive fact. There is a difference between an amount which a person
is obliged to apply out of his income and an amount which by the nature of the obligation cannot
be said to be a part of the income of the assessee. Where by the obligation income is diverted
before it reaches the assessee, it is deductible; but where the income is required to be applied to
discharge an obligation after such income reaches the assessee, the same consequence, in law,
does not follow. It is the first kind of payment which can truly be excused and not the second.
The second payment is merely an obligation to pay another a portion of one's own income, which
has been received and is since applied. The first is a case in which the income never reaches
the assessee, who even if he were to collect it, does so, not as part of his income, but for and
on behalf of the person to whom it is payable.”

Thus, the nature and purpose of obligation is the decisive test.

The colourable device aspect was not looked into during cases of those times. However, around
2000, when various anti-avoidance measures were adopted, cases are looked from the aspect of
colourable device also.

Diversion of income can be used as a tool to minimize the liability of a person and take the
benefits. This is the concept of profit shifting and base erosion. Companies use the tax haven
countries to shift their profits.

In Sunil J. Kinariwala case, SC discussed Bejoy Singh Dudharia v. CIT, 1933 – assesse had
succeeded to family ancestral wealth after death of father. The stepmother brought a suit of
maintenance in which a consent decree was made. The assesse was to pay a monthly payment
sum of money to stepmother by decree, directing that it was a charge on the appellant’s
resources. In computing the income, he claimed that the amount paid by him to stepmother in the
decree would be a diversion of income.
Here, the Privy Council said that the sum paid by assesse to stepmother was not his income. It is
not a case of application of appellant of a part of his income in a certain way. Rather, it is an
allocation of a part of revenue before it becomes income in his hands. As a charge was created

PC Malik v. CIT, 1938 6 ITR – here, under a will, certain payments had to be made to
beneficiaries and trustees from the property of testator. The PC held that such payment can only
be out of the income received by the assesse, and hence the PC held that it was an application of
income, and there was no diversion at the source. As here, the obligation was to be discharged
after the receipt of income from the property. Here, because there was no charge created by the
Court, it was held application of income. While in the earlier case, since charge had been created
by Court, it was held diversion of income.

CIT v. Mathubhai C. Patel, 1999 238 ITR 403 – the assesse’s father died on July 7, 1965. On his
death, the assesse inherited various assets amounting to Rs. 12,38,000 and liabilities worth Rs.
2,47,000. Liability was in respect of borrowing from Bank of India by assesse’s father in order to
meet his income tax liability. To borrow the fund, bank had granted OD facility to father. Father
pledged certain shares to the bank as guarantee to get OD facility. The assesse inherited
properties, and was also required to meet the liabilities. The dividend income which assesse
derived from shares pledged to bank was sought to be taxed.

The assesse claimed that since he paid interest to bank on OD account, that amount has to be
deducted from the gross receipts of the assesse. Dividend is the income of assesse, but from the
dividend, the interest paid to the Bank for OD should be deducted, and then income should be
calculated. He claimed that interest paid on OD is a diversion of income. While the revenue
department claimed that the entire dividend amount is the income, and interest paid on OD
cannot be claimed as diversion of income.

SC discussed various judgments. It also referred a 1996 SC case of Chinubhai. SC said that if a
man incurs a debt, he will have to pay it, and till it is repaid, he will have to pay interest on it.
Whether interest is deductible from income would depend on the provisions of IT Act. Merely
because of the liability of interest, the liability cannot be said to be diverted to the creditors.
The basic principle is that when a person maintains any party which he is obliged to maintain, it
would be application of income and not diversion. Even if a charge is created on the
properties of the assesse, the position would not change.
Thus, after this judgment, even if the Court creates a charge on property, it would not be a
diversion of income.

Diversion cases are very less because there are many exemption and deduction provisions are
present, and proving exemption under a particular provision is easier than proving it a diversion
of income.

Rajkot District Gopalak Cooperative Milk Producers Union v. CIT, 1993 ITR 590, Gujarat High
Court – assesse was a cooperative society. Gujarat government to hand over milk conservation
project which till then was run by the government. The project was in loss. Working of that
project was temporarily transferred to the union. The assesse was given the project on a leave
and license basis on a nominal fees of Rs. 1 per month. The assesse was under obligation to
maintain. As per agreement, the profits were applied to accumulated losses, and the remaining
amount was profit to the assesse. The assesse claimed deduction of Rs. 78000 paid by it to
Gujarat government towards the leave and license agreement. This 78,000 was claimed as
diversion of income.

There was a clear position that no legal or financial liability would accrue to the government if
assesse procured any fixed or movable assets. Working capital also had to be arranged by the
assesse. Some nominees of government were kept in the managing committee, and government’s
decision was final. Some profits were earned, but assesse filed nil returns, as he claimed that first
the profits have to be used towards accumulated losses, and after that, nothing was left to claim
as income.

The HC observed that even though assess was given a right to run the business, he was required
to first provide for the accumulated losses. Income tax would be levied on the real income,
which is the income left after the losses are covered.

However, this decision is problematic as in this manner, it can be used as a colourable device,
and any two persons can make an agreement to transfer business through license and cover
losses, in order to evade tax.

Bhumi Sudhar Nigam v. CIT, 2005 144 Taxman 294, Allahabad High Court – this gives an
opposite view from the previous case. Bhumi Sudhar Nigam was a state-owned company. The
UP government gave aid to the Nigam for various projects. The grant was with stipulation that
the sum provided by government should be kept in public ledger in the treasury i.e., government
accounts. There was an agreement that which provided an option that if grant is deposited with
commercial banks, and if any interest on deposit is accrued, it would belong to the state
government only. The account would be in the name of Nigam only. The assesse received
interests received on fixed deposits made by it on the grant in aid received from commercial
banks.

Question arose whether it is a diversion or application of income. Government said that the grant
received should be kept in government treasury. However, if deposit is made in commercial
bank, the account holder would be the Nigam only. Even if government has provided a grant,
since an option is provided to either deposit with public ledger account or with commercial bank.
If amount is deposited in the account of Nigam only, then whatever the condition, the
amount would accrue to the Nigam only. Thus, it is an application of income when the
interest accrued is later paid to government. If money was to be mandatorily deposited in public
ledger account, it would then belong to the government only, but not in this case where an option
is provided.

This is a sound judgment as even if one party is the state, even state can be used as a tax haven.
The profit can be shifted from company to state as a colourable device. To avoid this, such
arrangements have to be held application of income.

In Rajkot case also, it was a case of utilization of profits, and not diversion, but HC in that case
held otherwise, which is not good.

Examples of genuine cases of diversion of income (i.e., not voluntary, or gratuitous or through
agreement) – suppose there is partition of a HUF. HUF had been a partner in a partnership firm
with Karta as its representative. After partition, Karta remained as a partner. If profit is received
from the firm, would the profit belong to Karta only, or all members are entitled to it? Thus, this
is a diversion of income, as the Karta cannot be liable for the entire profit. [CIT v. Indra Mohan
Sharma, 1982 138 ITR 696 Bombay HC]

Similarly, creation of sub-partnership is another example of diversion of income.

L. Hansraj Gupta & Anr. v. CIT 1969 73 ITR 765, Delhi HC – Suppose ABC Ltd. is a
partnership firm with 3 partners A, B and C. As per the partnership deed, no partner could start a
new business without the consent of existing partners. If a partner starts a new business, profit
belonging to the new business would belong to the old partnership. A became a partner in a new
business XYZ Ltd. This is in contravention of the partnership deed. This was held as diversion of
income.

VNV Devaraju Chetty and Co. v. CIT, 1950 18 ITR 357, Madras HC – some of the partners had
retired from business reserving their rights in certain forward contracts entered into by the
partnership. The continuing partners thereafter realized the profits in respect of forward contracts
and paid their due shares to the retired partners. Whether this is diversion or application of
income. Court held this is a diversion of income, as the profit belong to the retired partners,
as they retired with their rights in these forward contracts. The profits received by
continuing partners was not their own income in entirety.

Thus, in case of contractual obligations also, diversion of income can be there.

CIT v. Kanchan Lal Palsania, 1983 141 ITR 284, Bombay HC – similar issue as the preceding
case was there.

CIT v. L. Bansidhar, 1968 67 ITR 374 Delhi HC – assesse succeeded his father’s share in a
private company. A clause in the AOA to effect that successor would have to pay a portion of
dividend in respect of these shares to his sisters. The company directly paid to the sisters.
Whether it is diversion or application of income. Thus, whether income diverted from the
source itself as dividend to sisters would be diversion or not. The assesse succeeded with this
condition. It was held to be diversion of income.

CIT v. Madras Race Club, 1996

Amitabh Bacchan v. Deputy CIT, 2005 Mumbai ITAT

CIT v. Tollygunge Club Ltd., 1977 107 ITR 776 SC

Recently, cases decided by Madras and Kerala HC:

Union of India v. The Society of Mary Immaculate, 2019 Madras HC – 12 nuns and sisters,
priests, and fathers in Church rendered their services as teachers in Missionary school. The
school received grant from state government to the extent of their salary. Thus, grant was paid to
the exact amount of salary. Thus, the salary of these persons was paid in the form of grant.
Question regarding taxability of salary – whether taxable in hands of teachers, or belongs to the
missionary being a religious and charitable trust. Assesses (Trust) claimed that they are bound by
Canon law by their vows of poverty to Christ, so they cannot be taxed for their salary. The
receipt of salary from the state government belongs to missionary only. By the vow, they have
suffered a civil death and have renounced the world, and their salary belongs to missionary itself,
and tax cannot be deducted at source. Since they do not exist, how can they be liable to salary.
So trust would be liable for tax, and trust is exempted under IT Act. Thus, they claimed diversion
of income.

Matter went to the Single Bench and then Division Bench. Single Bench held diversion of
income, and Division Bench reversed it. A similar case of Kerala HC also on this line. The
Madras HC held that this is a case of IT Act, and canon law cannot override the IT Act. Salary
belongs to those who render the services, and salary cannot be said to belong to trust. Thus,
they are liable to attract TDS. Provisions of IT Act are plain, simple, apolitical and areligious
in character. With great respect, the Single Bench has taken the impermissible route of taking IT
Act as secondary to canon law. Division Bench reversed it and held it a case of application of
income, making the salary taxable and subject to TDS.

The Division Bench judgment was stayed by SC.

INCIDENCE/LIABILITY OF TAX

Incidence of tax is dependent on status. There are 3 categories – resident, non-resident, and not
ordinarily resident (this category is applied only for individuals and HUF)

Liability/incidence to tax is defined in section 5 based upon the status. The status of a person is
determined as per section 6. Section 9 is the deeming provision and cross-border taxation and
DTAA is covered under that only.

Section 5 starts with subject to the provisions of this Act. This means it is subject to section 90
also which deals with DTAA. Thus, if DTAA gives a special circumstance, it would prevail over
section 5. Also, income tax is a tax on total income. The source is irrelevant.
Section 5 discusses scope of total income. Subject to the provisions of this Act, the total income
of any previous year of a person who is a resident includes all income from whatever source
derived which—

(a) is received or is deemed to be received in India in such year by or on behalf of such person;
or

(b) accrues or arises or is deemed to accrue or arise to him in India during such year; or

(c) accrues or arises to him outside India during such year – i.e., global income is taxable, if it is
earned by a resident.

Provided that, in the case of a person not ordinarily resident in India within the meaning of
subsection (6) of section 6, the income which accrues or arises to him outside India shall not be
so included unless it is derived from a business controlled in or a profession set up in India.

Thus, if a person is resident, then income received or deemed to be received, income accrue or
arise or deemed to accrue or arise in India, as well as income accrued or arise outside India, all
would be taxable in India.

If a person is not ordinarily resident of India, then income under (a) and (b) is taxable, but
income under (c) is not generally taxable. The condition for taxation is if it is derived from a
business or profession in India.

(2) Subject to the provisions of this Act, the total income of any previous year of a person who is
a non-resident includes all income from whatever source derived which— (a) is received or is
deemed to be received in India in such year by or on behalf of such person; or (b) accrues or
arises or is deemed to accrue or arise to him in India during such year.

Explanation 1—Income accruing or arising outside India shall not be deemed to be received in
India within the meaning of this section by reason only of the fact that it is taken into account in
a balance sheet prepared in India.

Explanation 2—For the removal of doubts, it is hereby declared that income which has been
included in the total income of a person on the basis that it has accrued or arisen or is deemed to
have accrued or arisen to him shall not again be so included on the basis that it is received or
deemed to be received by him in India.
Thus, for the third category i.e., non-resident, then only the first two categories of income are
taxable in India – received or deemed to received in India, or accrued or arise or deemed to
accrue or arise in India. The third category of accrue or arise outside India is not taxable under
any case.

However, sometimes, under the deeming provision, income arising outside India is also taxable
in India for non-resident.

Section 6 discusses residence in India. Section 2(31) defined persons and included various
heads such as individuals, HUF, association or body of persons, company or other artificial
juridical person. For each of such persons, we have to see when they would be considered
resident or non-resident.

For individual, there are three categories – resident, non-resident, not ordinarily resident.

Section 6(1) discusses individuals. An individual is said to be resident in India in any previous
year, if he—

(a) is in India in that year for a period or periods amounting in all to one hundred and eighty-two
days or more; or

(c) having within the four years preceding that year been in India for a period or periods
amounting in all to three hundred and sixty-five days or more, is in India for a period or periods
amounting in all to sixty days or more in that year.

Thus, there are two conditions for individual to be categorized as resident, either of which needs
to be fulfilled:

i. If the individual is in India for period of 182 days or more in the previous year. In
such case, the person’s worldwide income would be taxed in India, irrespective of
whether source is in India or outside.
ii. In the current year, he should have stayed in India at least for 60 days or more, and at
least 365 days or more in 4 preceding years. This 365 day period can be at one go
also, or in intervals also, provided that it amounts to total of 365 days in 4 years.

For instance, a person came to India on 1st January 2021, and stayed here till 31st August, 2021.
The person would be not be considered resident. As the previous year ended on 31 st March till
which he stayed only for 90 days. And in the current previous year, he stayed in India only for 5
months. Thus, we are concerned not with calendar year, but previous year for IT Act, which ends
on 31st March, 2021.

We see the residence year-wise. The status has to be determined for every year.

Current previous year is 1st April, 2021 – 31st March 2022. The 4 preceding previous years are
2020-21, 2019-20, 2018-19 and 2017-18. Say in 2017-18, 100 days, 18-19, 50 days, 19-20, 100
days and in 2020-21, 120 days, and in 2021-22 – 60 days. In such case, person would be resident
under second condition.

There are certain exceptions provided in the explanations.

Explanation 1—In the case of an individual—

(a) being a citizen of India, who leaves India in any previous year as a member of the crew of an
Indian ship as defined in clause (18) of section 3 of the Merchant Shipping Act, 1958, or for the
purposes of employment outside India, the provisions of sub-clause (c) shall apply in relation to
that year as if for the words ―sixty days, occurring therein, the words ―one hundred and
eighty-two days had been substituted;

(b) being a citizen of India, or a person of Indian origin within the meaning of Explanation to
clause (e) of section 115C, who, being outside India, comes on a visit to India in any previous
year, the provisions of sub-clause (c) shall apply in relation to that year as if for the words
―sixty days, occurring therein, the words ―one hundred and eighty-two days had been
substituted.

Thus, there are 3 exceptions:

1. If a person is citizen of India, and leaves India as member of crew of an Indian ship, then
the 60 days for current previous year would be substituted by 182 days rule. Thus, 182
day rule will apply.
2. Being a citizen of India, a person leaves India in any previous year for the purpose of
employment outside India, then also the 60 day rule would be substituted by 182 days
rule.
 3. If a citizen of India, or a person of Indian origin, being outside India, comes on a visit to
India (even as a tourist) in any previous year, then again 60 day rule would be substituted
by 182 days.

These have been added through an amendment, which states that 60 days occurring in section
6(1)(c) have been substituted by 182 days. Does this mean 182 days in current year plus 365
days in previous 4 years? As if 182 days is fulfilled, the person has already fulfilled the first
condition. Two interpretations are thus possible –

i. look at 182 days in current year + 365 days in previous 4 years.

ii. The moment 182 days criteria is fulfilled, the first condition under section 6(1)(a) is
already fulfilled, so there is no need to look at 365 days rule.

The language used is “for the words ―sixty days, occurring therein, the words ―one hundred
and eighty-two days had been substituted.” As a literal interpretation, this means that the 365 day
rule would still remain. This would amount to overriding section 6(1)(a). Hence, this is
controversial.

Another controversy is what is meant by “for the purposes of employment outside India” –
whether to seek employment outside India, or person is already employed in India, and in
relation to that employment only, he is going abroad. The general understanding is that person is
already employed and for purpose of that employment only, he is going abroad.

British Gas India 2006 155 Taxmann 326 Authority for Advanced Ruling (AAR) – interpretation
made by court that for the purpose of employment does not mean to seek employment. Person is
already employed and went abroad for that purpose.

Anurag Choudhary 2010 190 Taxmann 296 AAR – also relates to employment outside India.
Court also looked at the explanation. Since it is beneficial provision, only 182 day criteria is to
be looked at and then 365 day rule is not essential to be satisfied.

For meaning of employment, its scope was expanded by a circular issued by the department on
30th June, 1982 – employment has no technical meaning, and it includes self-employment. Thus,
CAs, doctors, lawyers, are included here. If in relation to such work, person went abroad, then
also it is included. 182 rule would be applicable and person would be covered in the explanation.
Such a person would be included only if he resided in India for 182 days.

Vijay Mallya v. Assistant CIT, 2003 131 Taxmann 477, Calcutta HC – even if a person is resident
for 181 days, he would be considered non-resident, as 182 days is the minimum period. The day
of arriving India and the day when a person leaves India, both would be counted in the 182 days
as full days. Number of hours would also be considered, but then it is the assesse’s burden to
prove.

Court has said that even if assessing officer accepts the claim of assesse, and assesse is non-
resident, then also he is duty bound to record the reason that why he is not holding the assesse as
a resident in India. The burden is however on the assesse to prove that why he is a non-resident,
as he has the data present of his presence in India. The assessing officer has to record the reasons
based on which he is holding a person as non-resident.

By an Amendment Act of Finance Act, 2020, Explanation 1(b) was extended as “and in case
of such person having total income, other than the income from foreign sources, exceeding
fifteen lakh rupees during the previous year, for the words ‘sixty days’ occurring therein, the
words ‘one hundred and twenty days’ had been substituted”. Being a citizen of India or person of
Indian origin, if income exceeding 15 lakh rupees in the previous year, then 60 days would be
read as 120 days. Thus, if income does not exceed 15 lakhs, then 60 days are read as 182 days.
But if income exceeds 15 lakhs, then it would be read as 120 days.

Section 6(1A) was also inserted by Amendment Act, 2020. It provided “Notwithstanding
anything contained in clause (1), an individual, being a citizen of India, having total income,
other than the income from foreign sources, exceeding fifteen lakh rupees during the previous
year shall be deemed to be resident in India in that previous year, if he is not liable to tax in any
other country or territory by reason of his domicile or residence or any other criteria of similar
nature.”

Explanation 2 is applicable for crew member of a foreign ship, as earlier benefit was for crew
member of an Indian ship. For the purposes of this clause, in the case of an individual, being a
citizen of India and a member of the crew of a foreign bound ship leaving India, the period or
periods of stay in India shall, in respect of such voyage, be determined in the manner and subject
to such conditions as may be prescribed.

Section 6(1A) is a deeming provision and overrides section 6(1). IA states that notwithstanding
anything in clause 1, an individual being a citizen in India, having total income, other than
income from foreign sources, exceeding 15 lakhs, shall be deemed to he resident in India if he is
not subject to tax in any other country or territory by virtue of his domicile or any other criteria
of a similar nature. Thus, in such case, the 60 days and 182 days rules become irrelevant.

This is contentious because there were a lot of representations that people in Dubai should be
taxed. However, this was not possible, because we cannot override the DTAA which is a
bilateral treaty, by making amendment in IT Act. Section 5 also states that it is subject to
provisions of IT Act.

This amendment would thus apply where we do not have any DTAA. In Vodafone case, as well
as Azadi Bachao Andolan case, SC has clearly held that we cannot override DTAA by an
amendment in IT Act.

DTAA says that a person can claim benefit if a person is ‘liable to tax’ in either of the countries.

Also, the word used is “if he is not liable to tax in any other country or territory”.

In Finance Act 2021, there was an amendment and section 2(29A) was added where meaning of
‘liable to tax’ was clarified to provide more force to amendment of 2020. This is because if
something is not defined in DTAA, then the domestic Act definition would be applicable. And if
something is not defined in IT Act also, then parties would mutually decide.

As per section 2(29A), liable to tax, in relation to a person and with reference to a country,
means that there is an income-tax liability on such person under the law of that country for the
time being in force and shall include a person who has subsequently been exempted from such
liability under the law of that country.

Liable to tax is a comprehensive subject, and subject to tax means imposition of tax under a
particular provision. Thus, the moment a person is liable to tax, this provision is not applicable.
For instance, in UAE, every individual is liable to tax, but because of exemption in the law, they
are not subject to tax.
In UK, by virtue of law, partners are subject to tax and not firms. Even though firms are not
subject to tax, they are still liable to tax by virtue of being an entity. Therefore, it has been held
that UK firms can claim benefit of DTAA by virtue of being liable to tax.

Thus, to enjoy the benefit of no tax, countries first have to make a law in order to make persons
liable to tax, so that the DTAA can become applicable, and then they can provide exemptions so
as to not make persons subject to tax. As because if there is no law, then it means there is no
liability to pay. And in such case, the deeming provision of section 6(1A) would apply, and
being a citizen of India, such a person would be liable to tax in India.

Section 6(2) provides that a Hindu undivided family, firm or other association of persons is said
to be resident in India in any previous year in every case except where during that year the
control and management of its affairs is situated wholly outside India.

Thus, general presumption is that firm, association of persons or HUF are considered residents of
India for the previous year. The exception is where for the previous year, the control and
management of the affairs (income generating activity) of such firm/association/HUF is wholly
situated outside India. Even if it is partly in India, it would be considered resident.

Control and management – suppose there is a partnership firm having mines in SA. Their
business is physically present in SA and a partner is also there. However, 3 partners are in India
and the policy decisions are taken from India only. Here, despite physical presence outside India,
firm would be considered to be controlled and managed in India, and firm would be considered
Indian resident. De jure control is important and physical presence is not relevant.

Under IT Act, only the stay in India is seen, and the reason for stay is irrelevant. Also, during
lockdown, demands were raised to increase the period of 182 days, or to exclude the period of
lockdown. Then government came with a circular that period of ban on travel would be excluded
from the 182-day calculation.

For certain open borders, such as India and Nepal, it cannot be said that merely because person
went to Nepal, he would become non-resident. The assesse will have to prove that he would be
non-resident.

When individual or HUF is considered not ordinarily resident

HUF’s status would be determined looking at the Karta’s position only.

Section 6(6) discusses when person is not ordinarily resident. A person is said to be "not
ordinarily resident" in India in any previous year if such person is—

(a) an individual who has been a non-resident in India in nine out of the ten previous years
preceding that year, or has during the seven previous years preceding that year been in India for a
period of, or periods amounting in all to, seven hundred and twenty-nine days or less; or

(b) a Hindu undivided family whose manager has been a non-resident in India in nine out of the
ten previous years preceding that year, or has during the seven previous years preceding that year
been in India for a period of, or periods amounting in all to, seven hundred and twenty-nine days
or less; or

(c) a citizen of India, or a person of Indian origin, having total income, other than the income
from foreign sources, exceeding fifteen lakh rupees during the previous year, as referred to in
clause (b) of Explanation 1 to clause (1), who has been in India for a period or periods
amounting in all to one hundred and twenty days or more but less than one hundred and eighty-
two days; or

(d) a citizen of India who is deemed to be resident in India under clause (1A).

Explanation—For the purposes of this section, the expression “income from foreign sources”
means income which accrues or arises outside India (except income derived from a business
controlled in or a profession set up in India) and which is not deemed to accrue or arise in India.

As per section 6(6)(a), if in 9 out of 10 previous years, the person has not fulfilled the criteria of
182 days, or 60 + 365 days. Or in the previous 7 years, he has been India for 729 days or less. If
either of these conditions is fulfilled, person would be not ordinarily resident.

In section 6(6)(b), for HUF also, same rule is there, and only the position of Karta is seen.

In section 6(6)(c), as per Explanation 1(b), the 60 day rule is substituted with 120 days or 182
days. So if the person is resident in India for 120 days or more, but less than 182 days, then
person would be considered not ordinarily resident. Thus, where total income exceeds Rs. 15
lakhs, then person would be considered not ordinarily resident if stay in India is 120 days or
more but less than 182 days.
In section 6(6)(d), a person deemed as resident in India under section 6(1A), he is categorized as
not ordinarily resident.

Thus, for status of ordinarily resident, following conditions are there:

i. Basic condition – stay in India is 182 days in previous year, or 60 days in current
previous year, and 365 days in 4 previous years.
ii. Converting the negative criteria of not ordinarily resident into positive sense – he is in
India for at least 2 years as a resident in the 10 previous years (as negative criteria is
being non-resident in India).

Section 6(5) – where the status of a person as resident, non-resident or not ordinarily resident, we
are not considering the source of income. The person would be considered resident/non-
resident/not ordinarily resident for all sources for the entire previous year. Thus, status is
determined for the whole previous year for all sources. If a person is resident in India in a
previous year in respect of any source of income, he shall be deemed to be resident in India in
the previous year relevant to the assessment year in respect of each of his other sources of
income.

Section 6(2) – control and management for HUF/firm/association of persons. The presumption is
always in favour of residence under the IT Act. The assesse has the burden to prove otherwise.

V. Subbayya Chettiar v. CIT, AIR 1951 SC 101 – Court laid certain tests to determine control
and management. The conception of residence in case of fictitious persons such as a company,
is as artificial as the company itself, and the locality of the residence can only be determined by
analogy, by asking where is the head and seat and directing power of the affairs of the company.
J. Patanjali observed the test

1. that ‘control and management’ signifies, in the present context, the controlling and
directive power, ‘the head and brain’ as it is sometimes called, and ‘situated’ implies the
functioning of such power at a particular place with some degree of permanence, while
‘wholly’ would seem to recognize the possibility of the seat of such power being divided
between two distinct and separated places. As a general rule, the control and management
of a business remains in the hand of a person or a group of persons, and the question to be
asked is wherefrom the person or group of persons controls or directs the business.
 2. Mere activity by the company in a place does not create residence, with the result that a
company may be ‘residing’ in one place and doing a great deal business in another.
3. The central management and control of a company may be divided, and it may keep
house and do business m more than one place, and, if so, it may have more than one
residence.
4. In case of dual residence, it is necessary to show that the company performs some of the
vital organic (1) 9 Tax Cas 373 functions incidental to its existence as such in both the
places, so that in fact there are two centres of management.

The test is from where the company is controlled.

Nikes v. CIT 1945 – a partner, under terms of partnership deed, had full power over control of
firm’s business. Firm was situated in SA. Here, the control from India was held insufficient.

Erin Estate v. CIT, 1958 34 ITR 1 SC.

CIT v. Nandlal, 1960 40 ITR 1 SC.

In these case, Court has laid down test of control and management – we have to see from where
the control is happening and from where control and management is taking place. The place of
business is not relevant. Presumption is always in favour of residence.

For status of company, section 6(3) is there. Before 2015, the test to declare company as resident
or non-residence was different.

A company is said to be a resident in India in any previous year, if—

(i) it is an Indian company; or

(ii) its place of effective management, in that year, is in India.

Explanation—For the purposes of this clause ‘place of effective management’ means a place
where key management and commercial decisions that are necessary for the conduct of business
of an entity as a whole are, in substance made.

Before 2015 Amendment, the same test of control and management of firms was applied. A
company was said to be resident if it was an Indian company, or control and management of its
affairs was fully situated in India. The only difference was that burden was on department to
prove management was wholly situated in India. However, the amendment replaced this test with
effective management test. This was to comply with international obligations as per OECD.

In 2016, draft guidelines were issued which defined what is place of effective management. On
14th January, 2017, final guidelines came to define this place of effective management. Circular
no. 8 of 2017, and circular no. 6 of 2017 are there.

Explanatory note to memorandum to Finance Bill also said that the Guidelines would be
followed. This is tiebreaker rule – if another country claims that place of effective management
is in their country. a company shall be said to be engaged in active business outside India if the
passive income is not more than 50% of total income, and less than 50% of total income and
employees are situated in India. In such case, the active business would be said to be conducted
outside India and place of effective management would be outside India.

The guidelines state that if there is any dispute between the states, then through mutual
agreement procedure in the DTAA, it would be determined. The OECD commentary also states
that each case has to be analysed on the basis of facts and circumstances, and then the decision
has to be taken. This is because conflict is always there.

For instance, for an individual, there tie-breaker rule under Article 4 of DTAA regarding
residence v. residence. As the moment a person resides for 182 days, person becomes resident,
and still, he may be citizen of some other country.

Also, there can be residence in one country, and source of income in another country. thus,
residence v. residence, and residence v. source are major areas of conflict, as 2 countries are
getting the right to tax because the incidence of tax depends on status. In such cases, DTAAs
between countries become import.

DOUBLE TAXATION AVOIDANCE AGREEMENTS [DTAAS]

There can be two kinds of agreements – limited agreements, and comprehensive agreements.
Comprehensive agreements cover all types of domestic aspects.

DTAAs are required because there can be conflict between two countries with respect to their
jurisdiction. For instance, if a person is declared as resident in two countries, then the person
would be liable to taxation in two countries on the same income, which would lead to double
taxation. DTAAs provide relief in case of double taxation. This was the main objective behind
DTAAs.

To claim relief of provisions of DTAA, person has to be declared resident of either of the states.
If a person is not resident of any of the states, then he cannot claim benefit of DTAA between the
two countries.

Residents are defined under IT Act. Different countries follow different criteria to declare any
person as resident. Because of this, double taxation can arise due to conflict of jurisdiction
because of residence.

Another conflict can arise because of residence and source. If resident is of US, while source of
income is in India, both India and US can tax. DTAA lays down certain conditions for taxation.
For instance, source country can tax only when certain conditions are fulfilled. If conditions are
fulfilled, the person can claim relief from resident country under the DTAA.

Section 91 states that if a person is resident of India, and income is earned in different
jurisdictions. If there is no DTAA, the tax is to be paid in both countries. As per section 91,
person can claim the tax charged as credit, and claim relief from double taxation. However, this
relief is only available to residents of India.

There are 2 model conventions – UN Model convention and OECD model convention.

DTAA is a beneficial agreement, as it provides relief to the assesse. Therefore, it would be given
a wider interpretation, and it would prevail over IT Act.

Article 4 of both Model conventions talks about definition of residence. Article 3 provides who
can claim – any person who is residence of either contracting state can claim benefit of the
convention. Article 4 defines residence as any person, who, under the laws of that state, is liable
to taxation therein, by reason of his domicile, residence, place of management, or any other
criteria of a similar nature.

Where by reason of provision of para 1, an individual is a resident of both contracting states,

then how to determine status. This is the tie-breaker rule. His residential status shall be
determined in accordance with the following rules: (the criteria are to apply one by one)
 1. Person shall be deemed to be resident of the contracting state in which he has a
permanent home available to him. This is the first criteria.
2. If the person has permanent home in both countries, he shall be deemed to be resident of
contracting state with which his personal and economic relations are more closer. This is
the centre of vital interest. If a person’s livelihood, family, etc. is in one country, he will
be considered resident of that country.
3. If the contracting state in which he has centre of vital interest cannot be determined, or he
has no permanent home in either countries, then he will be deemed to be resident of the
contractual state in which he has habitual abode. This will be seen by the number of days
resided in both countries.
4. If he has habitual abode in both or neither of the contracting states, then he shall be
deemed to be resident of contracting state of which he is a national.
5. If he is a national of both or neither of the contracting states, then through mutual
agreement procedure, both states will together determine whether country A or B has
right to claim residence. The competent authorities of contracting states would settle the
matter through mutual agreement procedure under article 25/26.

In other cases, such as in case of companies, the place of effective management is the applicable
rule. Normally, for companies, it is a settled position only.

Union of India v. Azadi Bachao Andolan, 2003 63 ITR 706 SC – this case is very important in
the interpretation of DTAA. Two circulars of government – 1994 and 2000 are challenged before
SC. First circular, which was issued by CBDT, which has the power to issue circulars for the
purpose of clarification (and not directory). Circulars are binding on the department, but not on
the Courts. Circular no. 682 dated March 30, 1994. Through this, capital gain of any resident of
Mauritius by alienation or transfer of shares of an Indian company would be taxable only in
Mauritius as per its taxation laws (in Mauritius law, there is no tax on capital gain, hence transfer
or alienation was exempted), and would not be liable to tax in India. Relying on this, large
number of FIIs resident in Mauritius invested in shares of Indian companies without being
subject to any tax.

In 2000, some IT authorities issued show cause notice to some FIIs functioning in India calling
them to show cause why they should not be tax for profits accrued in India. Basis was that the
resident companies of Mauritius were only incorporated in Mauritius, but were controlled and
managed outside India or Mauritius. FIIs were shell companies controlled in other countries.
Presence in Mauritius was only on paper. Some evidences stated that in one building in
Mauritius, more than 40,000 companies were registered, merely to get certificate of residence in
Mauritius.

Since these companies were not liable to tax in Mauritius, they could not claim benefit of DTAA
as they were not residents of Mauritius . Hence, the show cause asked these FIIs to pay tax.

On 4th April 2000, the Finance Minister issued press note that the view taken by IT authorities
did not represent or reflect the policy of India. We are still operating as per circular 682, and
exemption can be claimed on showing certificate of residence.

After this, to clarify the position, on 13th April, 2000 circular no. 789 was issued by CBDT, under
section 119 of IT Act for clarification regarding taxation of income from dividends and capital
gains under Indo-Mauritian DTAA. The provisions of the DTAA convention apply to both
countries. Article 4 of convention defines residence as any person, who, under the laws of that
state, is liable to taxation therein, by reason of his domicile, residence, place of management, or
any other criteria of a similar nature. FIIs are liable to tax in Mauritian law, and hence should be
considered resident of Mauritius. Since they are resident by virtue of the certificate of residence,
the DTAA is applicable to the FIIs.

The criteria of Mauritius is that if they give certificate of residence, the company would be
considered a resident of Mauritius. And the circular stated that CBDT will have to accept this
criteria. Accordingly, FIIs resident in Mauritius should not be taxable in Indian on the income
arising from transfer of shares of Indian companies.

A PIL was filed in 2000 by an NGO Azadi Bachao Andolan in Delhi HC. Petitioner claimed that
the circular should be declared ultra vires to section 119, as CBDT is not empowered to decide a
criteria as to how a person would be considered resident. Criteria is fixed under section 6 and it
has to be followed. The fixed criteria is the number of days of residence, place of effective
management, etc. Thus, either of these criteria should be followed by Mauritius, and certificate
of residence is not a criteria. ‘Similar nature’ under Article 4 cannot include certificate as an
evidence of residence. Nowhere under the IT Act, certificate has been allowed as a criteria of
residence to fix the status of a person. The person has to be either present there, or a national of
the country, or have place of business and management in that country.

Hence, certificate should be declared illegal, void and ultra vires to section 119.

High Court quashed the circular and declared it as beyond the power of section 119. But SC
reversed the judgment of HC.

SECTION 5 – INCIDENCE OF TAX

If there is an income considered to be received in India, i.e., it falls under section 5, it is still
subject to conditions of DTAAs. Then only it is taxable otherwise not. Thus, whether it is
actually taxable is subject to various other provisions of the Act.

Income is taxable from ‘whatever source’ derived. It means compensation, decree of court,
arbitration award, statutory benefit, salary, house property, business, windfall gain, lottery, gift,
etc. all are sources of income, whether legal or illegal. Thus, source is immaterial for purpose of
section 5.

INCOME RECEIVED IN INDIA

Receipt – income received in India or deemed to be received in India, or accrue or arise in India
or deemed to accrue or arise in India.

The deeming provision under section 9 has expanded the scope of receipt. Receipt denotes the
first occasion on which a person gets control over the money. Once received, it is only a
remittance. The place and time of receipt is important from the purpose of taxation. If place of
receipt is not India, it is not taxable. Time of receipt should be in the previous year.

Keshav Mills v. CIT, 1953 23 ITR 230 SC – Court discussed Pondicherry Railway Company v.
CIT AIR 1931. Here, Court said receipt of income refers to the first occasion when the
recipient receives the income under his control. If income and profits have been once received
by the recipient outside India, then they would not be chargeable, because what is taxable is first
receipt. For instance, if a person resident in India gets his salary in his bank account in UK, then
it would not be taxable on the basis of receipt, even though the entire salary is transferred to
Indian bank account.
Receipt of negotiable instruments like cheques, drafts – suppose a non-resident person in India
enters into transaction with a non-resident. The person made a condition that payment has to be
made through cheque. The dealer in UK pays money through cheque, and deposits the cheque in
post office in UK. Here, where is the place of receipt – where the cheque is deposited, or where
the cheque is received in India and encashed here. When the cheque is deposited in UK.
Applying the logic of Contract Act, a person is said to have accepted the cheque when the
cheque is delivered. There is a request by the assesse to make payment in cheque. The dealer in
UK can meet this request only when he deposits the cheque in post office. Thus, the post office
acts as an agent because of implied or express request of assesse. Thus, date of delivery of
cheque to post office is the place and time of receipt, and not the place/time of encashment
of cheque. As cheque can be encashed later on also.

This judgment has been criticized because a non-resident in India can evade tax by this mode as
non-resident is taxable only when the income is received in India.

CIT v. Ogale Glass Works, 1954 25 ITR 29 SC

Azam Jahi Mills Ltd. v. CIT, 1976 103 ITR 449 SC

In these cases, Court discussed place and time of any receipt through negotiable instruments

Constructive receipt – receipt includes constructive receipts as well. For instance, if a person
authorizes certain persons, or there is adjustment of cross-claims, it is also a receipt. Similarly,
settlement of account, exchange effected by book-entry or set off is also equivalent to receipt.

Trinidad Lake Asphalt Operating System v. CIT, 1944 13 ITR 14 PC – a company declared a
dividend to a shareholder who owed a like amount to company for goods supplied by company
to him. Company set aside the dividend declared against the debt owed. Entry was effected in
the corresponding books. Shareholder claimed that he had not received the dividend, so it was
not a receipt. Privy Council held that company was supposed to pay dividend to shareholder, and
shareholder was supposed to pay money to company for goods supplied by company. Both
adjusted their debts through a book entry. PC held that this is not a book entry, but actual
receipt of dividend by way of book entry.
Raghav Reddy v. CIT, 1962 44 ITR 720 SC – Constitutional Bench of SC decided the case.
Commission was payable by an Indian entity to a non-resident Japanese company working as an
agent on behalf of a merchant in India. Commission was payable to non-resident by merchant in
India. Non-resident directed the merchant that he need not pay the money now, but to make a
credit in the book entry to the extent of amount of commission, and whenever the merchant is
able to, he should remit the commission to the non-resident. Here, question arose as to place and
time of receipt. The SC held that place of receipt is in India since book entry is there in
India, as the moment credit is made in book entry, control is exercised over the receipt.
Time of receipt is also book entry, and not the time of actual remittance of money. Thus, even if
creditor allowed the money to remain in the hands of the debtor, it would be a receipt.

Tora Gul Boi v. CIT, AIR 1927 Lahore Court – Court said that place of receipt would be
considered where the matter was settled. There was an agent whose terms of commission were
not settled. He sold goods in Europe and received sale proceeds in Europe on behalf of principal
in India. He transferred the money to India. By way of consent decree, he was authorized to take
the money back. Court held that commission was received in India because of consent decree
in India. Hence, the place of receipt was India.

Thus, through an agent, constructive, actual receipt or deemed receipt is covered in section 5.

Deemed receipt – certain transactions are listed in section 7. There are some other provisions as
well, such as deemed profits.

INCOME ACCRUE OR ARISE IN INDIA

Second part of definition – accrue or arise or deemed to accrue or arise in India.

Difference between accrual and receipt – income is due and income is received. Does accrual
comes first or receipt comes first. When right to receive is arising, it is income accrued. While
when the income is under a person’s control, it is income received.

If accrual comes first, taxation is on that basis, and if receipt comes first, taxation is on that
basis. Generally, accrual comes first, and then receipt comes. For instance, last day of month is
the due date of salary, i.e., on the last day of month, person gets the right to receive the salary.
Suppose, a person receives the salary after 1 week. One week later would be the date of receipt.
However, liability to tax would arise from the date of accrual only. In case of salaried
employees, as TDS is deducted, the employer would be liable to pay TDS from the date of
accrual of salary only. The department would not wait for the payment of salary done by the
employer. Otherwise, employer would be considered as defaulter.

Sometimes, receipt can come before accrual also. For instance, in case of advance payments.

If income is received in the hands of residents outside India before its accrual – is it covered in
section 5. If this is the case, applying the general rule of section 5, it is not covered under the
section.

Sandhoriya Nursery v. CIT – Madras HC held that since definition of land is not given, so a plot
used in Nursery can also be considered land. The legislature accepted this interpretation, and
added an Explanation where income earned through nursery would be deemed to be agricultural
income.

Place and time of accrual is also important, similar to place and time of receipt. Place of accrual
should be in India, and time of accrual should be in the previous financial year.

‘Accrue’ and ‘arise’ are terms used for a similar purpose and there is no difference in their usage.
Accrual can be at a time or place prior to its quantification, as accrual merely gives the right to
receive. While the actual receipt is subject to quantification and computation.

Deemed to accrue or arise in India – through this, the scope of accrue or arise is sought to be
increased. Even though income has not accrued in India, through legal fiction, income is sought
to be taxed. Applicability of DTAA is because of section 9 only.

For instance, if a person has bank account in UK and cheque is received in UK account, it would
be received in UK only and not in India. However, if in this case, suppose it is said that since
services are rendered in India, so income would be deemed to be received in India. This is the
source based taxation under section 9 – even if place of receipt and accrual is in UK, still,
because the source of income is through rendering services in India, it would be deemed to
accrue and arise in India.
Here, DTAA would come into picture, and it would be seen whether Indian or UK has right to
tax. There can be active income – where only one country can tax. While in passive income, such
as dividends, etc., both countries can share the tax.

Suppose there is a UK law firm HSF which has provided consultancy to a non-resident person in
UK. They receive their payment in UK only. But that non-resident has utilized the advice in an
Indian project in India, suppose a merger in India. The law firm never visited India. The income
of this firm cannot be said to be received in India or accrue or arise in India. But this is an
example of fees for technical services in section 9 – if utilization of services is in India, service is
taxable in India. Thus, income of HSF which never visited India is still taxable.

Thus, because of section 9, ambit has widened very much and extraterritorial application of
section 9 is there. Thus, as it is case of double taxation, we have to look at DTAA to see whether
India or UK can tax the income. In some DTAAs, it is article 12, and in some, it is article 13.

For taxability of active income, there are different requirements, and for taxability of passive
income, there are different requirements.

Suppose there are 2 non-resident individuals – A and B, in US. A borrowed some money from B
amounting to Rs. 10 lakhs. A has to pay interest on loan of Rs. 1 lakh every year to B. Interest is
income in hands of B. Here, place of receipt and place of accrual is US. Suppose A has a
business/profession in India and utilized the Rs. 10 lakhs for any purpose related to his
business/profession in India. Can B be taxed on his interest income in India? Here, neither the
place of receipt nor place of accrual is in India. But because of section 9, interest income in B’s
hands would be taxable in India, as the provision states that if the interest payable in respect of
any debt payable or money borrowed is used for the purpose of business or profession in India, it
is taxable.

Thus, not the status of person, but place of utilization of money is important as per section 9.
This again leads to conflict, as B being resident of US, is liable to pay tax on income received by
him in US itself. However, still it is taxable in India, since the borrower has utilized the money in
business/profession in India.
Because it is double taxation, the India-US DTAA would become relevant and taxability of
interest would have to be seen. DTAA would always prevail over the IT Act. However, if there is
no DTAA, then B would be taxable in India.

Section 9 has had a lot of amendments till date. Almost every year, amendments happen in form
of explanations, provisos, etc. Also, amendments have retrospective effect. For instance,
amendment happened in 2012 and it was given effect to from 1962.

As per section 9(1), the following incomes shall be deemed to accrue or arise in India. All
income accruing or arising, whether directly or indirectly:

i. through or from any business connection in India, or

ii. through or from any property in India, or
iii. through or from any asset or source of income in India, or
iv. through the transfer of a capital asset situate in India.

In Vodafone case, Bombay HC held that capital asset was situated in India. However, SC
reversed it and held in favour of assesse that capital asset was not situated in India. As a result,
an amendment was brought to nullify the effect of judgment.

In the second part, through or from any property in India – the situs of property is relevant, and
not the situs of the payer or receiver. Normally, it is used for immovable property. For
instance, rent received on any land/building in India. Thus, it is not relevant whether the owner
of such property is not in India, and he also receives the rent outside India. Even though both
persons receiving and paying rent are outside India, and agreement is outside India, because
property is situated in India, it is taxable in India.

Suppose property is outside India, but both payer and receiver are in India. This is a case of
person resident in India. However, on the basis of source, since property is situated outside India,
the country where property is situated would also want to tax. In such cases, DTAA is very clear.
Income on immovable property is taxable in the country where the property is situated.

Thus, DTAA has made very clear that we will look at the situs of property only. It does not
matter the person is resident of which country.
Vodafone International Holdings v. Union Of India, 2012 SC – tax dispute of Vodafone
International Holding, which is a company resident in Netherland with tax authorities in relation
to acquisition of the entire share capital of CGP investment which is a company resident for tax
purpose in Cayman Islands.

Cayman Island company has controlling interest in HEL Ltd. which is Indian company. They
acquired 67% controlling interest of HEL. And Vodafone acquired 100% share capital in this
Cayman Island company. By doing this, share of HEL was acquired through Cayman Island
company, and issue was where was the situs of the transfer of shares.

Bombay HC held that situs would be in India as HEL company was acquired and HEL was
Indian company with business and market in India. thus, essentially it was Indian company.
Court applied effect doctrine, and said that the whole impact of transfer of share was in India, as
there was transfer of underlying assets in India. Hence, we can make an apportionment as to
what portion was transfer of share and what portion was transfer of underlying asset.

SC held that situs of the share is not in India, so it is not chargeable under section 9.

Revenue argued that purposive interpretation has to be given to section 9. Also, all income
arising whether directly or indirectly, thus this was a way of indirectly acquiring the assets and
indirect transfer. Court said that indirect can be used for the first 3 categories, but is not
applicable to the fourth situation i.e., transfer of a capital asset situate in India. If legislature has
used ‘situate’ it means legislature only wanted to tax direct categories. Asset that is being
transferred needs to be in India.

Revenue argued that we have to apply look through doctrine, and not look at doctrine. Substance
over form – we have to look through, and form over substance – we have to look at. Revenue
argued that by lifting corporate veil, we can see that the company has no liability, or significant
economic presence in India. If we apply substance over form, we can see that there is not transfer
of one share, but transfer of underlying assets in India only. But Court applied form over
substance doctrine.

SC said in para 71, section 9(1)(i) gathers in one place various types of income and directs that
income falling under each of the sub-clauses shall be deemed to accrue or arise in India.
Broadly there are four items of income. The income dealt with in each sub-clause is distinct and
independent of the other and the requirements to bring income within each sub-clause, are
separately noted. Hence, it is not necessary that income falling in one category under any one of
the sub-clauses should also satisfy the requirements of the other sub-clauses to bring it within the
expression “income deemed to accrue or arise in India” in Section 9(1)(i). In this case, we are
concerned with the last sub-clause of Section 9(1)(i) which refers to income arising from
“transfer of a capital asset situate in India”. Thus, charge on capital gains arises on transfer of a
capital asset situate in India during the previous year. The said sub-clause consists of three
elements, namely, transfer, existence of a capital asset, and situation of such asset in India.
All three elements should exist in order to make the last sub-clause applicable. Here, the first two
elements of transfer (as per section 2(47) and existence of capital asset were fulfilled. But the
third element was not fulfilled as the situs of the asset was in Cayman Island.

Therefore, if such a transfer does not exist in the previous year no charge is attracted.
Further, Section 45 enacts that such income shall be deemed to be the income of the previous
year in which transfer took place.

Consequently, there is no room for doubt that such transfer should exist during the previous year
in order to attract the said sub-clause. The fiction created by Section 9(1)(i) applies to the
assessment of income of non-residents. This fiction comes into play only when the income is not
charged to tax on the basis of receipt in India, as receipt of income in India by itself attracts tax
whether the recipient is a resident or non-resident. This fiction is brought in by the legislature to
avoid any possible argument on the part of the non-resident vendor that profit accrued or arose
outside India by reason of the contract to sell having been executed outside India. Thus, income
accruing or arising to a non-resident outside India on transfer of a capital asset situate in India is
fictionally deemed to accrue or arise in India, which income is made liable to be taxed by reason
of Section 5(2)(b) of the Act. 

A legal fiction cannot be expanded by giving purposive interpretation particularly if the result of

such interpretation is to transform the concept of chargeability which is also there in Section 9(1)
(i), particularly when one reads Section 9(1)(i) with Section 5(2)(b) of the Act. What is
contended on behalf of the Revenue is that under Section 9(1)(i) it can "look through" the
transfer of shares of a foreign company holding shares in an Indian company and treat the
transfer of shares of the foreign company as equivalent to the transfer of the shares of the Indian
company on the premise that Section 9(1)(i) covers direct and indirect transfers of capital assets.
For the above reasons, Section 9(1)(i) cannot by a process of interpretation be extended to
cover indirect transfers of capital assets/property situate in India. To do so, would amount to
changing the content and ambit of Section 9(1)(i). We cannot re-write Section 9(1)(i). The
legislature has not used the words indirect transfer in Section 9(1)(i). If the word indirect is read
into Section 9(1)(i), it would render the express statutory requirement of the 4th sub-clause
in Section 9(1)(i) nugatory.

Thus, the moment the word situate is used, the word indirect is negated. As situs/location is
used only in this part.

Unless the intent of legislature is there to apply the look through doctrine, the Court cannot apply
it. Also, effects doctrine may be relevant in the US context, but not in India.

Thus, Court ruled in favour of Vodafone. As per SC, there is no such concept of underlying
asset or effect and impact doctrine. Here, as Vodafone acquired shares of Cayman Island
company whose shares were situated in Cayman Islands, the situs is not in India, but in Cayman
Island.

After this judgment, Explanation 4 and 5 were added.

Explanation 4—For the removal of doubts, it is hereby clarified that the expression "through"
shall mean and include and shall be deemed to have always meant and included "by means of",
"in consequence of" or "by reason of".

Thus, as per legislature, the word ‘indirectly’ is also applicable for the 4 th category i.e., transfer
of capital asset. While the SC had said that because of word ‘situate’, indirectly would, not apply
to transfer of capital asset. And this amendment was made retrospectively since the inception of
IT Act.

Explanation 5 further clarified legislature’s intention to nullify the Vodafone judgment.

Explanation 5—For the removal of doubts, it is hereby clarified that an asset or a capital asset
being any share or interest in a company or entity registered or incorporated outside India shall
be deemed to be and shall always be deemed to have been situated in India, if the share or
interest derives, directly or indirectly, its value substantially from the assets located in India.

Thus, the legislature reinstated the view of the Bombay HC. The company is paying the amount
not for the share, but for the underlying assets which are situated in India.

There were three provisos added in 2017 and 2020. Before these provisos, explanation 3 was
added to define ‘substantial value’ in 2015, to give effect to explanation 5. It gave the criteria of
determining substantial value.

These amendments were challenged, but not under tax, but under BITs, on the ground that such
retrospective clarificatory amendments affect the BITs. Vodafone initiated arbitration before the
Permanent Court of Arbitration, Hague, on the ground that the retrospective amendment was in
violation of the fair and equitable treatment promised under two separate Bilateral Investment
Treaties (BIT)— The India-Netherlands BIT and the India-UK BIT. As a result, matter was
referred to arbitration, and ruling was received in favour of Vodafone. Then in 2021, the
government clarified that the amendments would not apply with retrospective effect but
with prospective effect, as retrospective effect would amount to reopening the Vodafone case.

The Amendment said that place of incorporation would not be considered a situs, rather the
place of underlying assets or place of substantial presence would be considered situs. As
shares are getting the value of assets which are present in India. While the Vodafone case said
that place of incorporation would be considered situs, and the place of underlying assets is
irrelevant.

In Vodafone case also, 11 billion dollars were paid by Vodafone not for a single share in
Cayman Island company, but the substantial value of the share derived from the underlying
assets which were present in India. This was the Amendment.

This amendment would not affect anything in DTAAs with any country. The problem in
Vodafone case was that we had no DTAA with Cayman Islands.

Thus, in interpretation of DTAA, the Vodafone case would be the deciding factor, and not this
amendment. As treaties cannot be overridden by a change in domestic legislation.
Snofi Pastures v. CIT, AP HC, 2013 – it held that the amendment did not have any impact on
DTAA. It was a question of 650 crores of capital gains tax. Issue was whether France or India
had right to tax. Court held that France had right to tax because the amendment in domestic law
does not have any effect over the DTAA between India and France. After this judgment,
Government of India filed SLP before SC challenging this judgment, along with Vodafone and
Azadi Bachao judgments, claiming that these judgments required reconsideration. However, it is
not clear whether the case has been decided or not. The main issue in the case was regarding the
treaty override. As a result, a Constitutional Bench was created by the Court. Issue was that since
retrospective effect is given to the explanation, it means that the provision was already in
existence, even before the DTAA. So it means that the effect given by the amendment was
already in existence as part of domestic law when the DTAA was signed, so DTAA should be
interpreted in that light.

There were two amendments. Explanation 5 nullified the effect of Vodafone case. Later, more
amendments in 2015, 2017 and 2020 when Explanation 6 and 7 were added.

Director, International Taxation v. Copal Research Ltd., 2015 371 ITR 114 Delhi HC – Delhi
HC said that amendment is valid, but no method to determine substantial value is given. After
this judgment, to clarify the situation and to explain meaning of substantial value, Explanation 6
and 7 were added.

There are cases decided by SC in relation to capital gains tax only B. Srinivas Shetty v. CIT,
1989 – SC made it clear that if it is not possible to apply the computation provisions on capital
gains, the capital gains are not taxable.

Applying this case, since we had no criteria of considering what is substantial value, the
amendment, although given retrospective effect since 1962, were made applicable only from
2015 when the criteria for substantial value was given.

Effect doctrine was used in some cases related to intellectual property prior to Vodafone case.

In Re Pfizer Corporation, 2004 271 ITR 101 Authority for Advanced Ruling – applicant is a
non-resident company incorporated in Panama and is part of Pfizer Group. Applicant owned
technology information pertaining to manufacturing of nutritional food components, which are
sold by Pfizer India (subsidiary of Pfizer) under the Brand of Protinex and Dumex. The Indian
company had been given exclusive rights to use the technological knowhow and trademark
in India without paying any royalty. All the innovation and improvisation was made in product
in India and selling was in India. TM was registered only in India. And global market for product
was created.

A sale and purchase agreement was entered into between the Parent company and EAC. EAC
Nutrition Ltd., a Denmark Based company, acquired the technology and trademarks from Pfizer
through two separate agreements. 1 agreement with Indian company for extinguishment of claim
and early termination of license. USD 7 million was paid as consideration for extinguishment of
license. Through another agreement with Parent company of Panama, technology information
was sold for USD 5 million. Condition was that the applicant shall deliver or made available to
EAC the technological information as outlined in the agreement in form of a dossier. The
handing over took place in Bangkok. EAC corporation, before making payment of 5 million,
withheld the taxes as TDS, as it was under the belief that as per Indian law, TDS had to be
deducted.

7 million dollars was taxable in India since money was received in India. No controversy is there
in this regard. Question is regarding taxability of 5 million paid by EAC to Pfizer company
incorporated in Panama. Thus, main issue was whether capital asset was situated in India or not.

Issue was that Pfizer objected to tax deduction at source. Whether the receipt by the applicant, a
company incorporated in Panama, from the transfer of technology in Bangkok, to a company
incorporated in Denmark, would be taxable in India. We need to see what is the situs here.

Trademark can be registered in various jurisdictions at the same point of time. Therefore, it
cannot be a criteria for determination of situs. Also, rights held by Indian subsidiary was only in
terms of exclusive license to use the trademarks and technical information, and not absolute
rights were vested with Indian company.

However, Indian company was paid 7 million dollars, which was more than the payment made to
Parent company, because it was the Indian company which made improvements to product in
India, created brand value for the product, and global market for product through India. Since the
effect and impact is in India, the situs of intellectual property should be in India. This was the
argument by revenue.
It was also argued that since IP was transferred in form of a dossier in Bangkok, since IP is a
movable property sold and purchased in Bangkok, the situs was not in India. Company argued
that situs for IP would either be in Panama, where IP is owned, or Bangkok, where IP is
transferred.

This argument was accepted by the Authority for Advanced Ruling. AAR observed that situs
always lies with the owner of IP. Since owner is based in Panama, situs would be in
Panama.

In 2006, a similar case came before AAR.

Fosters Australia Ltd. v. CIT, 2006 302 ITR 289 AAR – applicant is a tax resident of Australia.
It owned trademarks and other IP related to Fosters Beer. It gave exclusive license to use IP and
manufacture and sell beer. In 2006, Parent company executed a sale and purchase agreement
with UK Company Sab Miller for sale of assets and transfer of all title in all IP in India. Question
before AAR was whether capital asset was situated in India or not.

AAR applied Pfizer corporation case and observed that situs of IP lies with owner, hence
situs is in Australia.

Although not part of the decision, an important observation was made. If asset is situated in
India, it is immaterial whether transfer or sale is done outside India. In relation to the situs of IP,
regarding brand value, since the brand is getting its value from the market itself, in cases where
there is transfer of TM, we should always consider the place of creation of brand value as situs.
In case of creation of technical information such as patent, which are not associated with the
market, the place of ownership is situs. However, in case of TM, place of creation of brand value
should be taken as situs.

In Pfizer case as well as Fosters case, the amount was paid for acquiring the IP including the
brand value of the products.

Had the observation been applied in these judgments, an apportionment could be made as to
what percentage of the IP was relating to the technical information, and what percentage related
to the brand value which is associated with the market.
Situs of technical information is always with the owner, but situs of goodwill and brand value,
which is connected with the market, should be in the place where the market is there, as the
entire market related to the products is being purchased. Thus, distinction should be made
between IP associated with market, and IP not associated with market.

Also, after the explanations were added, explanation 4 can be applied to such cases, and even if
asset was indirectly situated in India, situs would be considered to be in India. If issue relates to
immovable property, then there is no question of indirectly situated. However, if issue relates to
transfer of shares or IP, then indirect way can be applied. For instance, if shares are transferred,
not just the share, but as consequence of it, the underlying assets and whole market are being
purchased. For instance, all the customers of HEL became customers of Vodafone acquired
CGP.

BUSINESS CONNECTION

It comes under section 9(1)(1). There can be fixed place, service, agency business connection, or
through showrooms, branch office, oil fields, mines, etc. Under DTAA, a somewhat similar term
is permanent establishment. DTAA provides that business income is taxed in the country of
residence, unless a company or enterprise has permanent establishment in the country of source.
Thus, to tax any business income, the condition of permanent establishment has to be
established.

There is difference between business connection and permanent establishment. Chargeability

provision is business connection, as chargeability of income has to be provided for under
domestic law, and then DTAA comes to provide relief. Business connection therefore has a
wider connection. If there is a permanent connection, there is always a business connection.
However, if there is a business connection, there may or may not be a permanent establishment.
If not, then due to DTAA, the country of source cannot tax the income. Otherwise, source
country has no right to tax business income under DTAA.

Permanent establishment is defined in DTAA under Article 5. Article 7 lays down that
business income is taxable only if there is permanent establishment. Article 5(1) of Model
convention states that permanent establishment is a fixed place of business through which the
business of enterprise is wholly or partly carried on. Article 5(2) provides some illustrations –
branch, office, factory, workshop, oil field, etc. can be fixed place of business.

Thus, there must be a fixed place of business, which is at the disposal of the enterprise, and the
business of enterprise should be carried out fully or partly through that place of business. These
three factors are important for determination of permanent establishment [PE].

Whether an activity has a fixed place of business is a mixed question of law and fact, and has to
be determined in each case.

Article 5(3) provides that agency PE is considered PE. Article 5(4) discusses project PE,
business PE, construction PE, etc. There can be service PE also, if a service enterprise has office
in India. Subsidiary PE can also be there. In this way, there can be various modes of business
through PE. Fixed place PE does not mean that it should be attached to earth. For instance, even
business through ship or trucks can be fixed place PE.

Agency PE – if someone is helping in concluding contracts in India, it can be agency PE. In

service PE – consultancy, managerial, etc. services can be provided.
Building/construction/project PE can be there if they are for fulfilment of construction or project.

There is a time factor as well in service PE. If service is provided from a company outside India,
then it would not be service PE unless the employees of the service are present in India for 60,
120 or 180 days. Time period depends on the conditions. Sometimes, in project PE also, time
limit can be 6 months. Suppose a person has a building contract and the building was constructed
in 5 months, it would not be termed as business PE.

In business connection, it is wider as mere presence can constitute business connection and there
is no time requirement. If it is shown that there is a PE, it would automatically be a business
connection, but not vice versa.

Business connection was first defined in Finance Act 2002-03 which was an inclusive
definition. Before it, no definition was there. Basic rule of business connection – business with
the country (on a principal to principal basis) which is not a business connection, or business in
the country which is a business connection.
For instance, if a person is running factory in Jodhpur. He orders machinery from a company in
US and paid Rs. 100 crores. Whether India can tax the profit on this 100 crore has to be seen.
This is not business connection as it is business with the country.

Suppose in the same example, US company has appointed a person in India as agent, and he
takes orders from Indian companies and places it to US companies, and then US company sells
machinery to India. This is business income because it is an example of business in the country.
Thus, in cases where there is business in the country (as the agent constitutes a business
connection through which business is done in India), it would be taxable.

A lot of activities have been added through Amendments in 2018 and 2020. These amendments
are based on base erosion and profit sharing action plans of OECD, which are related to Article 7
permanent establishment. It sought to include other aspects of business such as e-commerce,
OTT platforms, downloading, etc. For instance, in case of Netflix, even though no agent or office
in India, the customer base itself is a business connection.

Explanation 2 of section 9(1) defines business connection. It includes any business activity
carried out through a person who, acting on behalf of the non-resident—

(a) has and habitually exercises in India, an authority to conclude contracts on behalf of the non-
resident or habitually concludes contracts or habitually plays the principal role leading to
conclusion of contracts by that non-resident and the contracts are—

 (i) in the name of the non-resident; or

(ii) for the transfer of the ownership of, or for the granting of the right to use, property owned by
that non-resident or that non-resident has the right to use; or

(iii) for the provision of services by the non-resident; or

(b) has no such authority, but habitually maintains in India a stock of goods or merchandise from
which he regularly delivers goods or merchandise on behalf of the non-resident; or

(c) habitually secures orders in India, mainly or wholly for the non-resident or for that non-
resident and other non-residents controlling, controlled by, or subject to the same common
control, as that non-resident.
Thus, Explanation 2 provides different types of agency business connection.

Explanation 2A has also been added by Amendment Act of 2020. It provides that significant
economic presence of a non-resident in India shall constitute “business connection” in India.
This is because of action plans of OECD only. We incorporated those action plans. Significance
economic presence is also defined as:

(a) transaction in respect of any goods, services or property carried out by a non-resident with
any person in India including provision of download of data or software in India, if the aggregate
of payments arising from such transaction or transactions during the previous year exceeds such
amount as may be prescribed; or

(b) systematic and continuous soliciting of business activities or engaging in interaction with
such number of users in India, as may be prescribed:

Provided that the transactions or activities shall constitute significant economic presence in

India, whether or not—

(i) the agreement for such transactions or activities is entered in India; or

(ii) the non-resident has a residence or place of business in India; or

(iii) the non-resident renders services in India:

Even though resident has no place of business or residence in India, or does not render any
services in India, regardless of this, activities like downloading of data, software, transactions in
goods, services, etc. would constitute business connection.

Thus, customer database and downloading of data, etc. are also chargeable with tax. Since IT Act
provides chargeability, it is sought to have wide ambit, but this is subject to DTAA.

This digital tax came in 2020. Before this, there was equalization levy under Finance Act, 2016
(Chapter 8). This was required because companies like Google and Facebook earn a lot of
revenue from India through advertisements. However, there is no permanent establishment of
google in India, because PE is considered only in countries where Google has a server.
Equalization levy said that in case of advertisement services availed from such companies, the
payer in India has to withhold the taxes on payment made to companies outside India. In 2020,
we extended scope of equalization levy through another amendment in Finance Act.

Equalization levy or digital tax is thus a separate tax altogether, and it is not a tax under business
connection.

In 2020, Income Tax Rules were also amendment where it was made mandatory for such
companies to appoint a person in India. Because the moment a person is appointed in India, they
would be covered under business connection.

Now because of Explanation 3A, business connection for companies like Facebook and Google
can be established. However, since PE is not there, because of DTAA, these companies cannot
be taxed. Not only India, but a number of countries are facing such problems. Companies are
using a lot of tax heavens to minimize tax liability. For instance, Microsoft is basing its research
and development from Cayman Islands, and Apple is sourcing its sales of phones from Ireland,
just to avoid tax.

Under Multilateral Legal Assistance Treaty [MLI], all countries are signatories of it, and the
moment countries become parties to it, there would be no need for bilateral amendments. As in
bilateral agreements, a lot of time is taken in negotiations.

Concept of global minimum corporate tax – companies have to pay some amount of tax in source
countries and some tax in resident countries. This concept came in 2021 and it may be
implemented soon.

For instance, Amazon is also paying only 9% tax in US, as it is shifting its profits from high tax
to low tax regimes. Therefore, in global minimum corporate tax, two pillars have been envisaged
wherein one pillar provides for tax to resident country, and another pillar for tax to source
country. Thus, revenue sharing is envisaged.

If IP address is in India, it would be considered as a business connection in India. This has

come as part of significant economic presence which has been brought in the section. Thus,
server test is sought to be changed to IP address test. Thus, business connection has been
expanded.

For PE also, India is argued that for PE, place of server should be changed to place of IP address.
For business connection, there is inclusive definition, and only agency is included in it.

CIT v. RD Agrawal and Co., 1965 56 ITR 20 SC – Court defined business connection. A
business connection involves a relation between a business carried on by non-resident outside
India and yields profits and gains and there is some activity in the taxable territory which
contributes directly or indirectly to the earnings of those profits or gains. It also predicates some
element of continuity between the business of non-resident and the activity happening in the
taxable territory. Thus, stray or one-time transactions should not be included. If the activity gives
rise to some profits or gains, then there is business connection, and the person is liable to pay tax
on the part of income attributable to the non-resident through the business connection. Thus, not
the entire income of non-resident is taxable, but profit attribution rule is applicable.

Thus, definition is very vague, and at that time, there was no concept of DTAA also. However,
this judgment is applied in relation to DTAA. DTAA restricts the scope of business connection.
As per PE test, physical presence is required. This may be through a fixed place such as branch,
office, showroom, mine, oil field, etc. Service PE, subsidiary PE, building PE, project PE all
require a physical presence. Thus, if PE is established, then business connection is definitely
existing.

Formula One World Championship Ltd. v. Commissioner of Income Tax, International Taxation
(Formula One case), 2017 SC – appeal was filed by FOWC and Jaypee Sports International Ltd.
Challenge is against the judgement of HC passed in 2016. Filing to authority of advanced ruling,
then HC then SC. FOWC and Jaypee filed application before AAC. There was a race promotion
contract with Jaypee granting Jaypee to hold stage and promote Formula 1 grand prix in India for
USD 40 million. Some other agreements were also entered between Formula 1 and Jaypee and
their group companies. Two questions before AAR:

i. whether payment of consideration received by FOWC from Jaypee for raise

promotion contract was taxable as royalty or not, article 13 DTAA read with section
195 of IT Act, between UK and India.
ii. Whether F1 world championship had any PE in terms of Article 5 of DTAA, and if
yes, then it should be taxable as a business income.
AAR answered first question – consideration amounted to royalty under DTAA. Second question
was in favour of F1 – there was no PE in India. therefore, tax should be withheld as per section
195.

They challenged before HC based on first issue of royalty through writ petition in Delhi HC.
They claimed that it is not royalty as per DTAA. While revenue challenged the second ruling.

HC reversed finding of AAR on both issues. It held that consideration paid would not be treated
as a royalty. Ans F1 had PE in India, and was therefore taxable in India as business income.
Thus, taxability has shifted from royalty to business income through business connection.

HC didn’t accept plea of revenue that it was not a dependent PE. Jaypee is under obligation to
deduct taxes at the source.

All parties filed appeal to SC. F1 claimed that no tax is payable on consideration, as it is neither
royalty nor FOWC has a PE in India. Revenue has not challenged that consideration is not
royalty. Therefore, only question was regarding PE. Court discussed the entire agreement and
development of the concept. In the agreement, Jaypee for hosting, staging and promoting F1
grand prix, and for doing so, it entered into agreement with FOWC in 2011 known as race
promotion contract. Right to hold, stage and promote the F1 was given.

Another agreement, art work license agreement between the companies wherein for 1 million,
Jaypee got rights to use certain marks, etc. of FOWC.

SC held that there is a PE. Court said that we may say at the outset that the arguments
advanced before us were the same as those before the HC. Arguments of parties were discussed.
The basis for deciding the case in favour of revenue – India UK DTAA, definition of permanent
establishment under section 92F of IT Act also looked at (which is same as DTAA). Main
question was whether it is a fixed place PE or dependent agent PE. SC said that it is a fixed
place PE.

In a judgment of AP HC, meaning of PE was defined. Vishakhapatnam Port Trust Ltd. v. CIT,
1986 – here, Court defined PE. It is the virtual projection of a company into the soil of another
country. Based on this, it had to be decided whether FOWC had a projection in India. Whether
the roads where F1 happened were at disposal of FOWC or not. Whether there is a place of
business, and whether such place was at disposal of FOWC had to be seen. SC said that it cannot
be denied that Buddh international circuit (highway) is a fixed place. Court said:

“We are of the firm opinion, and it cannot be denied, that Buddh International Circuit is a fixed
place. From this circuit different races, including the Grand Prix is conducted, which is
undoubtedly an economic/business activity. The core question is as to whether this was put at the
disposal of FOWC? Whether this was a fixed place of business of FOWC is the next question.
We would like to start our discussion on a crucial parameter viz. the manner in which
commercial rights, which are held by FOWC and its affiliates, have been exploited in the instant
case. For this purpose entire arrangement between FOWC and its associates on the one hand and
Jaypee on the other hand, is to be kept in mind. Various agreements cannot be looked into by
isolating them from each other. Their wholesome reading would bring out the real transaction
between the parties. Such an approach is essentially required to find out as to who is having real
and dominant control over the Event, thereby providing an answer to the question as to whether
Buddh International Circuit was at the disposal of FOWC and whether it carried out any business
therefrom or not. There is an inalienable relevance of witnessing the wholesome arrangement in
order to have complete picture of the relationship between FOWC and Jaypee. That would
enable us to capture the real essence of FOWC's role.”

Thus, applying as a whole, it can be said that the whole road was at disposal of FOWC. Thus,
FOWC had full rights over the road. There was no question of Jaypee as an agent of
FOWC. Rather, whole road would be considered as a fixed place of business for FOWC. It
does not matter whether FOWC sent its employees to India or not. It is clear that the business of
FOWC was present in India as FOWC is carrying out its own business through the road.

Court also quoted the book of Philip Baker, according to which three characteristics must be
present in case of PE – stability, productivity and dependence. Court observed that all these three
characteristics are present in this case. This was because fixed place of business in the form of
physical location, i.e., Buddh International Circuit, was at the disposal of FOWC through which
it conducted business.

Hence, it would be permanent establishment, and the consideration of 40 million USD is subject
to taxation as per Article 5 of DTAA and section 9 of IT Act.
GVK Industries Ltd. v. Income Tax Officer, 1997 Andhra Pradesh HC – Court discussed certain
principles in relation to business connection. Business connection is a mixed question of fact
and law which has to be determined based on facts and circumstances of each case. There is no
precise definition under IT Act, as IT Act only gives agency as business connection. Court said
business connection has to be wide to admit any aspect, provided it has certain well renowned
factors or attributes. In the light of these factors, the facts and circumstances have to be seen.
There must be existence of close, real and intimate relationship and commonness of interest
between the foreign entity and Indian entity to establish a business connection. There must be
continuity of activity or operations of non-resident entity with the Indian party to constitute
business connection. To constitute “business connection” there must be continuity of activity or
operation of the NRC with the Indian party and a stray or isolated transaction is not enough to
establish a business connection.

Marendra Prasad Ray v. ITO, 1981 129 ITR 295 SC – this judgment is criticized. Here, range of
business connection was expanded to include even professional connection within business.
Court said that for purpose of tax, there is no difference between business and profession. A
barrister from UK came to India and argued a case which lasted a fortnight. The Indian solicitor
didn’t pay any fees, just assisted the barrister in hearing. The barrister received the fee outside
India. question was whether Indian solicitor would be considered business connection or not. SC
held that the Indian barrister constituted a professional connection, and therefore would be liable
as an agent of the non-resident. The term business includes professional as a part of it only.
Secondly, even if Indian solicitor didn’t brief or pay anything, he would be considered an agency
business connection – agent who helped argue the case in India.

The judgment was criticized in various aspects for its inclusion of professional connection as
business connection. Also, here, there was no real, continuous or intimate connection as SC said
in RD Agrawal case, as it was only a one-time matter which was argued in India. Also, the
Indian solicitor is not benefitting in any manner by assisting the barrister.

Because of these issues, amendments were made wherein income from royalty, income from
interest and fees for technical services were taxed in a separate provision. Consultancy was
considered as a technical service. Thus now, professional connection is not part of business
connection, but is taxed in technical services.
SC has held that section 9 will apply only when income is not received in India or has not
accrued or arisen in India.

Kanchan Ganga Sea Food Ltd. v. CIT, SC 2010 – Here, appellant company is incorporated in
Indian and engaged in sale and export of sea food. For that purpose, it obtained right to fish in
EEZ. Company entered into agreement chartering two bull trollers (fishing vessels) with a Hong
Kong company to fish in the EEZ. There is a clause in the agreement which is important. Clause
4 of agreement said that deponent owner (Hong Kong company) would provide the fishing
vessels as approved by the government of India for all-inclusive charter fees of 6 lakh USD per
vessel per annum. The charter fees is inclusive of fuel, maintenance, repairs, wages, and any
expenses incurred in connection with the vessel. It would also provide training, etc. to Indian.
Also, deponent owners would provide 70,000 or 15% of gross value of earnings from fish sales,
whichever is more, to the charterers.

Question was that trollers were delivered to assesse with full equipment at Chennai port. Voyage
commenced. The catch was assessed at Chennai port. Local taxes were levied and paid. After
delivering fishes, troller went back. The assesse didn’t withhold taxes at source. Notice under IT
Act was issued to show cause why the assesse should not be held responsible. The assesse
claimed that the operation was not conducted in India. Even if it constituted operation in India, it
was not an operation for mere purchase, so no income was taxable. Also, if entire income is not
taxable, there is no obligation to deduct taxes at source.

IT Officer rejected these contentions. Income earned by non-resident company was chargeable
with tax. The assesse made payment to foreign company without deducting taxes. Therefore,
assesse is in default as per section 201(1) of IT Act. Default of 1,66,91,000 including interest
was there. Interest of 15% from 1 April 1992 to the date of payment was to be paid.

The Deputy Commissioner declined to change the decision. Actual payment is made in the
Indian port. When the catch is brought in, and customs duty, etc. is give and catch is ascertained,
only after that the payment is given. Therefore, nature of receipt is to be considered from the
commercial point of view, which is from India only.

ITAT and HC also affirmed the orders. Matter went to SC. SC also confirmed the order. It said
that income is received in India. Court discussed section 5 and 9. SC said that concept of
profits and business connection should not be mixed up. Business connection and PE are
relevant for non-resident. But here, we are not concerned with such aspects. Appellant argued
that profits were not earned in India, since catch was made in EEZ.

SC said:

“From the plain reading of section 5 and 9, it is evident that total income of non-resident
company shall include all income from whatever source derived received or deemed to be
received in India. It also includes such income which either accrues, arises or deem to accrue or
arise to a non-resident company in India. The legal fiction created has to be understood in the
light of terms of contract. Here, in the present case the chartered vessels with the entire catch
were brought to the Indian Port, the catch were certified for human consumption, valued, and
after customs and port clearance non-resident company received 85% of the catch. So long the
catch was not apportioned the entire catch was the property of the assessee and not of non-
resident company as the latter did not have any control over the catch. It is after the non-resident
company was given share of its 85% of the catch it did come within its control. It is trite to say
that to constitute income the recipient must have control over it. Thus the non-resident company
effectively received the charter-fee in India. Therefore, in our opinion, the receipt of 85% of the
catch was in India and this being the first receipt in the eye of law and being in India would
be chargeable to tax. In our opinion, the non-resident company having received the charter fee
in the shape of 85% of fish catch in India, sale of fish and realization of sale consideration of fish
by it outside India shall not mean that there was no receipt in India. When 85% of the catch is
received after valuation by the non-resident company in India, in sum and substance, it amounts
to receipt of value of money. Had it not been so, the value of the catch ought to have been the
price for which non-resident company sold at the destination chosen by it. According to the
terms and conditions of the agreement charter fee was to be paid in terms of money i.e., US
Dollar 600,000/= per vessel per annum “payable by way of 85% of gross earnings from the fish-
sales”. In the light of what we have observed above there is no escape from the conclusion that
income earned by the non-resident company was chargeable to tax under Section 5(2) of the
Income Tax Act.

Therefore, it is taxable on the basis of receipt, since Indian company had control over the receipt.
And receipt means first receipt – when control over the money comes. This first receipt was in
India. Hence, the non-resident company received the money in India. Therefore, income was
taxable in India.

Explanation 1 to section 9(1)(i)

Explanation 1—For the purposes of this clause—

(a) in the case of a business, other than the business having business connection in India on
account of significant economic presence, of which all the operations are not carried out in India,
the income of the business deemed under this clause to accrue or arise in India shall be only such
part of the income as is reasonably attributable to the operations carried out in India;

(b) in the case of a non-resident, no income shall be deemed to accrue or arise in India to him
through or from operations which are confined to the purchase of goods in India for the purpose
of export;

(c) in the case of a non-resident, being a person engaged in the business of running a news
agency or of publishing newspapers, magazines or journals, no income shall be deemed to accrue
or arise in India to him through or from activities which are confined to the collection of news
and views in India for transmission out of India;

(d) in the case of a non-resident, being—

(1) an individual who is not a citizen of India; or

(2) a firm which does not have any partner who is a citizen of India or who is resident in India;
or

(3) a company which does not have any shareholder who is a citizen of India or who is resident
in India,

no income shall be deemed to accrue or arise in India to such individual, firm or company
through or from operations which are confined to the shooting of any cinematograph film in
India;

(e) in the case of a foreign company engaged in the business of mining of diamonds, no income
shall be deemed to accrue or arise in India to it through or from the activities which are confined
to the display of uncut and unassorted diamond in any special zone notified by the Central
Government in the Official Gazette in this behalf.

For (a), there is FAR Analysis – for profit attribution rule. F means functions performed by
Indian entity. A means assets involved in business in India. R means risk assumed by the Indian
entity. All these three have to be considered. After this, whatever is left, is income attributable
outside India. However, even SC has observed that there is some guesswork involved in this, and
it is not a scientific rule.

This rule is applicable in section 9 and is also applicable for DTAA in Article 7.

Thus, 4 exceptions to the deeming provision are provided in explanation 1.

CIT v. Hyundai Heavy Industries, 2007 291 ITR 482 SC – attribution rule is discussed by the
Supreme Court here.

CIT v. Excel Industries Ltd., 2013 219 Taxmann 379 SC – “accrue or arise” is discussed by the
Supreme Court.

Section 9(1)(ii)

Income which falls under the head "Salaries", if it is earned in India.

Explanation—For the removal of doubts, it is hereby declared that the income of the nature
referred to in this clause payable for—

(a) service rendered in India; and

(b) the rest period or leave period which is preceded and succeeded by services rendered in India
and forms part of the service contract of employment,

shall be regarded as income earned in India;

The wording says ‘salary’, but it is not taxable as income from salary, because there is no
employer. Only those parts of income is taxable as salary, where there is relation between payer
and payee. If income from retainership, professional services, technical services, etc., it is not
taxable as salary.
Under the deeming provision, only income which is taxable as salary is covered. It is clearly said
that it should be for a contract of service, and not contract for service. If services are rendered in
India, and for that income is received, it would be taxable as salary. But this leads to double
taxation, for instance, if a UK person comes to work in India, and UK firm deposits salary in his
UK bank account. Still, salary is earned in India, because service is ‘rendered in India’.

In OECD convention, article 15 talks about income from employment. If a person is resident of
another country, and is receiving income for services rendered in source country, it would be
taxable in source country. Certain exceptions have been created in the convention. But general
provision is it would be taxable in source country if it is rendered in source country.

Thus, as per IT Act, taxability of salary depends on where it is earned.

Section 9(1)(iii) - income chargeable under the head "Salaries" payable by the Government to a
citizen of India for service outside India;

Section 9(1)(iv) – dividend paid by an Indian company outside India. Generally, as per DTAA,
both source and resident country divide the tax amongst themselves.

Lot of amendments have been made, and by 1976 Amendment, section 9(1)(v) has been added.

Section 9(1)(v) – income by way of interest payable by—

(a) the Government; or

(b) a person who is a resident, except where the interest is payable in respect of any debt
incurred, or moneys borrowed and used, for the purposes of a business or profession carried on
by such person outside India or for the purposes of making or earning any income from any
source outside India; or

(c) a person who is a non-resident, where the interest is payable in respect of any debt incurred,
or moneys borrowed and used, for the purposes of a business or profession carried on by such
person in India.

In case of interest, royalty or fees for technical service, the taxability depends on who is the
payer and what is the residential status of the payer.
First, any amount of interest payable by the government is taxable, irrespective of to whom and
where it is paid.

Second, if the payer of interest is a resident in India (section 6), then it is taxable in India.
Exception – suppose A is a resident and B is non-resident. B gave a loan of 10 lakhs to A. 1 lakh
per year is the interest payable by A. Question is taxability of 1 lakh in the hands of B paid by A.
B would be taxable for interest income if these 10 lakhs is utilized by the person in India. If A
had utilized the money in business or profession outside India, or to invest outside India, or any
other source outside India, then B would not be taxable.

Thus, two important things are who is the payer, and where is the income utilized. In such
cases, the liability to deduct tax was on A (as B is non-resident). The presumption is that if A is
resident, then it is always taxable in India, except if A proves A has utilized money in business,
profession or any other source outside India.

Thus, place of utilization of income is important. Burden to prove the place of utilization of
income outside India is on the payer of interest. B (payee of interest) is nowhere in the picture.

In the third condition, if the payer of interest is non-resident, the burden shifts. Earlier, burden
was on the resident. But in case of non-resident payer, burden is on the revenue to prove that
the place of utilization of income is in India. However, the provision says that utilization
should be for the purpose of business or profession in India. The provision is restricted to
business and profession and not for any other source. If payer and payee is non-resident, then the
interest would be taxable if the money is used to carry out business or profession in India.

Suppose both A and B were non-resident. A utilized the 10 lakhs borrowed from B to purchase
land in India. Then A paid interest to B of 1 lakhs. Whether B would be liable for tax on interest
income – here, it is not a business or profession of A. First, we have to look whether it is
business or profession or not, and then only we will decide whether it is utilized in India or not.
Since purchase of land is not a business of A, the interest would not be taxable in India.

Thus, this is beneficial for the payer as well as payee.

We see the payer here because taxes are always enforced through the payer (payer has the
obligation to deduct taxes at source). As the payee can be in any country, so it is difficult to trace
it. TDS was created for administrative convenience as it is difficult to enforce tax liability on the
payee, especially if payee is non-resident.

Explanation—For the purposes of this clause—

(a) it is hereby declared that in the case of a non-resident, being a person engaged in the business
of banking, any interest payable by the permanent establishment in India of such non-resident to
the head office or any permanent establishment or any other part of such non-resident outside
India shall be deemed to accrue or arise in India and shall be chargeable to tax in addition to any
income attributable to the permanent establishment in India and the permanent establishment in
India shall be deemed to be a person separate and independent of the non-resident person of
which it is a permanent establishment and the provisions of the Act relating to computation of
total income, determination of tax and collection and recovery shall apply accordingly;

(b) “permanent establishment” shall have the meaning assigned to it in clause (iiia) of section
92F;

If a foreign bank, say HSBC, has a branch in India. A loan was provided from outside India to
Indian Branch Office. The interest paid on this income would be taxable as per this Explanation.

Here, whatever income earned by the Indian Branch is attributable to taxation as business
connection and permanent establishment under section 9(1)(i) would be taxable as business
income read with DTAA. Additionally, the interest payable by Indian branch would be
considered as a separate income and would separately taxable. As this income is not coming
through business connection, it cannot be taxed as business income under section 9(1)(i).

A branch of bank has various sources of income from Indian customers, so income earned from
these sources is taxable as business income. However, the interest paid by Indian branch to
foreign branch, which is not attributable to business connection, is taxed separately under section
9(1)(v).

For interest, royalty and technical services, it is considered as passive income, and both the
source and resident countries have the right to tax, although the rate of tax is kept low. While for
active income, such as business income, it is fully taxable in the source country.

Section 9(1)(vi) – income by way of royalty payable by—

(a) the Government; or

(b) a person who is a resident, except where the royalty is payable in respect of any right,
property or information used or services utilised for the purposes of a business or profession
carried on by such person outside India or for the purposes of making or earning any income
from any source outside India; or

(c) a person who is a non-resident, where the royalty is payable in respect of any right, property
or information used or services utilised for the purposes of a business or profession carried on by
such person in India or for the purposes of making or earning any income from any source in
India.

If royalty is payable by the government, then it is always taxable in India. If a person is resident,
then the payer has to establish before the authority that he used the information, rights, etc. for
business or profession outside India, or earning income from any source outside India. If the
person can establish this, income would not be taxable in India. Thus, place of utilization should
be in India. If a person is paying royalty for using any copyright, information, database, etc., then
place of utilization of the right, property, information for which royalty is payable should be in
India for it to be taxed. Thus, here the presumption is in favour of taxability, unless the payer
shows that utilization was outside India.

If payer is non-resident, then royalty would only be taxable if the rights, property, information,
etc. is utilized for business or profession or any other source in India. Thus, this provision is
wider than interest, as here, even if utilization for any other source in India, it would be taxable.
Here, presumption is in favour of non-taxability unless the department proves utilization in India.

Meaning of royalty – OECD Model Convention does not discuss sharing, as it says that resident
country should tax. While UN Model Convention gives right to source country also, subject to
some limitations. UN Model Convention gives a wider definition than OECD Model
Convention. Generally, we favour UN Model Convention while framing DTAAs.

Overall as well, OECD Model Convention favours resident based taxation, and UN Model
Convention favours source based taxation.
Article 12 of UN Model Convention discusses royalties. It provides that royalties arising in a
Contracting State and paid to a resident of the other Contracting State may be taxed in that other
State.

However, such royalties may also be taxed in the Contracting State in which they arise and
according to the laws of that State, but if the beneficial owner of the royalties is a resident of the
other Contracting State, the tax so charged shall not exceed per cent (the percentage is to be
established through bilateral negotiations) of the gross amount of the royalties. The competent
authorities of the Contracting States shall by mutual agreement settle the mode of application of
this limitation.

The term “royalties” as used in this Article means payments of any kind received as a
consideration for the use of, or the right to use, any copyright of literary, artistic or scientific
work including cinematograph films, or films or tapes used for radio or television broad casting,
any patent, trademark, design or model, plan, secret formula or process, or for the use of, or the
right to use, industrial, commercial or scientific equipment or for information concerning
industrial, commercial or scientific experience.

Explanation 2 of section 9(1)(vi) – For the purposes of this clause, “royalty” means consideration
(including any lump sum consideration but excluding any consideration which would be the
income of the recipient chargeable under the head “Capital gains”) for—

(i) the transfer of all or any rights (including the granting of a licence) in respect of a patent,
invention, model, design, secret formula or process or trade mark or similar property;

(ii) the imparting of any information concerning the working of, or the use of, a patent,
invention, model, design, secret formula or process or trade mark or similar property;

(iii) the use of any patent, invention, model, design, secret formula or process or trade mark or
similar property;

(iv) the imparting of any information concerning technical, industrial, commercial or scientific
knowledge, experience or skill;

(iva) the use or right to use any industrial, commercial or scientific equipment but not including
the amounts referred to in section 44BB;
(v) the transfer of all or any rights (including the granting of a licence) in respect of any
copyright, literary, artistic or scientific work including films or video tapes for use in connection
with television or tapes for use in connection with radio broadcasting, or

(vi) the rendering of any services in connection with the activities referred to in sub-clauses (i) to
(iv), (iva) and (v).

This provision is very wide, and almost everything in relation to royalty is sought to be include –
transferring rights, use of rights, services, etc. This is because the charging provision is IT Act,
but it is subject to DTAA.

Under DTAA, in the OECD Model Convention, Article 12 states that royalties arising in a
contracting state and beneficially owned by resident of other contracting state shall be taxable
only in that other state. Thus, it is clear that it is always taxable in the resident country only.

Royalty means the payment of any kind received for a consideration for use or right to use any
copyright, patent, trademark, design, or information concerning industrial, technical or scientific
experience. Thus, a very limited definition is given under OECD Convention.

It will be taxable only when there is a permanent establishment and royalty is arising out of
permanent establishment. And this would anyways not be taxable as it would be taxable in
section 9(1) where it is taxable as business income.

Thus, sharing is not provided in OECD convention. It does not favour the Indian tax
jurisprudence of source-based taxation.

One thing is that capital gain is not covered in section 9(1)(vi) i.e., if there is complete transfer or
outright sale of any information, right, property, trademark, etc., then it is not covered in
definition of royalty. As it would be covered in section 45 of IT Act as capital gain.

FEES FOR TECHNICAL SERVICES

Section 9(1)(vii) – Income by way of fees for technical services payable by—

(a) the Government; or

(b) a person who is a resident, except where the fees are payable in respect of services utilised in
a business or profession carried on by such person outside India or for the purposes of making or
earning any income from any source outside India; or

(c) a person who is a non-resident, where the fees are payable in respect of services utilised in a
business or profession carried on by such person in India or for the purposes of making or
earning any income from any source in India.

For government, it is clear that it is always taxable in India. For resident, presumption is of
taxability, unless person shows that utilization was for business or profession or any other source
outside India. For non-resident, presumption is of non-taxability, unless the revenue proves that
it is utilized for business or profession or any other source in India.

Thus, the test is of place of utilization only.

Explanation 2—For the purposes of this clause, “fees for technical services” means any
consideration (including any lump sum consideration) for the rendering of any managerial,
technical or consultancy services (including the provision of services of technical or other
personnel) but does not include consideration for any construction, assembly, mining or like
project undertaken by the recipient or consideration which would be income of the recipient
chargeable under the head “Salaries”.

Thus, there is difference between salary and fees for technical services. If fees is payable like a
remuneration, in some cases, it is taxable as salary also. Difference has to be identified based
on the nature of contract or agreement. If it is contract of service, then it would be taxable
as salary. But if it is contract for service, then we will see whether it fulfils the requirements
of section 9(1)(vii) or not.

Here, whether place of rendering of services is important – payment is made by the payer, but
rendering of services is by the payee. Even if services are rendered outside India, but the services
are utilized in India, would it be covered under section 9(1)(vii).

In 2007, SC decided a case which unsettled the concept of fees for technical services. Then
amendments were required to reinstate the position. But even after that, some HCs followed the
SC position. Then there was another amendment to nullify the effect of judgments.
Ishika Wajima Harima Heavy Industries Ltd. v. Director of International Taxation, 2007 288
ITR 408 SC – appellant company incorporated in Japan, formed a consortium and entered into an
agreement with Petronet LNG Ltd. in India for setting up LNG receiving storage and
degasification facility in Gujarat. The contract both the offshore and onshore supply. Offshore
and onshore supply of goods and services was covered. Question was on outshore supply of
services. Onshore supply of goods and services is taxable, and offshore supply of goods is not
taxable. The contention was only regarding offshore supply of service. Services were rendered
outside India, but were utilized in India. The only question was whether such offshore supply of
services is taxable or not in India.

Court held that for income to be taxable, a territorial nexus has to be established in the line of
international practice, which is a precondition for taxing services under deeming provision of
section 9(1)(vii), and for this, twin test has to be fulfilled – services have to be rendered as well
as utilized in India. A live link between rendering and utilization has to be established then
only a service can be taxable under section 9(1)(vii) read with section 5.

Court applied certain principles to establish the territorial nexus doctrine and live link principle.
In order to attract taxability in India, services should be both rendered and utilized in India.
Sufficient territorial nexus between the rendition of services and territorial limits of India is
necessary to make the income taxable. It must have sufficient territorial nexus with India so as to
furnish a basis for imposition of tax.

Essential test of territorial nexus was derived by Court from section 5. Court said that even
definition provides that rendition of services has to be looked into. But from where the Court is
coming at this conclusion is not clear.

The only relevant factor for royalty is where the right, information, database, property is utilized.
Nowhere, the place of agreement or place of rendering is important. The same logic is applied in
section 9(1)(vii) as well. But Court still said that both rendition and utilization is required to be in
India under section 9(1)(vii).

This decision was in January 2007. And in Finance Act 2007 only, an amendment was made.
Explanation was inserted to clarify doubts created by SC.
Explanation—For the removal of doubts, it is hereby declared that for the purposes of this
section, income of a non-resident shall be deemed to accrue or arise in India under clause (v) or
clause (vi) or clause (vii) of sub-section (1) and shall be included in the total income of the non-
resident, whether or not the non-resident has a residence or place of business or business
connection in India.

When income is deemed to accrue or arise for section 9(1)(v)(vi) and (vii), there is no need of
territorial nexus between place of rendition and utilization of rights, service, information,
interest, etc. The Amendment was given retrospective effect since the inception of the clauses in
1976.

In the Memorandum of Explanation and Explanatory notes, the amendment was clarificatory in
nature and the purpose was clear – the source rule would apply, situs of payer, situs of service
and situs of utilization of service have to be considered. Where the situs of rendition of service
is, is not relevant. Therefore, intent was to give legal sanctity to the source rule. Place of
residence is not required, place of business or business connection is also not required to be in
India. thus, there is no requirement for anything connected with the place of rendition of
service to be in India.

After this Amendment, there were some cases decided by HCs.

In November 2008, CIT v. Siemens, Bombay HC 2009 310 ITR 320 Bom HC – Court made an
observation here. Fees for technical service was not an issue at all. Court just made an
observation while discussing territorial nexus and live link that Ratio of Ishika Wajima case was
overcome by the amendment.

In December 2008, Clifford Chance v. DCIT, 2009 318 ITR 237 Bom HC – Court here
discussed Ishika Wajima case. Issue is in relation to taxation of non-resident in section 9.
Clifford Chance is a UK law firm which provided advice to various clients who were non-
residents. Some services were rendered in India, and some were rendered from outside India.
However, all the services were utilized in India only in Indian projects. They made separate bills
for services rendered outside India and services rendered in India. Issue was whether whole of
the fees received for service was chargeable in India, or only those part of fees received for
services rendered in India was chargeable in India.
The department contended that ratio of Ishika Wajima has been overruled by the amendment.
Therefore, only place of utilization of services is relevant, and not place of rendering services.
Therefore, entirety of fees would be chargeable in India.

COURT RELIED HEAVILY ON ISHIKA WAJIMA AND HELD THAT

FEES WOULD BE TAXABLE ONLY WHEN SERVICES WERE BOTH
UTILIZED AND RENDERED IN INDIA. THUS, EVEN AFTER THE
AMENDMENT WHICH CAME INTO EFFECT FROM 1 ST APRIL, 2008,
THE COURT STILL FOLLOWED THE 2007 JUDGMENT OF SC IN
ISHIKA WAJIMA. SEIMENS CASE WAS NOT CITED AT ALL.

Court noted the amendment but didn’t give any opinion in that regard.

The judgement can be interpreted in two ways:

1. As per principles of statutory interpretation, explanation cannot curtail the meaning of the
provision and does not clarify the legislative intent. However, this is unsustainable since
purpose of amendment was very clear – to overcome the effects of the judgment.
2. The explanation does away only with residence or place of business connection in India
and not all aspects of territorial nexus. This argument is also not sustainable because if
we consider fees for technical services as a business, then it would automatically fall
under section 9(1)(1). The entire objective of legislature was to treat interest, royalty and
technical services separately despite there being no place of business or business
connection or residence in India.

Court just said that provision of section 9(1)(vii)(c) is very clear, so we need not look into the
explanation.

There is a similar conclusion reached by Karnataka HC in Jindal Thermal Power Company v.

CIT, 2009 235 CTR 220 KTK HC – Court said that the plain reading of the provision
(explanation) suggests that the criteria of residence or business connection has been done away
with. However, the criteria of rendering and utilization of services in India remains
untouched by the legislature. When the provision is clear, there is no basis to look into the
Memorandum of Explanation. Thus, the amendment in no way affects the Ishika Wajima case.
ITAT Mumbai, on whom HC judgement is binding, has taken a contradictory view. Deputy
Director, International Taxation, v. TATA Iron and Steel Company Limited, 2009 34 SOT 83
Mumbai ITAT – ITAT distinguished Clifford Chance on the ground that argument of non-
taxability of offshore services applied only when fees was paid by non-resident. In this case,
since payer was no resident, Court applied section 9(1)(vii)(b) and reading it with the
amendment which clearly says that situs of utilization is important.

In another ITAT case, Court distinguished Clifford Chance case on the ground that payer was a
resident. [Royed Registered Industries Services case]

In Finance Act, 2010, there was a further addition to the explanation in view of the controversy.

The 2010 amendment said:

Explanation—For the removal of doubts, it is hereby declared that for the purposes of this
section, income of a non-resident shall be deemed to accrue or arise in India under clause (v) or
clause (vi) or clause (vii) of sub-section (1) and shall be included in the total income of

the non-resident, whether or not—

(i) the non-resident has a residence or place of business or business

connection in India; or
(ii) the non-resident has rendered services in India.

The second clause was added through the 2010 Amendment. Thus, it was
made abundantly clear that place of rendering services does not have to be
looked into, and the only relevant consideration is place of utilization of
services. This amendment was also made with retrospective effect since 1976
[inception of section 9(1)(v)(vi) and (vii)]

The finance minister also stated that to remove doubts with respect to source rule.

Linklaters LLP v. ITO, ITAT Mumbai 2010 – this was March 2010 and was decided before the
Amendment came into effect. Thus, they decided based on the previous position of law, or on the
basis of the Finance Bill. and Ashapura Minichem v. ACIT which was clearly decided after the
2010 Amendment.

Constitutional validity of section 9 was challenged in GVK Industries v. ITO, 2011 SC – the
issue of constitutionality of extra-territorial application of laws was discussed. As section 9 has
extraterritorial application – person not in India, and not doing anything in India is taxed by
section 9(1)(v)(vi) and (vii). SC upheld the constitutionality of the entire section. As section 9
is based on source-based taxation. Also, non-resident is not being taxed, rather only those
activities undertaken/utilized in India, and therefore it is being taxed.

For technical services, cases:

Kotak Securities v. CIT, 2016 383 ITR 1 SC – definition of technical services has been
explained.

GVK Industries v. CIT, 2015 371 ITR 453 SC – definition of consultancy services has been
explained.

Bharti Cellular Ltd. v. CIT, 2011 330 ITR 239 SC – human intervention is required for taxability
under fees for technical services.

Cummins Ltd. case, Authority for Advanced Ruling, 2016 – Indian UK DTAA and questions
regarding taxability of fees for technical services in light of DTAA.

In Re Cummins Ltd., Authority for Advanced Ruling, 2016 – the applicant, Cummins Limited,
UK is a company incorporated in the UK. Cummins Technologies India Limited (CTIL) is a
company incorporated in India. CTIL is engaged in the business of manufacture and sale of
turbochargers. Indian company is purchasing components from third party US and UK
companies. There is an agreement between UK company and Indian company. UK company is
providing supply management services to Indian company as per which 5% of the supply has to
be paid as supply management service fee as per the agreement. Applicant has requested answer
as to whether this fees paid is taxable as royalty or business income:

i. Based on facts of case, whether supply management service fees received by UK

company is in the nature of technical service fees or royalty.
 ii. If Cumins limited does not have PE in India, whether it is chargeable as business
income.
iii. If not liable to tax, then whether it is covered under catgory of transfer pricing or not
requiring arms length evaluation.
iv. If it is taxable, whether section 195 will be applicable for withholding tax or not.

It is established that CTIL is not a business connection and UK company does not have a
business connection in India. The relevant question is whether it is royalty or fees for technical
services. Court looked into the agreements, and Article 13 of India UK DTAA for definition of
royalty and fees for technical services.

Revenue argued another aspect of India UK DTAA to deny the benefit of DTAA. India and UK
had signed a protocol to amend DTAA and introduce limitation on benefit clause under article
28. Article 28 states that benefit of this convention shall not be available to a resident of
contracting state or with respect to any transaction undertaken by such resident if the main
purpose or on of the main purposes of creation of such resident or transactions done by him was
to obtain benefits under the DTAA.

The AAR said that the objection of revenue that applicant’s action is a scheme for tax avoidance
is without any merit. Applicant maintained the gl

There is no dependency on the UK company. Indian company is free and independent and a
separate authority from UK company. UK company is not imposing any condition on them.
Indian company is free to get supplies from anyone.

It is important to see whether services provided under agreement would lead to imparting
technical knowledge, experience, skill and knowhow to the Indian company. The agreement
shows that only purpose is to obtain competitive market pricing from the suppliers. No technical
knowledge or expertise is being imparted from the UK company to Indian company. As per
DTAA, only if technical knowledge, experience, skill, etc. is imparted to the Indian user, then
only fees is taxable.

Similarly, it is not transfer of any right, property, information, etc., so it is not taxable under the
IT Act. Thus arguments of taxability of royalty or FTS were negated. Decision was in favour of
applicant.
A HC judgment was also discussed to explain the meaning of ‘make available’. FTS would be
taxable only in India if expertise, technical knowhow, skill, etc. is made available to Indian
company. This term is not under the IT Act, but it has been inserted in the DTAA. In IT Act, we
only see where the service is utilized and we do not see whether some skill, knowledge is made
available.

ROYALTY

Its definition under IT Act is very wide and covers almost all aspects. Royalty is also defined
under UN and OECD Model Conventions. As OECD tends to favor resident-based taxation,
definition is narrower. While UN wants to extend benefits to source countries as well, so
definition is wider.

Software

There are discussions regarding software transfer or downloading to be considered as royalty.

Whether it is the transfer of right in a copyright, or transfer of copyrighted article. If former, it is
royalty, if latter, it would be considered sale of goods, which means business income. Business
income is taxable only when there is a PE as per DTAA. And distributors, retailers, etc. are not
considered PE for any software developer. A number of cases are decided by Delhi HC, Bombay
HC, KTK HC, ITAT Mumbai, Delhi, AAR. After 15-16 years, in 2006-07 it started and in 2021,
it is settled by SC which clarified views on transfer of software and its taxability. SC held that in
all these cases, it is a case of copyrighted article, so it would not be taxable as royalty, rather only
as a business income if there is a PE in India. Thus, decision was in favor of assesses and against
revenue. Decision came in March 2021. However, there are chances that amendment is made to
nullify the effect of the judgment.

Even before GST came, there were concerns as to whether software is a good or service. If good,
then state Act would apply, and if service, then central legislation, i.e., service tax would apply.

TCS Ltd. v. State of Andhra Pradesh, 2005 – two categories of software made by SC –
canned/uncanned, branded/customized. SC concluded that there can be customized (tailormade)
or branded software, or canned and uncanned. Branded software is readily available to everyone
without making any changes, such as Windows 10. It is considered a good, and
tangible/intangible form is not relevant. If it is customized software, this issue was not decided
by Court as it was not an issue before it.

Even after the judgment of SC, they started taxing customized software. States said that even if it
is customized, it is a good. While Centre argued that if it is customized, it has to be made as per
requirements, so it should be considered as a service. GST has removed certain difficulties in
software, however, still differentiation between goods and services is important, as supply of
goods and supply of services would make a difference in GST regime. Taxation rate, or
central/state tax issue has been resolved since GST is a common and uniform tax. However, in
certain aspects, there is a different route for supply of goods and supply of services. For that
purpose, distinction is important.

In IT Act also, issue was regarding transfer of right in copyright or transfer of copyrighted
article. In some cases, Court has said that it is copyrighted article. While in others, in favor of
revenue i.e., sale of right in copyright.

In 2012, an Amendment was made.

Decisions in favor of taxpayer:

Motorola Inc v. Deputy CIT, 2005 95 ITD 269 Delhi ITAT Special Bench – Special Bench
judgments are binding over all the ITATs all over India, unless jurisdictional HC decides and
gives different opinion. Here, the assesse corporation entered into contract with cellular operators
for supply of hardware with imbedded software. Whether this transfer of imbedded software
would be chargeable as royalty is the issue.

Special Bench observed that CR in relation to a computer program as per CR Act includes right
to sell, commercial rental etc. of computer program. However, rights were available only to
owners of computer program. If not owner, it means they didn’t have any right in CR. Therefore,
no transfer of right in CR, therefore not taxable as royalty.

Just because one has copyrighted article, does not mean that one has CR in it. here, they could
use software only for purpose of own operation and maintenance. There was clear bar against use
for commercial purpose. The transfer was not of any right in CR but only for copyrighted article.
Cellular operator was prohibited from making any copy of the software. Making copies is
allowed only for backup purposes. Therefore, merely because he is permitted to take the copies
just for backup purpose, it cannot be said that he has CR in article. Payment by cellular operator
is not for any CR in software, rather only as a copyrighted article. Therefore, payment cannot
be considered as royalty. It is a sale of goods which can only be taxed as business
connection read with PE.

Dassault System, 2010 188 Taxmann 223 AAR New Delhi – assesse was engaged in selling
software through independent distributor/reseller. Reseller took order from end users and placed
back-to-back orders on Dassault. On acceptance of order, it provided license key via email to end
users. End users were enabled to directly download software through weblink. Whether this
transaction is transfer of right in CR or transfer of copyrighted article.

Distributor only takes the order, and placed it back-to-back to Dassault.

Decisions in favor of department:

Gracemec Corporation v. Assistant, international Taxation, 2012 Delhi ITAT – whether reselling
of software by distributors amounted to transfer of coypright. A lot of distributors were
appointed, they copied the software, sold to Indian distributors. This was sold to various
distributors and then sold to end users. Question is whether transfer of right or copyrighted
article.

Delhi Tribunal observed that in absence of any ambiguity under Indian law, there was no need to
look at OECD convention. Provision says that right is transferred. Here, end user is purchasing
right to use the goods, which is a transfer of right in copyright, and not transfer of copyright.
Thus, they held in favour of the department.

CIT v. Samsung Electronics Co. Ltd. 2011 16 Taxmann 141 KTK HC

CIT v. Synopsis International Limited 2011 212 Taxmann 454 KTK HC

In both cases, similar issue regarding taxability of software. In both cases, KTK HC held that it is
transfer of right in CR and subject to royalty taxation. Thus, decisions were in favour of
department.
Citrix Systems Asia Pacific Private Limited v. Director of International Taxation, 2012 AAR
New Delhi (before amendment) – issue whether software transfer is royalty or business income.
Appellant is company incorporated in Australia. It has entered into agreement with distributor for
sale of their softwares and hardware in India. Ingram Micro India limited, an independent Indian
company, for distribution. Question regarding taxability on payment made for software and
hardware products by Ingram. Applicants relied on Dassault case where it was considered sale of
goods and not transfer of rights.

Here also, since independent distributor, no business connection, therefore no question of PE.

Therefore, department wanted to tax it as royalty. AAR discussed CR Act, definition under IT
Act. It is clear that right to use is purchased, not ownership. There is only right to use software.
AAR said that it was not persuaded by the Dassault case. No concept of transfer of copyrighted
article exists in Indian jurisprudence.

DIT v. Infrasoft Ltd. 2013 39 Taxmann 88 Delhi – Court disagreed with judgment of KTK HC in
Samsung and Synopsis cases. Transaction was covered in DTAA, and it didn’t apply the
amendment to the treaty. Even if amendment is applied retrospectively, it cannot override
DTAA.

Nokia Networks Ltd. case has also said the same thing. Court also discussed Snofi Pastures case
AP HC case.

Post Amendment also, it was not clear whether it was transfer of right in CR,

All the judgments went to SC in appeal. Finally, in 2021, Engineering Analysis Centre of
Excellence Private Limited v. CIT. The Court framed 4 issues to discuss. In all categories, SC
decided in favour of assesse – it is a case of sale of goods only, and not royalty.

The first category deals with cases in which computer software is purchased directly by an end-
user, resident in India, from a foreign, non-resident supplier or manufacturer. Court said this is a
case of sale of goods, and not royalty.

The second category of cases deals with resident Indian companies that act as distributors or
resellers, by purchasing computer software from foreign, non-resident suppliers or manufacturers
and then reselling the same to resident Indian end-users. Here, also, Court said this is a case of
sale of goods.

The third category concerns cases wherein the distributor happens to be a foreign, non-resident
vendor, who, after purchasing software from a foreign, non-resident seller, resells the same to
resident Indian distributors or end-users. Like Gracemec Corporation case. Here also, Court said
it is a case of sale of goods.

The fourth category includes cases wherein computer software is affixed onto hardware and is
sold as an integrated unit/equipment by foreign non-resident suppliers to resident Indian
distributors or end-users (like Infratech and Citrix cases). Here also, it is a case of sale of goods.

The Court said that this would be the case when transactions covered are purely covered under
domestic Act. If DTAA is involved, the change in domestic law would not affect it.

In Re Skill Soft Ireland Ltd. 2015 62 Taxmann 304 AAR – it also relates to similar issue. Here,
income was considered as royalty. However, 2021 SC judgment is applicable to it.

SOURCES/HEADS OF INCOME

Section 14 states that save as otherwise provided by this Act, all income shall, for the purposes
of charge of income-tax and computation of total income, be classified under the following heads
of income:

i. Salaries.
ii. Income from house property.
iii. Profits and gains of business or profession.
iv. Capital gains.
v. Income from other sources.

It is divided in 5 heads which are mutually exclusive to each other. Every head has its own
method of computation, taxability, deduction, etc. The first duty of taxpayer is to define which
head to income he should be taxed in.

Every head of income has its own charging provision. Section 14 is a charging provision for the
total income. For instance, income from salary is chargeable under section 16. Thus, each
provision has to be separately seen for charging a particular head. Also, head are mutually
exclusive – one head cannot be mixed with other head.

From all these heads, we will calculate the total income which would be taxable under section
14.

Salary – 15-17

House property – 22-27

Business and profession – 28-44

Capital gains – 45-55

Other sources – 56-59

Other sources would be looked at only when other heads are not applicable.

Capital gain has a separate taxation system, and slab system is not applicable to it.

After finding out net taxable income from different sources, we find the total taxable income.

Various deductions are available commonly called section 80C deductions. They are not made
from the individual heads, but from the total income.

There was an amendment made in 2001, and given retrospective effect since inception of the
Act. Section 14A was added. Expenditure incurred in relation to income not includible in total
income.

(1) For the purposes of computing the total income under this Chapter, no deduction shall be
allowed in respect of expenditure incurred by the assessee in relation to income which
does not form part of the total income under this Act.

If a person has incurred any expenditure in relation to an income which does not form part of the
total income, no deduction can be claimed in relation to that. Thus, expenditures not connected
with taxable income were disallowed.

Earlier, there was no clarity regarding this. In various cases, SC held in favour of assesses,
therefore this amendment was brought.
CIT v. Maharashtra Sugar Mills, AIR 1971 SC 2434

CIT v. Indian Bank Ltd., AIR 1965 SC 1473

Rajasthan State Warehousing Corporation v. CIT, 2000 242 ITR 242 SC

In these cases, it was held that if it is individual income, the expenditure cannot be disallowed,
even if it does not form part of total income.

However, legislature clarified that legislative intent was different, and such expenditure cannot
be allowed.

Amendment Act of 2006 inserted sub-clauses 2 and 3. (2) The Assessing Officer shall determine
the amount of expenditure incurred in relation to such income which does not form part of the
total income under this Act in accordance with such method as may be prescribed, if the
Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the
correctness of the claim of the assessee in respect of such expenditure in relation to income
which does not form part of the total income under this Act.

Thus, how it is to be apportioned, the method for this was not prescribed earlier, and added
through 2006 Amendment. As the section cannot be applied unless the procedure for
apportionment is clear.

Rule 8D of Income Tax Rules was inserted by this Amendment, which prescribed the method of
apportionment between taxable, non-taxable income and expenditure in relation to taxable and
non-taxable income. Thus, in effect, the amendment was applicable only from 2006.

Section 14A (3) stated that the provisions of sub-section (2) shall also apply in relation to a case
where an assessee claims that no expenditure has been incurred by him in relation to income
which does not form part of the total income under this Act. even if a person is not claiming any
expenditure, then also section 14 would be applicable. If assessing officer is not satisfied with
correctness of the claim, then he may apply section 14A and rule 8D.

Proviso has been added through 2002 amendment, as revenue had started reopening the
assessment on the basis of this amendment. It was clarified through this proviso that if
assessment is already completed on or before 2001, then the assessment cannot be reopened.
Thus, power of the department was limited.
nothing contained in this section shall empower the Assessing Officer either to reassess
under section 147 or pass an order enhancing the assessment or reducing a refund already made
or otherwise increasing the liability of the assessee under section 154, for any assessment year
beginning on or before the 1st day of April, 2001.

Before 2020, dividend was taxable by the company itself, on which dividend distribution tax was
paid by the company. Thus, it was not taxable in the hands of shareholder. Suppose a person
incurs expenditure of 10 lakhs on purchasing shares on which he gets dividend. Would this
expenditure be allowed to be claimed – the problem here is that tax is chargeable from the
company, and it is not taxed in the hands of the shareholders.

Dividend is given out of accumulated profits, which belongs to shraeholders itself. Thus, it is the
shareholders’ liability which is paid by the company. It is not the case that dividend is exempted
from tax, its just that the company is paying on behalf of shareholder. Thus, it is a case of
economic taxation.

Justice Ishwar Committee was formed to recommend on economic taxation, and it recommended
such expenditure should be exempted.

In 2020, amendment was made which again shifted the liability of paying tax on dividend to the
shareholders. As otherwise, it was loss to the shareholders. So section 14A would not be applied
in such cases after 2020 amendment, and such expenditure was allowed to be claimed.

CIT v. Warfort Shares and Stockbrokers Private Limited, 2010 326 ITR 1 SC – SC made it clear
that this provision is only applicable on expenditure incurred in relation to income not part of
total income. It does not apply to trading or business loss. As in expenditure, there is obligation
to pay. While this is not the case with business loss which happens because of the nature of
business. For instance, bad debts is a business loss. Thus, section 14A would not be applicable to
it. Business or trading loss cannot therefore be disallowed.

Distinction cannot be made between legal and illegal business. Even in illegal business, there can
be business loss.

Where there is obligation to pay, such as interest, it is expenditure, and covered under section
14A.
Godrej and Boyce Manufacturing Company v. DCIT, 2010 328 ITR 81 Bombay HC – court
upheld validity of section 14A.

Maxodd Investment Limited v. CIT, 2012 347 ITR 272, Delhi HC, and same case went to SC
2014 402 ITR 640 SC.

CIT v. Reliance Utilities and Powers Limited, 2009 313 ITR 340 Bombay HC – suppose
company borrowed money, and utilized it for purpose which is not taxable. Company has own
funds as well, so it can use such funds for non-taxable income and borrowed funds for taxable
income to claim benefits of exemption. Revenue claimed that it cannot be identified whether it is
own funds or borrowed money.

Court clarified that the relation is not required. It is logical that if person has own funds, they will
use them for non-taxable purposes, and borrowed funds for taxable purposes.

The question was whether interest payments could be claimed as deductions or not.

In case where a person holds shares as a stock in trade as a dealer of shares – he borrows money
and purchases shares out of that money. he then earns dividend also because he holds the shares.
Whether dividend would be covered under section 14A – SC held in maxoff case that
apportionment has to be made whether shares are being held as a dealer or as a shareholder.

Earlier, such interest paid on borrowed money was not allowed to be claimed as expenditure. At
least after 2020, interest would be allowed.

SECTION 15

The following income shall be chargeable to income-tax under the head “Salaries”—

(a) any salary due from an employer or a former employer to an assessee in the previous year,
whether paid or not;

(b) any salary paid or allowed to him in the previous year by or on behalf of an employer or a
former employer though not due or before it became due to him;

(c) any arrears of salary paid or allowed to him in the previous year by or on behalf of an
employer or a former employer, if not charged to income-tax for any earlier previous year.
Three forms of salary – salary which is due, salary which is received, and the arrears of salary.
Salary is taxable on the basis of due or received, whichever is earlier. Due means that when right
to receive arises, while received refers to the first occasion when the money is under one’s
control.

For instance, as per service rules of an organization, salary becomes due on the last day of the
month, called the due date. But due to financial crunch, salary is paid after a few days. Still, as
per IT Act, even if salary is not paid/received, it would be taxable on due basis i.e., whichever
comes first. Generally, salary becomes due first, and then it is received. Receipt can come before
due in case of advance payment of salary. In such case, a person would be liable to pay tax on
received basis, as receipt comes first.

Third form of salary is arrears of salary, which is always taxable on receipt basis. Arrears are
when there is an increase in salary from a back date with retrospective effect. Then salary for say
1-2 years is received in form of arrears. There are various pay commissions. Suppose the
government says that Pay Commission would be applicable from 2019, then arrears of salary
would be received. Similarly, there is DA which may increase in any month, but is considered to
be due from January only.

The relationship of employer and employee i.e., contract of service and not contract for service,
should be there for income to be taxable as salary. If the relation of payer and payee is not of
employer and employee, then the income is not taxable as salary under IT Act.

Whether salaries of MPs and MLAs, CM, Ministers, High Court and SC Judges, etc. are taxable
as salary. Also whether emoluments received by director of a company would be considered as
salary. Director may be considered as employee depending on the nature of agreement and
relation between director and the company. Generally, he is not considered as such, but if
because of agreement, documents, resolution, etc., he is treated as employee, his income would
be considered salary.

Law firm lawyers are also not employees in most of the cases, as they are retainers of the firm
and retainership agreement is signed and retainership fees is given. Thus, income is charged as
income from profession. However, if a lawyer joins a company as an in-house counsel, the
person is an employee, as the nature of agreement and treatment is different.
Although HC and SC judges are constitutional functionaries and are not subject to hire and fire,
etc., they themselves held that their income is salary for purpose of IT Act.

Devakinandan Agarwal v. Union of India, 1999 237 ITR 872 SC – SC held that to our mind,
there is a misconception here. It is true that HC and SC judges have no employer, but that ipso
facto dosent mean that they do not receive salary. They are constitutional functionaries. Article
125 and 221 deal with their salaries, and explicitly state that what judges receive are salaries.
Therefore, their income is taxable as salary under IT Act because of the language of Article 125
and 225, despite their being no relation between payer and payee of employer and employee.
This is a special situation.

Same position is taken for MPs and MLAs holding post of a Minister or CM. Because a person is
holding a post, he is a constitutional functionary, and therefore his income is taxable as salary.

Lalu Prasad v. CIT, 2009 316 ITR 186 Patna HC – Court interpreted article 161 of Constitution
which makes it clear that CM is appointed by Governor and hold the post during the pleasure of
governor. Therefore, their income should be considered income from salary only. Therefore,
exemptions under other heads were denied.

However, if MP or MLA is not holding any post of Minister in the government, then their
income would not be salary. Rather, it would be income from other sources.

Remuneration paid to Attorney General, Advocate General, Solicitor General, etc., whether it is
taxable as salary – they are also considered as retainership arrangement between government and
the persons. They hold the constitutional positions, and are working full time for the government
during their tenure, but it is considered a contract for service.

CIT v. Govind Swaminathan, 1998 233 ITR 264 Madras HC.

Union of India v. Prothiba Banerjee, 1995 6 SCC 765 SC – receipt is purely a professional
receipt, it is a contract for service and not contract of service. Therefore, it is a professional
income, and not income from salary.

Salary need not be monthly, it can we weekly, fortnightly, daily wages, or in the form of bonus,
commission, etc. also.
Income from employment is salary, but income from office not amounting to employment can be
professional income or income from other sources.

There are 4 portions or salary:

1. Basic salary – section 17(1). Monthly, daily, weekly, etc. There can be commission,
bonus, etc. also based on turnover, transactions, etc.
2. All retirement benefits – section 17(1). Even after the end of employment, whatever a
person gets is also salary as it is linked to the work done. It includes pension, gratuity,
leave salary (leave encashment).
3. Perquisites – section 17(2). Benefits provided by the employer during the employment.
After the employment ends, there is no taxation of perquisites. For instance, perks include
rent-free accommodation, accommodation at discounted rates, ESOPs, free drivers,
servants, medical/educational fees reimbursement. Whatever a person gets from his
employer can be a perquisite. It can be monetary as well as non-monetary. If it is received
in kind, there is a formula to convert it into cash.
4. Profits in lieu of salary – section 17(3). Compensation received because of modification
in the terms and conditions of employment.

For instance, in case of gratuity, as per Payment of Gratuity Act or Central Government rules,
some allowances are partly taxable, some are fully taxable. Gratuity is taxable, but when it will
be exempted is provided in section 10(10). As all exemptions are provided in section 10 only.

Section 10(10)

(i) states that any death-cum-retirement gratuity received under the revised Pension Rules of the
Central Government or, as the case may be, the Central Civil Services (Pension) Rules, 1972, or
under any similar scheme applicable to the members of the civil services of the Union or holders
of posts connected with defence or of civil posts under the Union (such members or holders
being persons not governed by the said Rules) or to the members of the all-India services or to
the members of the civil services of a State or holders of civil posts under a State or to the
employees of a local authority or any payment of retiring gratuity received under the Pension
Code or Regulations applicable to the members of the defence services.
ii) any gratuity received under the Payment of Gratuity Act, 1972, to the extent it does not
exceed an amount calculated in accordance with the provisions of sub-sections (2) and (3) of
section 4 of that Act.

iii. any other gratuity received by an employee on his retirement or on his becoming
incapacitated prior to such retirement or on termination of his employment, or any gratuity
received by his widow, children or dependants on his death, to the extent it does not, in either
case, exceed one-half month's salary for each year of completed service, calculated on the basis
of the average salary for the ten months immediately preceding the month in which any such
event occurs, subject to such limit as the Central Government may, by notification in the Official
Gazette, specify in this behalf having regard to the limit applicable in this behalf to the
employees of that Government.

The first category deals with pension received under Central Government Pension Rules. This is
completely exempted from taxation. Second category deals with gratuity received under Payment
of Gratuity Act. This would be partly exempted as per the Act.

There are 3 rules for exemption of gratuity. Section 4 of Payment of Gratuity Act provides for
minimum standard for calculation of gratuity. 15 days salary for each completed year of service.
Thus, 15 days salary * length of service. 15 days means last drawn salary * 15/26 (as it is
considered to be 26 working days in a month). Salary here only means basic salary plus dearness
allowance.

If length of service is 25 years 6 months, in such case, 6 months will not be considered. While if
it is 25 years 7 months, then it would be taken as 26 years.

Second is the actual receipt of gratuity, and the third is the maximum threshold limit of gratuity.
After 7th pay commission, 20 lakh threshold is prescribed. Whichever is lower of these three will
be exempted. Suppose actual receipt is 8 lakhs and minimum is 6 lakhs, then 6 lakh is exempted
and 2 lakh is taxable.

Suppose actual receipt is 25 lakhs, and 16 lakhs is minimum, then taxable is 9 lakhs.

If actual is 30 lakhs and minimum is 26 lakhs, and since maximum is 20 lakhs, then 30 – 20 = 10
lakhs would be taxable.
Section 10(10)(iii) is for the purpose of taxing the gratuity received by those persons who are not
covered by Payment of Gratuity Act. The rule is the same, except that instead of 15 days, it is
half month average salary, and calculated from last 10 months average salary, and then
multiplied by length of service. Here, fraction rule is not applicable, and whatever is the
completed years would be taken.

Provisos to section 10(10):

Provided that where any gratuities referred to in this clause are received by an employee from
more than one employer in the same previous year, the aggregate amount exempt from income-
tax under this clause shall not exceed the limit so specified.

Provided further that where any such gratuity or gratuities was or were received in any one or
more earlier previous years also and the whole or any part of the amount of such gratuity or
gratuities was not included in the total income of the assessee of such previous year or years, the
amount exempt from income-tax under this clause shall not exceed the limit so specified as
reduced by the amount or, as the case may be, the aggregate amount not included in the total
income of any such previous year or years.

As per first proviso, if gratuity in same year is received from two employers, the threshold would
remain 20 lakhs only, and not 20+20 lakhs, as threshold is employee specific. Suppose ABC has
provided 15 lakh gratuity, and XYZ has provided 16 lakhs gratuity. Still, maximum limit for
calculation would be 20 lakhs only.

Second proviso states that gratuity is received in two different previous years. Suppose ABC
gives gratuity of 10 lakhs in 2005, and as per Rules applicable in that year, the entire 10 lakh is
claimed as non-taxable. Suppose in 2022, 15 lakh gratuity is received. As per rule, maximum
threshold would be 20 – 10 lakh = 10 lakh rupees. Thus, exemption of only 10 lakhs can be
claimed, as exemption is applicable only once in the lifetime of an employee. Since he had
already claimed 10 lakh exemption, that would be deducted. If in previous years only, entire 20
lakh exemption has been claimed, then for the current gratuity received, entire gratuity would be
taxable and no exemption.

CIT v. PM Mehra, 1003 201 ITR 930 Bombay HC

CIT v. Savita Ben N. Amin, 1986 157 ITR 135 Gujarat HC

Bombay High Court interpreted meaning of completed years of service. Completed years of
service does not mean with one employer. If in last 30 years, person has worked with 3-4
employers, then the entire term would be considered as completed years of service, if he has not
received gratuity from previous employers. If only the last employer provided gratuity, and with
that employer alone, person worked for say 8 years. Still, because he worked total 30 years with
previous employers, the Court has said that entire 30 years would be considered as completed
years of service. And if 1 or 2 of the previous employers provided gratuity, then the period
worked with that employer would not be included in completed years of service, and second
proviso would also be applicable here.

Although the burden is on the last employer only, since it is a beneficial provision, the Court
interpreted completed years of service to not just mean service with single employer.

The second case discusses certain manipulations. If a person works for 5 years, receives gratuity
and then retires. Then again, person joins, works for 5 years and again receives gratuity and
retires. The Court said that although this is a colourable device, there is no problem, as the
threshold of exemption would be reduced as per second provisop.

There are various allowances, some of which are fully taxable, and some are partly taxable.
There are also notified allowances – where maximum limit of exemption is provided by the IT
Act. For instance, say for high altitude allowance, 20,000 exemption threshold is provided. If
income is less than 20,000, then it is fully exempted. And if more than that, then income to the
extent of 20,000 will be exempted.

There are travelling allowances and daily allowances in service. Here, actual receipt or actual
expenditure, whichever is less, would be exempted. Same is in case of telephone, internet
allowances. All these are subject to actual receipt or actual expenditure, whichever is less.

Section 10(14) provides these exemptions.

(i) any such special allowance or benefit, not being in the nature of a perquisite within the
meaning of clause (2) of section 17, specifically granted to meet expenses wholly, necessarily
and exclusively incurred in the performance of the duties of an office or employment of profit, as
may be prescribed, to the extent to which such expenses are actually incurred for that purpose;

(ii) any such allowance granted to the assessee either to meet his personal expenses at the place
where the duties of his office or employment of profit are ordinarily performed by him or at the
place where he ordinarily resides, or to compensate him for the increased cost of living, as may
be prescribed and to the extent as may be prescribed.

House rent allowance – section 10(13A) read with Rule 2A. Method of computation of
exemption is provided under the Rule.

(13A) any special allowance specifically granted to an assessee by his employer to meet
expenditure actually incurred on payment of rent (by whatever name called) in respect of
residential accommodation occupied by the assessee, to such extent as may be
prescribed55 having regard to the area or place in which such accommodation is situate and other
relevant considerations.

Explanation—For the removal of doubts, it is hereby declared that nothing contained in this
clause shall apply in a case where—

(a) the residential accommodation occupied by the assessee is owned by him; or

(b) the assessee has not actually incurred expenditure on payment of rent (by whatever name
called) in respect of the residential accommodation occupied by him.

The first requirement is that it has to be proved that person is paying the rent. The expenditure
has to be proved, and without it, exemption cannot be claimed. The rent can be paid to father,
spouse, etc. also, and still, exemption can be claimed. However, if person himself is the owner of
house, exemption cannot be claimed. Recently, ITAT Delhi has decided that even if rent is paid
to spouse, it can be claimed as exemption. Rent has to be paid, to whom it is paid is not relevant.

The extent to which exemption can be claimed is provided in Rule 2(A). There are three methods
of calculation:

i. 50% of annual salary can be claimed in metro cities. In any other place, 40% of
salary.
 ii. Actual receipt annual of allowance (HRA). There has to be a provision in the service
rule/contract where HRA is to be paid. If there is no HRA provided by employer,
there is section 80 – provision of claim of HRA.
iii. Rent paid to the landlord over 10% of salary.

Whichever of the three is lowest, will be exempted. And difference between exempted and actual
amount would be part of salary.

Here, salary means only basic salary and dearness allowance.

Suppose a person is in Delhi. His basic salary and dearness allowance is 60,000. He receives
house rent allowance from employer of 20,000. He also pays 20,000 as rent to landlord.

Annual salary is 7,20,000 so monthly salary is 3,60,000.

HRA is 2,40,000.

Rend paid over 10% of salary = 2,40,000 (yearly rent) – 72,000 (10% of salary) = 1,68,000.

Thus, minimum of the 3 is 1,68,000, so deduction for exemption would be 1,68,000.

Suppose 10% of salary is 2,40,000 itself, in such case, rent paid over 10% of salary would be
zero. This means that entire rent paid is taxable.

Perquisites

1. Allowances are always in cash, while perquisites may be in cash or kind.

2. Allowances are part of service contract, while perquisites may or may not be. For
instance, gift during festivals can be perquisites.
3. Perquisites must have legal origin i.e., if a person is not authorized to receive the benefit,
it is not a perquisite. Perquisite is considered only when a person is authorized to receive
the benefit. Then only it would be taxable as a benefit. In 1964, CIT v. LW Russel, Court
has held that perquisites are taxable as salary only if they have a legal origin.
4. Perquisites can be provided to employee or his family members also. Even that is taxable
as a perquisite.
5. Perquisites are taxable only when they are received during the employment, and not after
retirement.
 6. Perquisites are taxable when they have personal advantage to employee i.e., individual
attributability to the employee. For instance, if company provides bus service, it is not
personal advantage as it is a common benefit. However, if company provides car to a
person, it is a perquisite.

Rent free accommodation is a common perquisite. To determine rented value of such perquisite
in cash. For instance, accommodation provided by the government to its officials, judges, etc. In
government, rent is equivalent to the license fees paid on such premise. It is a very nominal
amount. Only around 1500-2000 is deducted from the salary as perquisite.

However, in case of private employees, it depends on the population of the place. If population is
more than 25 lakhs, 15% of salary, if between 10-25 lakhs, 10%, and less than 10 lakhs, 7.5%.

If perquisites are in kind, method of conversion into cash is provided in IT Rule 3.

Any compensation received by empllyeee during employment or after cessation of employment,

is taxable as salary. Tax treatment is provided in section 10 only. For instance, retrenchment
compensation is valued as per section 25F of IT Act. Last salary multiplied by total length of
service is the retrenchment compensation.

Rule under section 10(10)(b) provides how much is exempted from retrenchment compensation.
It is the least amount of the three – amount under IDA, actual receipt or 50,000 rupees.

Deductions under salary – one is standard deduction available to all employees. It is 50,000
annually, available to everyone irrespective of salary and without any proof.

Second deduction is professional tax. It is governed by Article 276. State government can impose
this tax on any person – state or private employee working in the state. Limit is provided by
constitution itself – state government cannot impose more than 2,500 as professional tax per
year. So if this tax is paid, the deduction can be claimed.

INCOME FROM HOUSE PROPERTY (SECTION 22-27)

If a person lets out house for rent, such income is taxable. This is the only chapter in IT Act
wherein income is taxable on notional basis – even when no real income is there i.e., even if it is
not let out, there are expected lettable values which have to be provided for.
Section 22 states that the annual value of property consisting of any buildings or lands
appurtenant thereto of which the assessee is the owner, other than such portions of such property
as he may occupy for the purposes of any business or profession carried on by him the profits of
which are chargeable to income-tax, shall be chargeable to income-tax under the head “income
from house property”.

Annual value means the lettable value, which can be real or expected.

Whether the section covers only residential properties or commercial properties as well – income
from building is there, which can be both commercial and residential. House property is also not
defined. Even tent house, open theatre, swimming pool is also a building. A person is realizing
money by owning any property.

There is a thin line between income from house property and income from building. For
instance, if a person owns 20 different types of buildings and lets them out to different persons
on rent basis, both for residential and commercial purposes. Suppose a company whose object
clause is to construct building and let it out on rent basis for the purpose of residence.

The exclusion is for instances where the building is occupied by the person to carry on a business
or profession, such as an office/factory of the owner. It does not talk about letting out the
building as a matter of business. The provision is there because otherwise even doctors or
lawyers or companies would have to pay taxes on their offices on notional basis.

How to decide whether business or house property – as charging provisions and exemptions are
different.

Suppose NLUJ lets out parts of the building to bank, etc. It is not primary nor secondary purpose
of NLU, so whether it would be house property, business or other sources.

Suppose a person constructs hotel, and lets out rooms for rent on daily basis, whether it is house
property or business income. Or suppose a person constructs hotel and lets out the hotel itself on
fixed monthly rent. Suppose a person lets out the hotel on rent of 50% of profits.

This is not clear till date and there have been various judgments of SC. There is a 2015 judgment
but it confined itself to the facts of the case.
Section 22 is not clear as to what kind of buildings are covered – whether person owns as
individual, or as a company, etc.

Second problem is how to decide the ownership – whether the legal owner is only included or
beneficial/deemed owner is also included. There is a settled view on this and SC has said that
owner can be anyone, and need not only be a legal owner.

Section 27(i) states that an individual who transfers otherwise than for adequate consideration
any house property to his or her spouse, not being a transfer in connection with an agreement to
live apart, or to a minor child not being a married daughter, shall be deemed to be the owner of
the house property so transferred.

Not the transferee but the transferor would be considered a deemed. A colourable device is
created to transfer the source in favour of the spouse. Thus, even if property is owned by the
spouse, transferor would be liable under IT Act.

Section 27(ii) – the holder of an impartible estate shall be deemed to be the individual owner of
all the properties comprised in the estate. Impartible estate means property which is not subject
to partition. For instance, property for a common benefit is impartible estate. Here, legal owner is
all the persons, but 1 person is managing on behalf of others.

Section 27(iii) – a member of a co-operative society, company or other association of persons to

whom a building or part thereof is allotted or leased under a house building scheme of the
society, company or association, as the case may be, shall be deemed to be the owner of that
building or part thereof.

As a beneficial/deemed owner, the person would be liable, and not the company which is the
legal owner.

Section 27(iiia) – a person who is allowed to take or retain possession of any building or part
thereof in part performance of a contract of the nature referred to in section 53A of the Transfer
of Property Act, 1882, shall be deemed to be the owner of that building or part thereof.

For instance, power of attorney holder is allowed to deal with the property. This is a part
performance of contract. Here, the person in whose favour the power of attorney would be liable
even though he is not the legal owner.
Section 27(iiib) – a person who acquires any rights (excluding any rights by way of a lease from
month to month or for a period not exceeding one year) in or with respect to any building or part
thereof, by virtue of any such transaction as is referred to in clause (f) of section 269UA, shall be
deemed to be the owner of that building or part thereof.

Suppose A is lessor and leases out property to B for 6 months. Then after 6 months, it was
renewed and property was leased out for 50 years. If initially, the lease is for less than a year,
then lessor would be considered to be owner of the property. Thus, here, A would be considered
owner. However, if property is leased for not less than a year initially, and continues for 12
years, then the lessee would be owner for the purpose of income.

Section 27(vi) – taxes levied by a local authority in respect of any property shall be deemed to
include service taxes levied by the local authority in respect of the property.

CIT v. Potdar Cement Private Limited, 1997 226 ITR 625 SC – SC said that under the common
law, owner means a person who has a valid title legally conferred to him after satisfying
requirements of law. However, for section 22, having regard to ground realities and object of
income tax, owner is a person entitled to receive income from a property in his own right. He has
full control over the property and is enjoying property rights in that, even though he is not a legal
owner of the property.

In some cases, the entire money is funded by one person in favour of another, and such another
person constructs building. Such questions of colourable device have also been dealt with by the
Court.

Chennai Properties and Investment Limited v. CIT, 2015 SC – because object clause of the
company to own and let out building, then it is a business. But individuals do not have object
clause. So in such case, it would be house property.

Sultan Brothers v. CIT, 1964 SC – SC was very clear that object is not a decisive factor. Building
is not a commercial asset. Legislature would not create a chapter for miniscule things

CIT v. National Storage Private Limited, 1967 66 ITR 596 SC

Rayala Corporations Private Limited v. Assistant CIT, 2016 SC – here, Court followed Chennai
Properties.
In 2015, Court unsettled the position regarding house properties. But the judgment was not final,
as it was decided in light of specific facts. It is for the assesse and revenue to take a stand.

In all cases before 2015, house property is house as a property, it cannot be business income.
Legislature has not created a difference between residence and commercial property. But after
2015, Court said that if object clause of a company says that its object is to let out buildings, then
it would be business income. However, since individual cannot have an object clause, the same
cannot be applied to them.

Taxability of composite income in house property

When letting out of building is not dominant/important, rather, it is the services which are more
important and nature of transaction is complex one. Providing service cannot be separated from
letting out the room. Even for purpose of accounting, the value of room and value of services
cannot be separated and it is indivisible.

In such case, total income is taxable as income from business and services

In some cases, if building is let out with some other attachments such as furniture, etc. The
charge is made for building as well as fittings and furnishing. Here, this is separable. Income
from letting out room would be income from house property, and income from furniture, etc. is
income from other sources.

If a cinema theatre is let out, not the building, but the screens, projector, etc. would be more
important, and it would be considered income from business. If in a commercial mall, different
shops are let out, and separate charges are made for lift maintenance, watchman, etc., in such
case it is separable – income from letting out shops is house property, and income from other
aspects is other sources.

Income from software parks – services are more dominant than the building. If transaction is a
complex one and is inseparable, then total income would be considered as income from business.
But if it is separable, income from building would be considered house property, and other
income would be income from other sources.

This was held in the National Storage case.

CIT v. National Storage Private Limited – Company constructed vault under cinematographic
rules, according to fixed rules of storing cinema. In such case, it is a complex transaction, as
building is taken for the purpose of the vault. Service is more important, since it is composite
income, entire income would be considered as income from business and profession.

It is the nature of operations (for what purpose letting out – for enjoyment of building or other
things) and not the capacity of the owner (ownership) that must determine whether the income is
taxable. If an individual owns house, and a company owns house, it is the same thing.

If it is bare letting out for the purpose of enjoyment of building itself, it is house property, and if
it is for the purpose of enjoying other services, it is business income. It is not relevant whether
the owner is company or individual.

Chennai Properties and Investment Ltd. v. CIT – CPL is an Indian company. Its main objective,
as stated in MOA, is to acquire properties in Madras and let out those properties. Assesse rented
the properties and the rental income was considered business income. Assessing officer tried to
bring it under income from house property as it is bare letting out of building and no services are
provided. Assesse filed appeal before commissioner of appeal which upheld it was business
income. ITAT also said it is business income. Madras HC set aside ITAT and held it is house
property. HC followed 2 judgments of SC – East India Housing and Land Development and
Trust v. CIT, 1961 42 ITR 49 SC, and Sultan Brothers Ltd. v. CIT AIR 1964 SC 1389.

In East India – a company was incorporated with object of buying and developing the properties
to create a market and to let out that market. SC said the because main object is to develop
properties itself, letting out is incidental. If it is let out, there is question of business income or
house property. If it is sold, it is clearly a capital gain (if it was investment). SC held it was house
property, as letting out was for enjoyment of building only. Relying on this, HC said it is house
property.

In Sultan Brothers (constitutional bench) – assesse let out fully equipped and furnished building
for 6 years for running hotel and for ancillary services. Lease provided for building and hire for
furniture and fixtures. SC said that whether nature of assets is decisive – commercial assets or
property for enjoyment of property rights. Whether it is business has to be decided in
circumstances of each case. It would not be business income if it is exploitation of property by
the owner. A commercial asset is only an asset used in a business and nothing else, and business
may be carried on with practically all things. Therefore, it is not possible to say that a particular
activity is business because it is concerned with an asset with which trade is commonly carried
on. Court didn’t find anything in the cases referred, to support the proposition that certain assets
are commercial assets in their very nature. The present letting of the business did not amount to
business income.

In 1922 Act, section 9 was house property and section 10 was business income. Court

Even if object of company was to acquire land, develop it into buildings and let it out, it would
not convert house property into business income. Object clause cannot be a conclusive test to
determine whether transaction is income from house property or business income.

Based on this, HC held house property. However, SC reversed the judgment. Court said it agreed
with Sultan Brothers, but relied on Karanpura Development Company Limited v. CIT, 1962 44
ITR 362 SC – 3 Member Bench. Company was formed with object of acquiring and disposing of
underground coal mining mines, inserting coal fields. Lease over large areas, developing them as
coal fields, sub-letting them to collieries and extracting coal. This is similar to Chennai case, as
the object in both was to construct/develop and let out.

Whether it is composite income or mere letting out – what is dominant – enjoyment of coal field
or extraction of coal. Here, extracting coal is important. If it is a complex income which is
inseparable, the dominant thing is extracting coal, then it would be business income.

SC relied on Karanpura case and decided in favour of assesse holding it is income from business.
However, Chennai property was not actually complex income – as the only purpose was to
construct and let out buildings, which is different from Karanpura, where object was mining, and
not enjoyment of coal field.

Court said we are following Sultan Brothers because the case itself said that case has to be
decided on the basis of facts and circumstances of each case. However, in Sultan Brothers, it was
clearly said that object clause is not the decisive factor of house property or business income.

This has opened the door for litigation, as if it is decided on facts of the case, it is not binding,
and constitutional bench judgment would be more important.
CIT v. Bhoopalan Commercial Complex and Industries Private Limited, 2003 262 ITR 517 KTK
HC – assess was a private company. One director had taken land on lease basis from
otherpersons. Director executed registered deed of transfer in the name of company, transferring
his lease rights. The company constructed buidinh on this property and leased out. It was treated
as business income. Commissioner treated it as income from house property.

We need to see whether company is owner. Court followed Potdar Cement and held that even
deemed owner would be owner. Here, since lease hold rights are transferred, company would be
deemed to be owner. Here, lease was not for less than 1 year as per section 27 r/w section
269(uaf), lessee would be considered owner.

HC said that irrespective of the fact that one of the objects of assesse was to construct building
and let them out, the income would be considered income from house property, as it was solely
the enjoyment of property rights which was given.

Thus, there was settled position before 2015 – irrespective of ownership by company or
individual, unless services are dominant in nature, letting out for enjoyment of property rights is
income from house property.

Similarly, it cannot be said that if it is at a large scale, it is business income and not house
property.

If NLU rents out building to bank – it letting out of property is incidental which is subservient to
fulfil the main purpose. It is income from other sources, and neither house property or business
income.

CIT v. Modi Industries, 1994 210 ITR 1 Delhi HC – where letting out is incidental or
subservient, it is income from other sources.

Building which is let out by real estate companies

For them, building is a stock in trade. Their object is to construct and sell buildings. Suppose if
they couldn’t sell it, they let it out, whether it is house property, business income or income from
other source.

For a real estate company, buildings are trading assets. So whether it would be business
income or house property:
CIT v. Neha Builders, 2008 296 ITR 661 Gujarat HC – building was treated as stock in trade
because company was real estate. It was let out for some time. Question was regarding taxability
of income. Court considered letting out as business income because building was a stock in
trade/trading asset for the company.

Mangalam Homes Pvt. Ltd. v. ITO, 2010 325 ITR 281 Bombay HC – similar case. HC said it is
income form house property as it is letting out of building. Whether building is held by company
as stock in trade or investment asset would not make any difference. And it cannot be said as
being used for own business and profession, as the object of company is to sell houses and
buildings, and not let them out.

CIT v. Ansal Housing Finance and Leasing Company Ltd., 2013 354 ITR 180 Delhi HC –
similar issue was there. real estate company let out unsold building for some years. Question was
regarding taxability. Delhi HC considered chargeability under section 22. We cannot consider
any artificicla difference between building as stock in trade or capital asset. Whether it is held as
investment asset or stock in trade does not make any difference in section 22. Therefore, income
from building is considered income from house property. since main purpose is letting out the
building itself for its enjoyment, it is house property only.

Nirmala Sahu case – temporary letting out of property was considered by Court as business
income and not income from house property. Thus, there have been different views taken by
different HCs.

In 2017, legislative intent was made clear – whether building is held as investment or trading
asset would not be relevant, and in both cases, it would be considered income from house
property. Through section 23(5), some clarity was given.

Section 23 – how to determine annual value. Legislature made clear through amendment which
clarified the legislative intent. Section 23(5) was inserted by Amendment Act, 2017 with effect
from April 1, 2018 and said that where the property consisting of any building or land
appurtenant thereto is held as stock-in-trade and the property or any part of the property is not let
during the whole or any part of the previous year, the annual value of such property or part of the
property, for the period up to 2 years from the end of the financial year in which the certificate of
completion of construction of the property is obtained from the competent authority, shall be
taken to be nil.

This means that stock in trade would be considered as house property only since it is enjoyment
of building. However, there can be exemption of 2 years from notional tax. As building is
anyways taxable on notional basis under section 22. So if building is constructed as stock in
trade for sale. But if suitable buyer is not found, then 2 year exemption from tax is given. If say
1000 flats are constructed, and 200 are vacant as unsold. Will they be covered under notional
basis for tax under section 22 – yes they are. But exemption from notional tax is given for 2
years. If it is sold off during this period, there is no problem. But even after 2 years, if it is not let
out, the tax has to be paid on notional basis.

Thus, even if stock in trade, building is taxable as house property. Thus, what is important is the
dominant intention of the party – whether to enjoy the building, or any other purpose. If letting
out is incidental or subservient to main business, then it would be income from business.
Whether it is letting out by company, individual or real estate, it is not relevant. Thus, composite
income cases would always be cases of business income.

Lands appurtenant thereto – which is part and parcel of the building i.e., land required for
enjoyment of building. If land is vacant and has capacity to earn separate income, it is not land
appurtenant.

Building should not be occupied by the assesse for his own business or profession – such as
hospital, lawyer/CA’s chamber. A shareholder, if provides building free of cost to company to be
used as head office, then this exemption of section 22 would not be applicable. As it is the
company, and not the shareholder, which is carrying on business or profession as the owner.
While in partnership, a partner can give his property to be used as head office for partnership
firm, and it would be considered own business and profession, and partnership firm is not a
separate entity.

SECTION 23

Meaning of annual value – rateable, notional, actual value.

As per section 23(1), the annual value of any property shall be deemed to be—
(a) the sum for which the property might reasonably be expected to let from year to year; or

(b) where the property or any part of the property is let and the actual rent received or receivable
by the owner in respect thereof is in excess of the sum referred to in clause (a), the amount so
received or receivable; or

(c) where the property or any part of the property is let and was vacant during the whole or any
part of the previous year and owing to such vacancy the actual rent received or receivable by the
owner in respect thereof is less than the sum referred to in clause (a), the amount so received or
receivable.

Earlier, actual value was not considered for the purpose of section 23. It was added later. Either
the notional value, or actual value, whichever is higher, would be the annual value. But this is
subject to sub-clause (c).

Clause (a) gives the expected or notional rent. (b) gives the actual rent which is received or
receivable. The higher of the two would be considered the annual rent. Now there can be three
types of notional rent: fair rent, municipal value or standard rate.

Fair rent – arms-length value. We see the rent derived from house in a similar locality on letting
out the house. On a similar location, in similar situation, the rent derived is fair rent.

Municipal value – the municipality always fixes the rateable value for properties. It is fixed
location-wise. Whichever is higher of fair rent and municipal value would be considered notional
value. Thus, higher value would be annual value. But this is subject to standard rent – rent fixed
under the Rent Control Act. If this Act applies in the location, then it would be standard rent. SC
has said that if Rent Control Act is applicable, notional rent cannot exceed notional rent.

If Rent Control Act does not apply, then standard rent would not be taken into consideration.

A let out property to B for 10,000 per month. B sub-let the property to C for 15,000 per month.
Revenue said that we will consider 15,000 for taxation. But Court held the sub-let value cannot
be considered as fair rent.

There are questions as to with what kind of properties are to be compared with for determination
of fair value.
Actual rent – what is the actual rateable value of the house. Generally, notional value is lower
than actual value, which changes every month. But there can be alterations and manipulations in
actual rent. For instance, letting out to a relative, and charging a very nominal value which is
lower than the notional rent. Whichever is higher of notional and actual rent would be
considered. Department says that the rent charged is not actual rent as it is being charged from a
relative.

Notional rent is a deemed value, so it is generally the average value. Unless some manipulation
or colourable device is claimed, authority can consider. Otherwise, there is no mechanism to find
out whether it is actual rent.

Sometimes, the rent may be low, but interest free security deposit can be charged, which is very
high. Whether notional interest on security deposit can be added as actual rent – it may be that
security deposit has influenced the determination of rent. If the fair/notional rent is also coming
similar to the actual rent, then it cannot be claimed that security deposit has influenced the
fixation of rent. But if it is shown that fixation of rent is influenced, the authority can consider it.

In clause (c), the property had been let out in earlier years, and property is ready (on board, to let
is written), but a suitable tenant was not found. And if actual rent is less than notional rent, then
the actual rent would be taken as the annual value. Even if the property was vacant for an entire
year i.e., actual rent was zero, it means that no tax would be charged in that year for the property.

Actual rent should be lower than the notional rent only because of vacancy, and not because
lower rent is being charged. If rent is lesser because of other reasons, then clause (c) is not
applicable.

The intention to let out has to be shown, otherwise the property would anyways be taxable on
notional value.

Section 23(2) states that where the property consists of a house or part of a house which—

(a) is in the occupation of the owner for the purposes of his own residence; or

(b) cannot actually be occupied by the owner by reason of the fact that owing to his employment,
business or profession carried on at any other place, he has to reside at that other place in a
building not belonging to him,
the annual value of such house or part of the house shall be taken to be nil.

There are two categories of house. This was inserted later in 1962. As IT authorities charged
Nehru – his house was vacant, and it was charged tax because of Nehru’s residence at PM
House. Thus, it was considered that at least 1 house should be exempted.

If a person has one house and uses it for his residence (self-occupied house), it is not covered
under section 23 and no tax would be there. If person has 1 house, and the house is vacant (say
because of business/profession/employment in another place. Here also, it would be considered
as self-occupied house and no tax would be charged.

CIT v. Avadh Behari Rohatgi – a judge had personal accommodation in Delhi. As he was a
judge, he shifted to HC residence in Delhi itself. Court held that this provision is only applicable
when house is in different cities. But Delhi HC held that other place doesn’t mean house should
be in other city. Even if in the same city, for purpose of employment or business, person resides
in another location, exemption can still be claimed.

After 2020, exemption has been extended to 2 houses.

There is no question to add notional interest which may arise and to add that in the actual rent.
This

ITAT Delhi Special Bench, CIT v. Moni Kumar Subba, 2011 199 Taxmann 301 – department
was trying to add notional interest which may arise on interest free security deposit to the actual
rent. Court said that anyways there is notional interest where fair rent is estimated, and if it is
higher, it will be taken as rent. Therefore, revenue’s plea was denied.

CIT v. K. Street Light Electric Corporation, 2011 336 ITR 348 – Punjab and Haryana HC.
Owner of property received interest free security deposit which was disproportionate to the rent,
in relation to the actual value of monthly rent. Court considered this colourable device. They
followed McDowell case and said that actual rent would not be followed since it is colourable
device. Rather, Court looked at notional value only, and not the actual value.

In section 23(c), if it is shown that property is vacant despite property being ready to be let out,
and if actual rent is lesser than notional rent, or even zero, then also, actual value will be taken as
the annual value, and there would be no tax.
In a number of cases, Court said regarding section 23(c) that property has to be let out property.
If there is a new property, and a person advertised in newspaper and appointed an agent. Despite
this, he couldn’t let out property, then section 23(c) would apply. Thus, it has to be shown by
assesse is ready to let out. If it is a new property, it does not need to be shown that property has
been let out in the past.

23(c) would apply only when lesser rent is there because of property being vacant, and not
because lesser rent is charged.

If a person has a house which he resides in. For the purpose of employment, he goes to some
other place in a rented accomodation or accommodation provided by employer and house is
vacant. In such case, benefit of section 23(2) can be claimed and no tax would be charged on
person’s own accommodation.

Section 23(3) – The provisions of sub-section (2) shall not apply if—

(a) the house or part of the house is actually let during the whole or any part of the previous year;
or

(b) any other benefit therefrom is derived by the owner.

If a person only has 1 house, but he derives any benefit by letting out the house for a part of the
year, or a part of the house, then benefit of section 23(2) is not available. If say the top floor is let
out, or if house is let out for a few days, then also section 23(2) would apply.

Thus, section 23(2) is subject to section 23(3).

Section 23(4) – Where the property referred to in sub-section (2) consists of more than two
houses—

(a) the provisions of that sub-section shall apply only in respect of two of such houses, which the
assessee may, at his option, specify in this behalf;

(b) the annual value of the house or houses, other than the house or houses in respect of which
the assessee has exercised an option under clause (a), shall be determined under sub-section (1)
as if such house or houses had been let.
If a person has 4 houses in Mumbai, Delhi, Jodhpur and Jaipur. All 4 are self-occupied i.e., there
is no let out, and each house is occupied by the person and his relatives. Then, he can choose any
of the two properties as being self-occupied, and for the rest of the properties, they would be
taxable on a notional basis, even if they are not being let out.

Looking at family culture, partition, etc., through Finance Act, 2020, benefit was extended to 2
houses, earlier it was limited to 1 house.

Thus, person would choose the two houses with higher notional value as being self-occupied.

In section 23(5), if building is held as a stock in trade by a real estate company, and is let out, it
would be covered under house property only.

DEDUCTIONS ALLOWED UNDER HOUSE PROPERTY

There are two deductions allowed under section 24. Income chargeable under the head "Income
from house property" shall be computed after making the following deductions, namely—

(a) a sum equal to thirty per cent of the annual value;

(b) where the property has been acquired, constructed, repaired, renewed or reconstructed with
borrowed capital, the amount of any interest payable on such capital:

Provided that in respect of property referred to in sub-section (2) of section 23, the amount of
deduction or, as the case may be, the aggregate of the amount of deduction shall not exceed
thirty thousand rupees :

Provided further that where the property referred to in the first proviso is acquired or
constructed with capital borrowed on or after the 1st day of April, 1999 and such acquisition or
construction is completed within five years from the end of the financial year in which capital
was borrowed, the amount of deduction or, as the case may be, the aggregate of the amounts of
deduction] under this clause shall not exceed two lakh rupees.

One deduction is standard deduction – which is available to all properties and everyone. It is
30% of annual value. Everyone can claim this without asking any proof or evidence or anything.
All deductions have been clubbed together under this standard deduction.

Second is interest – whatever interest payments are made in relation to the property.
But both these deductions are available only to let out property and not self-occupied property.
For self-occupied property, there is no standard deduction, as there is no annual value. Interest
can be claimed for self-occupied property, as person may have taken loan for construction of
property. But there are two limits – 30,000 Rs. Annual, or 2 lakh rupees annual. These
deductions are provided in the provisos.

2 lakh rupees deduction can be claimed only when following conditions are met:

1. When capital is borrowed on or after April 1, 1999 (as amendment in 1998).

2. Second is building is constructed or acquired within 5 years from the end of year when
capital was borrowed.
3. Third, money was borrowed for construction or acquisition of property, and not for any
other purpose.

Then the person can claim 2 lakh rupee deduction for interest.

In situations when these conditions are not fulfilled, Rs. 30,000 deduction can be claimed.

Earlier, the period was 3 years rather than 5 years.

If a person does not get possession of property within 5 years, person cannot claim deduction of
interest on the EMI being paid. Suppose on April 1, 2022, person borrowed 50 lakhs to book a
flat. Company promised to hand over the flat within 5 years. But due to financial issue/labour
problem, company couldn’t hand over within 5 years. This means person would not be able to
get benefit of deduction.

Here, it is part of tax planning that person lets out the property first whenever he gets the
possession. Then property is not self-occupied and standard deduction and interest deduction is
available without any limit. And then when person is in position to repay the loan, he can occupy
the property.

Where does the income come in self-occupied property – as there is no notional rent also. Here,
person can set off the interest against salary/business income/income from profession, etc.

Suppose property is let out, person can claim benefit of interest even if person has borrowed
capital from a friend/relative. Here, person has to only show that he is paying the interest, and no
certificate has to be shown. While in self-occupied property, benefit of interest can be claimed
only when money is borrowed from an institution authorized to issue a certificate of payment of
interest.

If a person borrowed capital to book a building, then person does not have any building in his
possession. This means that chargeability provision of section 22 is not applicable, then how can
computation provision of section 24 can apply.

Explanation of section 24 provides how such interest can be claimed. Where the property has
been acquired or constructed with borrowed capital, the interest, if any, payable on such capital
borrowed for the period prior to the previous year in which the property has been acquired or
constructed, as reduced by any part thereof allowed as deduction under any other provision of
this Act, shall be deducted under this clause in equal instalments for the said previous year and
for each of the four immediately succeeding previous years.

This provides a mechanism to claim the interest paid before acquisition or construction of
property. Interest shall be deducted in equal instalments for pervious year and each of the 4
immediately succeeding previous years.

Suppose property is acquired in 5 years. In 5 years, 5 lakh interest is paid. 1 lakh can be claimed
in year of acquisition of property, and 1 lakh each in each of the succeeding previous years from
the year of acquiring the property.

Provided also that no deduction shall be made under the second proviso unless the assessee
furnishes a certificate, from the person to whom any interest is payable on the capital borrowed,
specifying the amount of interest payable by the assessee for the purpose of such acquisition or
construction of the property, or, conversion of the whole or any part of the capital borrowed
which remains to be repaid as a new loan.

Suppose a person borrowed capital from someone not authorized to issue the certificate. Then if
self-occupied property, the benefit cannot be claimed. But this condition is not applicable for let-
out property. The only proof required is that someone provided the money, and interest is being
paid for it.

Suppose a person borrowed capital from SBI @ 9% pa and constructed building. He paid interest
for 1-2 years. After that, he decided to shift the loan to HDFC as they provide loan @ 7%. He
took new loan from HDFC to repay the SBI loan. Can he claim benefit of interest paid on taking
new loan to repay original loan. Here, since purpose is to repay original loan, the purpose is not
directly to acquire or construct the property. Revenue argued this is not allowed for benefit.

But legislature said this interest is also deductible as even if not directly, the second loan also is
in relation to acquisition or construction of property.

Explanation has been added to clarify the position—For the purposes of this proviso, the
expression ‘new loan’ means the whole or any part of a loan taken by the assessee subsequent to
the capital borrowed, for the purpose of repayment of such capital.

Thus, if new loan to repay original loan, the interest on it is also deductible.

Thus, if agent is appointed and commission is charged, it is not deductible. There are only two
deductions allowed from house property.

SECTION 25

Amounts not deductible from income from house property— Notwithstanding anything
contained in section 24, any interest chargeable under this Act which is payable outside India
(not being interest on a loan issued for public subscription before the 1st day of April, 1938), on
which tax has not been paid or deducted under Chapter XVII-B and in respect of which there is
no person in India who may be treated as an agent under section 163 shall not be deducted in
computing the income chargeable under the head ‘Income from house property.

This overrides section 24. Suppose under section 24, A in India borrowed 50 lakhs from B in US.
A used the money for constructing building in India. He is paying interest of 1 lakh to B. A can
claim deduction. For B, 1 lakh is income which is taxable under section 9. Section 25 provides
that if A deducts tax at the source on the interest paid, then only he can claim deduction under
section 24. Thus, deduction of interest can be claimed only when TDS is applied for the interest
payment made.

Some relaxations are also provided – if B has appointed C as agent in India, and C is in India
only, then A would not be liable to deduct TDS, as C can be charged in India. TDS is only for
administrative convenience. Since C is there as representative assesse, TDS need not be
deducted.
SECTION 25A

There were three provisions before this – section 25A, 25AA and 25B. Section 25A is an
amalgamation of all these provisions.

Special provision for arrears of rent and unrealised rent received subsequently—

(1) The amount of arrears of rent received from a tenant or the unrealised rent realised
subsequently from a tenant, as the case may be, by an assessee shall be deemed to be the income
from house property in respect of the financial year in which such rent is received or realised,
and shall be included in the total income of the assessee under the head ‘Income from house
property’, whether the assessee is the owner of the property or not in that financial year.

(2) A sum equal to thirty per cent. of the arrears of rent or the unrealised rent referred to in sub-
section (1) shall be allowed as deduction.

If we receive rent as arrears, or receive the rent which is unrealized, then how such rent should
be treated. Unrealized rent – tenant becomes defaulter and doesn’t pay rent. But after some years,
due to court order or settlement, he pays rent. This is unrealized rent.

Arrears of rent – when the rent is increased from retrospective effect, then rent would be
received in the form of arrears.

Both arrears and unrealized rent are subject to two deductions. Section 25A itself is a charging
provision, and condition of section 22 is not applicable. The title ‘special provision’ means that
section 22 is not applicable. Condition of section 22 is that there should be a building, and it
should be owned by the person. Here, even if building or owner is not there, still, arrears are
received subsequently, income is chargeable under section 25A.

SECTION 26

Property owned by co-owners—Where property consisting of buildings or buildings and lands

appurtenant thereto is owned by two or more persons and their respective shares are definite and
ascertainable, such persons shall not in respect of such property be assessed as an association of
persons, but the share of each such person in the income from the property as computed in
accordance with sections 22 to 25 shall be included in his total income.
Explanation—For the purposes of this section, in applying the provisions of sub-section (2) of
section 23 for computing the share of each such person as is referred to in this section, such share
shall be computed, as if each such person is individually entitled to the relief provided in that
sub-section.

When building is owned by more than one person. Suppose 4 persons are co-owners of building,
then whether it is taxed individually, or as association of persons. If the portions of buildings are
definite and ascertainable, then all would be considered as individual assesse for section 22, and
each will be individually liable for payment of tax, and can individually claim benefits.

If portions are not definite or ascertainable, then they are taxable as association of persons.

Scheme of making it part of total income

There is gross annual value (actual or notional). After that, house tax and other municipal and
local taxes are deductible. After this, we get net annual value. On it, there is 30% annual
deduction and interest deduction. After this, we get taxable income from house property which is
part of total income.

There is no requirement of income coming from building, but requirement of building itself.
Suppose BJP has 100 offices – whether they are taxable. No, political parties are exempted from
tax under section 10(13A).

Buildings owned by trade unions are also exempted under section 10.

For ex-rulers, one palace is exempted under section 10.

If building is owned by a club on the principles of no profit no loss (for members only). Court
has said that principle of mutuality would be applicable, and it would not be taxable. Chelmsford
Club v. CIT, 2000 243 ITR 89 SC.

Other buildings which are exempted:

i. Income from farm house – section 10(1).

ii. Annual value of any one palace of ex-ruler – section 10(19)(a).
iii. Property income of local authority such as municipality or Nagar Nigam – section
10(20).
 iv. Property income of an approved scientific research association – section 10(21).
v. Building owned by hospitals or educational institutions – section 10(23)(c).
vi. Property income of a trade union – section 10(24).
vii. House property held for charitable/religious purpose – section 11.
viii. Building owned by political parties – section 10(13A).
ix. Building occupied to carry on own business or profession or self-occupied property –
section 22.

Regarding applicability of DTAA – if property is outside India, and person is earning rent out of
it. First, we have to see whether person is resident or non-resident. DTAA provides any income
from immovable property is taxable where the property is situated, and not where the person is
situated. Thus, country which has jurisdiction over the property has the right to tax.

PROFITS OR GAINS FROM BUSINESS OR PROFESSION [SECTION 28-44]

Here, we are not determining income or profits in business. The profit in the profit and loss
account or receipt and expenditure account is taken. As everyone has to maintain these accounts.
IT Act provides that profits as per profit and loss or receipt and expenditure account would be
taken, but we will make adjustments over it, as accounting standards are not applicable to IT Act.

Thus, every person will have to maintain two sets of profit and loss account and receipt and
expenditure account, as some expenditures can be allowed in accounting standards, while they
are not allowed for IT Act.

For instance, under IT Act, freebies provided by pharmaceutical companies to doctors are not
allowed as deduction under IT Act for these companies. While companies can claim these as
expenditures under accounting standards.

Thus, we have to test the expenditure on the basis of various conditions and judgments whether it
is allowed or not allowed to be claimed.

In Delhi HC, a case related a person who purchased 10 Armani suits, and claimed them as
business expenditure under section 37 of IT Act. For accounting standards, it was allowed. But
Court held that it is not allowed under section 37. As it cannot be ascertained how many of the
suits are for the purpose of business.
Thus, every receipt and expenditure is tested on the basis of IT Act, and accounting standards are
not binding on IT Act.

We are not calculating profits or losses, but are just making adjustments based on IT Act.

Capital receipts cannot be business income. Thus, the moment something is taxable as business
income, it means it is a revenue receipt. In accountancy, there is deferred revenue expenditure –
expenditure has a lifespan of say 10 years. But in tax, there is no concept of deferred revenue.
For IT Act, it can only be revenue or capital. If capital, it is not covered under business and
profession and if revenue, it is taxable as business income.

SECTION 28

Section 28 is a charging provision under business and profession. It is divided in two parts. First
part is a general charging provision and second part is a special charging provision –
particular/specific transactions which are covered as business income, which may look like
capital receipt, but are chargeable as revenue receipts under business income. For instance,
compensation received for the loss of agency. Loss of agency means commercial rights loss and
therefore looks like capital receipt. But it is covered under section 28 as a revenue receipt.
Similarly, non-compete and not to carry on business, against which compensation is received, is
a transfer of right. This also looks like a capital receipt, but is covered as a revenue receipt.

The following income shall be chargeable to income-tax under the head "Profits and gains of
business or profession",—

(i) the profits and gains of any business or profession which was carried on by the assessee at any
time during the previous year;

Profits and gains of business and profession are chargeable under IT Act. There has to be a
business or profession carried on by assesse at any time in the previous year i.e., April 1, 2022 to
March 31, 2023. If a person has a plant, but has not started functioning, then section 28 would
not be applicable. Even if business has started on 31st March, still it would be taxable.

Business and profession are defined. Section 2(13) defines business and section 2(36) defines
profession. For tax treatment purpose, there is no difference between business and profession.
Business has an inclusive definition and includes any trade, commerce or manufacture or any
adventure or concern in the nature of trade, commerce or manufacture.

Commerce is a wider aspect than trade. Here, service is not included specifically. If commerce is
applied in a wider perspective, service can also be included in it.

Essential characteristics to constitute a business

If an FII has invested and purchased shares in India, is this considered as an investment or
trading assets. If shares are considered trading assets, then it is business. If trading assets are
sold, it is business income. While if investment, which is capital, is sold, it is a capital gain.

If a dealer is holding land, it is a trading asset. But if he holds land as investment, then it would
be capital gain.

How to decide whether holding is as a trading asset or as an investment i.e., whether it is

business or capital gain.

If shares held by FIIs are considered as trading assets, then it is business income. Business
income can only be taxed as per DTAA when there is permanent establishment in India.

There is circular no. 4 of 2007 which was issued to clarify the issue as to shares held by assesse
as a trading asset or investment asset. It gave some criteria, but was not a conclusive test.
Determination has to be based on facts and circumstances.

In 2015, Amendment came which was imposed by government due to different treatment of
shares by FIIs. Shares held by FIIs were considered investment assets under section 2(14), as
accounting treatment was not binding on the IT Act. Generally seen, shares held by FIIs are for a
long time. They can be treated as both investment or trading assets for purpose of accounts. But
since this is not applicable, determination would have to be made on the facts and circumstances.

Even if no risk factor, no profit motive, no organized or continuous activity, still it can be a
business. As the term mentioned is ‘adventure’, it can be a single isolated activity also.

If there is trading asset, then the trader does various acts to earn profits. But for investment asset,
investor does nothing but depends on the market for profits.
Suppose a person holds a 10-acre plot as an investment asset and wants to sell his plot. There
was a willing buyer to purchase the entire plot. But the person still divides the plot into small
plots and then sells them to individual buyers. Whether it is capital gain or business income.
Although this was an investment asset, this is not a capital gain. It is not a business, but looks
like a business. Even if it is not organized or continuing activity, since there is a profit
motive involved, and some planning and efforts are made, it would be considered an
adventure in the nature of business.

Here, if it is proved that there was no buyer for the entire plot, and therefore, he sold to
individual buyers, it would be considered as capital gain.

If a person invented something, manufactured it, and sold them in the market. Whether this is
business income or income from other sources. It is not a business, but looks like a business.
Here, the primary intention is not important, but the subsequent conduct is important.

ITO v. Rani Ratnesh Kumari, 1980 123 ITR 343 Allahabad HC – similar facts to the plot case.
HC said that in order to find out whether a transaction is an adventure in the nature of trade, the
initial intention is important, but not determinative. The subsequent conduct is also important.
The relevant facts to be seen in this behalf are: firstly, as to whether the transaction in dispute
was not in the line of the business of the assessee and secondly, whether it was an isolated or a
single instance of the business or there was a series of similar transactions. 

Thus, how the assesse is treating the asset is decisive. Not the nature of asset, but the nature of
operation (how the assesse treats it) is important.

In one case, Court considered that if money is borrowed from a friend to purchase shares, the
Court said it is a business income. As normally, for investment, money is not borrowed, rather, it
is own money which is invested. If money is borrowed, then it means that person wants to trade
in shares and earn profits out of them.

Thus, the facts and circumstances of the case are important.

CIT v. Prabhu Dayal 1971 82 ITR 802 SC – it is not necessary that to constitute trade, there
should he a series of transactions. Even an isolated transaction can be considered trade if it
has clear indica of trade – risk factor, profit motive, planning, etc.
Profit motive is not an important factor for business. Even if there is no profit, but there is a
commercial or business activity, it is taxable under IT Act.

Profession is not defined. It is just said that profession includes vocation. Vocation is also not
defined under IT Act. But business is also a vocation. Then what is the difference between
business and profession. As if profession includes vocation, it means profession includes
business also.

For IT Act, for tax treatment, there is no difference between business and profession.

CIT v. Manmohan Das, 1966 59 ITR 699 – profession is something where special knowledge or
intellectual skill required. But in business also, some skill is required depending on the nature of
the business.

But for IT Act, there is no difference between business and profession.

CIT v. Abdul Ghani Murtezi, 1995 2013 ITR 738 Raj HC – at that time, there was gift tax Act,
and gift was included in IT Act only in 1998. Question was whether assesse who received
voluntary payments would be part of business income or gifts. Voluntary payments were made to
persons such as gurus, etc. So whether such money received by the person would be income
from profession or income from other sources (gift). Here, the assesse was a khadim in dargah. A
person made some payments to the khadim of around Rs. 1 lakh to show his return for the
blessings received.

Court discussed income from business and profession, and held that this was income from gift.
This was because donations were received from his personal quality and high esteem, and is
not part of performance of his normal duties. Thus, it is not income from profession.

Thus, payments to priests, gurus (not trusts), because of their high esteem, then it would be
taxable as income from other sources (gift), and not income from profession.

If payment is made to trusts, different provisions are applicable, and they are not taxable in any
case.

Suppose payments made to sportspersons or actors – what is received from exercising one’s
skills and normal functions is income from profession. But if say a fan or supporter makes some
voluntary payments or gifts, it is taxable as income from other sources. We have to see whether
he is rendering his ordinary services and receiving in lieu of that (such as from director,
producer, etc.), or whether because of his personal quality.

Section 28(ii)

It is a special charging provision and includes all types of compensation received by the assesse.
It has included various types of compensation taxable as revenue receipts. Any compensation or
other payment due to or received by—

(a) any person, by whatever name called, managing the whole or substantially the whole of the
affairs of an Indian company, at or in connection with the termination of his management or the
modification of the terms and conditions relating thereto;

(b) any person, by whatever name called, managing the whole or substantially the whole of the
affairs in India of any other company, at or in connection with the termination of his office or the
modification of the terms and conditions relating thereto;

(c) any person, by whatever name called, holding an agency in India for any part of the activities
relating to the business of any other person, at or in connection with the termination of the
agency or the modification of the terms and conditions relating thereto;

(d) any person, for or in connection with the vesting in the Government, or in any corporation
owned or controlled by the Government, under any law for the time being in force, of the
management of any property or business;

(e) any person, by whatever name called, at or in connection with the termination or the
modification of the terms and conditions, of any contract relating to his business;

First is for Indian company, and second is any company in India.

If there is termination of agency (which is a right), it is an extinguishment of a right, which is a

capital asset. But by making special charging provision, it is made a revenue receipt.

The last point incorporates the general situation. This has been added as a residuary provision by
Amendment Act of 2018. In general case, if there is termination of any contract relating to a
business, it would fall under the fifth provision, and it would be treated as revenue receipt.
Before amendment, there was confusion as to whether it is taxable as a revenue receipt or a
capital receipt.

Section 28(iii) - income derived by a trade, professional or similar association from specific
services performed for its members. Thus, if any income is received from any specific service
performed, it is taxable here. For instance, chairman of FICCI, or Bar Council or BCCI.

Section 28(iiia-e) are export incentive provisions.

(iiia) profits on sale of a licence granted under the Imports (Control) Order, 1955, made under
the Imports and Exports (Control) Act, 1947 (18 of 1947);

(iiib) cash assistance (by whatever name called) received or receivable by any person against
exports under any scheme of the Government of India;

(iiic) any duty of customs or excise re-paid or re-payable as drawback to any person against
exports under the Customs and Central Excise Duties Drawback Rules, 1971;

(iiid) any profit on the transfer of the Duty Entitlement Pass Book Scheme, being the Duty
Remission Scheme under the export and import policy formulated and announced under section
5 of the Foreign Trade (Development and Regulation) Act, 1992 (22 of 1992);

(iiie) any profit on the transfer of the Duty Free Replenishment Certificate, being the Duty
Remission Scheme under the export and import policy formulated and announced under section
5 of the Foreign Trade (Development and Regulation) Act, 1992 (22 of 1992);

In (a), license is capital asset, as it gives the right to do business. Trading asset is a stock in trade
(inventory) i.e., in which the person is dealing. Any license is a capital asset, as it gives the right
to carry on a business.

Goods can be privated goods which no one is allowed to import. Some are licensed goods, on
which import is permitted upon grant of license. Thus, if there is import license, it is capital
asset, but is still taxable as revenue receipt. These were brought under business income as it was
not possible to cover them in capital gains (discussed later).
In (b), exports are normally tax free as they are important source of foreign exchange. Any cash
assistance received by exporter from any scheme of export incentives would be taxable as
income from business and profession.

In (c), exports are tax free. But to purchase raw materials, GST has to be paid. Thus, taxes are
paid on domestic consumption of purchase, manufacturing, transport, etc. These taxes can be
claimed as duty drawback from the government under the Customs Act and Duty Drawback
Rules. This is also covered as income from business.

In (d) and (e), duty entitlement passbook and duty-free replenishment certificate. Here, remission
can be claimed. If such certificates are transferred, the transfer is subject to tax on business and
profession, even thought right is transferred, making it capital asset.

In section 28(iv), the value of any benefit or perquisite, whether convertible into money or not,
arising from business or the exercise of a profession. Perquisites are additional benefits given to
employees. But employees are covered under salary. However, if being a professional or in
business, perquisites are received from the clients, such as free accommodation, free travel, etc.
Even if it is monetary or non-monetary, if professional or businessman receives any perquisite, it
is taxable. If in kind, the same rule of conversion into money applied for employees would apply.

A person was director of a company. Company provided a big house in Delhi with car. He was
also finance secretary, so was provided house. He had to pay tax for benefits or amenities
received in the course of business of profession. But professionals were not taxable. Therefore,
amendment was made in 1962.

In section 28(v), any interest, salary, bonus, commission or remuneration, by whatever name
called, due to, or received by, a partner of a firm from such firm. But this is subject to section 40.
The partnership firm cannot provide any amount as salary. If salary has to be claimed as a
deduction or exemption under IT Act, section 40 has to be followed.

There is a similar explanation under section 15 as well.

Proviso provides that where any interest, salary, bonus, commission or remuneration, by
whatever name called, or any part thereof has not been allowed to be deducted under clause (b)
of section 40, the income under this clause shall be adjusted to the extent of the amount not so
allowed to be deducted.

Thus, salary, remuneration, bonus, etc. is subject to section 40(b) which gives various
considerations such as paid up capital or gross receipts.

Section 28(va) – any sum, whether received or receivable, in cash or kind, under an agreement
for—

(a) not carrying out any activity in relation to any business or profession; or

(b) not sharing any know-how, patent, copyright, trade-mark, licence, franchise or any other
business or commercial right of similar nature or information or technique likely to assist in the
manufacture or processing of goods or provision for services:

Under capital gains, compensation under non-compete agreements cannot be taxed as capital
gains. Before 2002-03, such compensations, being capital receipts, were not taxable. But after
that, amendment was made to cover these as revenue receipts in IT Act. Any negative covenants
for not carrying on business or profession are taxable.

Partial restraints on trade are allowed, not absolute restraints. However, for IT Act, this doesn’t
matter. Enforceability of agreement is not relevant for IT Act. Also, whether the source is legal
or illegal is of no importance. If any sum is received for non-compete agreement, it is taxable.
Thus, even illegal sources of income are taxable.

Explanation—For the purposes of this clause—

 (i) "agreement" includes any arrangement or understanding or action in concert—

(A) whether or not such arrangement, understanding or action is formal or in writing; or

(B) whether or not such arrangement, understanding or action is intended to be enforceable by

legal proceedings;

Thus, even though non-compete is absolute, the compensation is still taxable.

Here, this is a revenue receipt. But the problem is what would be the nature of this expenditure
for the payer – whether it is a capital or revenue expenditure. Before 2003, even receipt was a
capital receipt. So can it be said it is still a capital expenditure in the hands of payer. If it is
revenue expenditure, it is allowed as a deduction. But if it is capital expenditure, it is not allowed
as deduction. Also, if capital expenditure, it should lead to creation of a capital asset. On such
capital asset, even if a right, whether depreciation has to be there. As all commercial rights, even
if intangible, are depreciable. But this position has not been clarified. In some cases, Courts have
held this as revenue expenditure, while in others, it has been held as capital expenditure.

If something is not taxable in capital gains, then it would automatically be taxable in section
28(va). In capital gains, difference between consideration and cost of acquisition is capital gain.
SC has said in 1981 that if cost of acquisition is not discernible or there is no cost of acquisition,
then it would not be taxable as capital gain. In case of self-generated goodwill where cost of
acquisition is not ascertainable, Court has said there would be no capital gain. But to nullify this,
goodwill has been made taxable under section 28 where cost of acquisition is considered nil
and any cost paid over and above the assets is the goodwill.

For transfer of right to carry on business (in case of non-compete), it is also a self-generated asset
and there is no cost of acquisition. Because it is not taxable as capital gain, the legislature
brought it under section 28(va).

Guffic Chem P. Ltd. v. CIT, 2011 332 ITR 602 SC – here, company was a pharmaceutical
company which transferred its TM to Ranbaxy. Ranbaxy gave 50 lakh rupees as a non-compete
that Guffic would not carry similar business for 20 years. Agreement was under 1997-98.
Department wanted to tax this income. Assesse said there is no provision which taxes such
receipt, as this is capital receipt but there is no cost of acquisition. Department said since
amendment in 2002-03, it should be given a retrospective effect since it is clarificatory in nature.
But Court said that since it is amendatory in nature, it will only be given prospective effect.
Therefore, income was not taxable.

Court has also discussed whether it is revenue or capital expenditure. If revenue expenditure, it
can be claimed as full exemption. Suppose Bikaji gave 50 lakhs to Haldiram for not selling
Bhujia in Jodhpur for 20 years. For Haldiram, this is revenue receipt under section 28. But for
Bikaji, whether this is capital expenditure. For this, we need to see whether any capital asset is
purchased. Here, not goodwill, but only right to carry on business or sell the product in Jodhpur
is purchased. Right is also a capital asset. Right to practice trade and profession is also a self-
acquired right.
If logic of taxability in hands of recipient is brought, the same cannot be brought for payer. If
receipt was capital receipt before 2003, can expenditure be considered capital expenditure. Also,
since capital assets are depreciable, whether depreciation can be claimed on the capital asset. In
physical assets, buildings, plant and machinery and fixtures and furniture are depreciable. But in
intangible assets, all commercial, intellectual, etc. rights are depreciable. Because rights such as
patent, copyrights, etc. are for a fixed period (lifespan), depreciation is allowed on them under
section 32. Also, irrespective of lifespan of the right, they are depreciable. Thus, TMs are also
depreciable. Lifespan is important to determine the rate of depreciation, which is fixed in the
accounting standards.

Thus, rights are depreciable.

Indo Global Corporation Finance Limited v. ITO, 2012 ITAT Mumbai – assesse transferred his
merchant banking business. the purchaser paid 5 million to MD and 10 million to company as
non-compete. Assesse himself treated it as deferred revenue expenditure since agreement was for
3 years. But there is no such concept in IT Act. Department claimed that it should be
considered as capital expenditure since it is for lifespan. Court accepted this. Also, since
right has a lifespan of 36 months, Court allowed depreciation on that. Thus, benefit was given to
assesse as he could write off it in some years.

Delhi Special Bench ITAT, Ace Tecumseh v. ACIT, 2010.

Chennai ITAT, ACIT v. Real Image Tech Private Limited, 2009.

In all these cases, issue was whether payment made by assesse to recipient to have non-compete
or restrictive covenants was revenue or capital expenditure. It was considered capital
expenditure. Also, depreciation was allowed on the capital asset.

Court has also held that since goodwill is a commercial/business right, it should be subject to
depreciation.

Amendment was made in Finance Act, 2021, where, in section 32, it was added that goodwill
and other business rights are not depreciable. This Amendment came to nullify the effect of
judgments.
Under section 28(vi), any sum received under a Keyman insurance policy including the sum
allocated by way of bonus on such policy.

Explanation provides that Keyman insurance policy shall have the meaning assigned in section
10(10D).

It is the policy taken by the employer on the life of an employee. Keyman is an important person
in the factory or office. Thus, if during the life, any sum allocated or any bonus under this policy
is taxable as revenue receipt.

In section 28(via), the fair market value of inventory as on the date on which it is converted into,
or treated as, a capital asset determined in the prescribed manner

When stock in trade is converted into capital asset – the conversion is in the books of accounts
only. Here, there is no income, as there are only debit and credit entries in the books. Here, the
fair market value of inventory as on the date of conversion would be considered the income and
would be taxable as revenue receipt. Suppose a person has a jewellery shop and he closes it. He
will convert the jewellery which was his trading asset into capital asset. Similarly, a dealer of
land can convert his land into capital asset if he stops the business of dealing in land.

In section 28(vii), any sum, whether received or receivable, in cash or kind, on account of any
capital asset (other than land or goodwill or financial instrument) being demolished, destroyed,
discarded or transferred, if the whole of the expenditure on such capital asset has been allowed as
a deduction under section 35AD.

Section 35AD talks about certain deductions of a specified business. For instance, if a hospital is
constructed, money is spent on construction, which is a capital expenditure, but it can be claimed
as deduction. Suppose after a few years, person sells the hospital. He earns income out of the
sale. This income would be taxable under section 28. Person cannot claim double benefits by
claiming full capital expenditure and enjoying the sale also.

This provision was added in 2009.

CIT v. TB Sundaram Iyenger and Sons, 1996 222 ITR 344 SC – Court explained the concept of
revenue receipt and capital receipt. The nature of receipt is important and its treatment in the
hands of the assesse. For instance, if a person borrowed 10 lakhs from another. The loan is a
capital receipt. After 2 years, due to some limitation or contractual arrangement or settlement,
the money does not have to be paid back. The person puts money in the general reserve. Whether
this amount is the income of the person or not i.e., whether the nature of receipt has changed.
This is an income as it is extinguishment of liability. Person has to right off the liability.
Therefore, it is an income.

Explanation 2—Where speculative transactions carried on by an assessee are of such a nature as

to constitute a business, the business (hereinafter referred to as “speculation business”) shall be
deemed to be distinct and separate from any other business.

It is read with section 43(5) and section 73. Here, distinction is created between general business
and speculative business because of section 73. Section 73 says these will be treated differently.
Thus, loss in speculative business cannot be set off against profits from general business. As
speculative business involves risk. Speculative business involves business in stock market,
derivatives market, futures trading etc. where there is more risk factor.

Section 43(5) defines speculative transaction as a transaction in which a contract for the purchase
or sale of any commodity, including stocks and shares, is periodically or ultimately settled
otherwise than by the actual delivery or transfer of the commodity or scrips.

If the transaction is leading to business, it is a speculative business.

But there are some exceptions to speculative transactions also. For instance, if a person is dealer
of wheat and enters into future trading contracts, it is not a speculative transaction, because the
person is dealing in such commodities. Thus, it is general business. But if a person is dealer of
wheat, and enters into future trading of jewellery, it is a speculative transaction.

Similarly, if a broker deals in share markets, it is a general business.

Proviso to section 43(5) gives 5 transactions which are generally speculative, but are considered
as exceptions:

Provided that for the purposes of this clause—

(a) a contract in respect of raw materials or merchandise entered into by a person in the course of
his manufacturing or merchanting business to guard against loss through future price fluctuations
in respect of his contracts for actual delivery of goods manufactured by him or merchandise sold
by him; or

(b) a contract in respect of stocks and shares entered into by a dealer or investor therein to guard
against loss in his holdings of stocks and shares through price fluctuations; or

(c) a contract entered into by a member of a forward market or a stock exchange in the course of
any transaction in the nature of jobbing or arbitrage to guard against loss which may arise in the
ordinary course of his business as such member; or

(d) an eligible transaction in respect of trading in derivatives referred to in clause (ac) of section
2 of the Securities Contracts (Regulation) Act, 1956 carried out in a recognised stock exchange;
or

(e) an eligible transaction in respect of trading in commodity derivatives carried out in

a recognised stock exchange, which is chargeable to commodities transaction tax under Chapter
VII of the Finance Act, 2013,

shall not be deemed to be a speculative transaction.

A direct nexus is required between the business carried out and the speculative transaction.
Being a jeweller dealing in jewellery, if a person enters into future trading with respect to
diamond, there is a nexus. Hence, it is excepted.

S. Vinod Kumar Diamonds Private Limited v. ITO 2013 35 Taxmann ITAT Mumbai – direct
nexus has to be there between the commodity in which a person deals, and the commodity in
which future trade is undertaken.

These transactions look like speculative transaction, because contract is settled without actual
delivery, but since person is dealing in them in the ordinary course of business, it is considered
general business.

Burden is on assesse to prove that it is the hedging contract, or he is dealing in same commodity
leading to it being general business. It has been held in CIT v. Joseph John, 1968 67 ITR 74 SC.

There are two ways a contract is settled – without breach, or followed by breach settled with the
quantum of damages without actual delivery. In breach also, contract is settled through damages,
and without actual delivery. But this is not a speculative transaction. Only if a contract is
settled without breach and without actual delivery, it is a speculative transaction. It has
been held in Davenport and Company Pvt. Ltd. v. CIT, 1975 100 ITR 715 SC.

Actual delivery is opposed to notional delivery – actual delivery means transfer of possession. If
just a delivery note is transferred, it is still a speculative transaction.

CIT v. Bhagwandas Rameshwar Dayal, 1984 149 ITR 387 Delhi HC – If it is a repeated activity,
then only it would be a business, and would be considered for purpose of seeing speculative
transaction.

Person was a dealer of land. But his assets were considered fixed assets. Later, there was transfer
of land. Revenue wanted to tax it as business income since land is stock in trade. But Court said
since assesse himself has treated it as fixed asset, the land would not be treated as a trading asset.
There is no restriction or limitation on the assesse in IT Act from doing so. Pune ITAT case
decided this very recently.

DEDUCTIONS OR EXPENDITURES ALLOWED UNDER IT ACT FROM BUSINESS INCOME

Section 29 provides that income referred to in section 28 shall be computed in accordance with
the provisions contained in sections 30 to 43D.

Section 30 to 43D are the provisions which allow deductions or expenditures from business
income. Section 30 to 36 are specific deductions for particular purpose or activities. Section 37 is
a general deduction which is very controversial. Revenue always tries to restrict its scope to
disallow the claim, and assesse tries to widen it to claim deduction.

Section 40, 40A and 43B override the other provisions which allow deductions. Only if these
conditions are fulfilled, deductions can be claimed. Otherwise, no deduction is allowed. Section
40A has overriding effect over all other Acts in India, even the Contract Act.

Section 41 relates to deemed profit. Section 41 itself is a charging provision. Thus, section 28
ingredients are not relevant. Any income arising under section 41 shall be taxable under section
41 itself.

Some deductions are allowed by SC even though there is no provision under IT Act. It is allowed
just on the basis of general commercial principle – to tax a real/true income. SC has allowed
deductions of trading/business loss. There are two losses – loss from the business, and loss in the
course of business. Loss arising in course of business is called business/trading loss. And loss
from the business is the profit and loss account where expenditure is more than receipts. It is not
loss in the course of business, but loss from business. It is not covered here. But loss in the
course of business which is incidental to business is allowed under section 29. SC has allowed
such losses to be claimed as deduction based on general commercial principles.

Suppose there is robbery in banks and cash is taken. It is loss in the course of business i.e.,
trading loss, since for a bank, cash is a trading asset. It is incidental to business, it is revenue in
nature, and it is actual loss, not anticipated. Such loss is not covered in any provision. But SC has
said that such loss should be allowed to be claimed as deduction.

This is a question of fact based on nature of operation of business, risk involved in the business,
etc.

Also, to allow such deduction, there is no difference between legal and illegal business. As
general commercial principles would apply in both legal and illegal businesses. For instance, if a
person is a smuggler of currency notes or jewelry, which constitute his stock in trade. Such
smuggled item is confiscated from the house of smuggler by the authority on a raid. Whether this
is a trading loss – on basis of general commercial principles, even this loss should be allowed.
SC has held in 2006 that this loss should be allowed. As profits from such illegal businesses are
taxable.

TA Qureshi v. CIT, 2006 157 Taxmann 514 – legal and illegal business. Loss from illegal
business is allowed to be claimed as deduction. HC decided case based on morality. But SC
reversed it. Person was a doctor, but was also running business of dealing in narcotics. CBI
arrested this person, and raided office, and confiscated narcotics. For the filing of return under IT
proceedings, he claimed this confiscation as a business loss. Assessing officer disallowed. ITAT
allowed. HC disallowed. Matter to SC.

HC decided the case based on section 37 explanation 1. This was added through amendment in
1998 with retrospective effect from 1962. For the removal of doubts, it is hereby declared that
any expenditure incurred by an assessee for any purpose which is an offence or which is
prohibited by law shall not be deemed to have been incurred for the purpose of business or
profession and no deduction or allowance shall be made in respect of such expenditure.

HC decided on this basis. Since what person was doing is an offence, it is not allowed.

Question before SC was also to see difference between business expenditure and business loss.
In expenditure, there is a consent or obligation. But in loss, there is no consent or obligation.
Here, it was a loss, as contraband was loss.

Thus, section 37 was not applicable as here, it was not an expenditure for the purpose of an
offence. And the case concerns trading loss as per section 29. Thus, HC decision was not correct.
SC said that HC adopted an emotional and moral approach rather than legal approach. although
assesse conducted a wrongful act, law has to be kept separate from morality. Decision cannot be
based on moral grounds. If a person is being asked to pay tax on an illegal activity, he should
also be allowed to claim deduction for loss. Also, there is no provision which prohibits claiming
such loss from illegal activity.

IT Act 1922 case – Calcutta Company Ltd. v. CIT, 1959 37 ITR 1 SC – Court led down some
conditions for claiming business loss under IT Act:

1. Loss should be revenue in the nature. Capital loss is not allowed in business loss.
2. Loss should be incurred during the previous year.
3. Loss should be incidental to business or trade.
4. It should be real and not notional loss or anticipated loss.
5. It should have been actually incurred not merely anticipated.
6. There should not be any direct or indirect restrictions under the Act.

If all these conditions are fulfilled, trading loss can be allowed even in case of an illegal
business.

SC discussed meaning of incidental to trade/incidental to business. Cit v. Nainital Bank Ltd.,

1965 55 ITR 707 SC.

In 2008, a case was decided by HC. A person was a business dealer in tobacco and was in forest
area of MP for a business tour. He was kidnapped. He paid ransom of 40 lakhs. He claimed this
as a business expenditure. Question was whether it is hit by explanation 1. The purpose here is
payment of ransom which is not offence. High Court allowed the expenditure.

Court has also allowed expenditure to be claimed for voluntary payments in form of gifts,
houses, vehicles to employees on the basis of commercial expediency.

Thus, if there is a loss, there is no question of legal or illegal. But if expenditure, it has to be
looked whether it is for a legal or illegal purpose.

CIT v. Piyara Singh, 1980 124 ITR 40 SC – SC discussed legal or illegal and allowed
expenditure. Person was smuggler of currency notes. He was caught on Rajasthan border and the
currency was confiscated. He claimed this as a business loss. The Court allowed it.

Section 30 provides for specific deductions for expenditures incurred for running any building.
In respect of rent, rates, taxes, repairs and insurance for premises, used for the purposes of the
business or profession, the following deductions shall be allowed—

(a) where the premises are occupied by the assessee—

 (i) as a tenant, the rent paid for such premises; and further if he has undertaken to bear the cost
of repairs to the premises, the amount paid on account of such repairs;

(ii) otherwise than as a tenant, the amount paid by him on account of current repairs to the
premises;

(b) any sums paid on account of land revenue, local rates or municipal taxes;

(c) the amount of any premium paid in respect of insurance against risk of damage or destruction
of the premises.

If own building, then water tax, etc. can be claimed as deductions. Also, repairs on building can
be claimed as deduction – repairs for preservation and maintenance of the building. For instance,
repairing door is allowed which is a current repair. But if any asset (such as door or floor) has to
be changed, it is not a current repair, but an accumulated repair, which is not allowed to be
claimed as deduction.

Any rent (if as a tenant, person is running a business in building), it can be claimed as deduction.
Similarly, insurance premium paid can be claimed as deduction.
Repairs and insurance of plant, machinery and furniture can be claimed as deduction.

Depreciation – diminution in the value of an asset. All tangible assets (except land) are subject
to depreciation due to wear and tear.

There are following categories of assets for purpose of depreciation:

1. Building – there are 3 categories of depreciation here. For residential building, 5%

depreciation, for commercial building, 10%, and for temporary structures, 100%
depreciation.
2. Plant and machinery – here, there are 8 different rates of depreciation. Different assets are
subject to different rate of depreciation.
3. Furniture and fittings – they are subject to fixed 10% rate of depreciation.
4. Intangible assets – here also, depreciation is allowed. For all intangible rights, be it IPR
or other commercial rights, there is fixed depreciation of 25%. It is amortization –
exploitation of asset for generating revenue. If revenue is taxable, then asset used for
generating it should be allowed to be claimed as depreciation. For any asset, there is a
lifespan, so there is decreasing value based on that. Thus, the rate also varies.

Under section 32, it is called depreciation allowance.

There are two methods of depreciation – written down value method, and straight line method.

In straight line method, it is not related with the wear and tear, or exploitation of asset. A fixed
rate of depreciation based on the lifespan is charged.

In written down value, it is based on the exploitation of the asset. The accumulated depreciation
is subtracted from the asset’s original value.

In income tax calculation, written down value method is mandatorily to be followed.

Another different with accounting standards is that in AS, depreciation can be claimed on
individual assets. While in IT Act, depreciation is chargeable on the block of assets.

First, asset should be chargeable with depreciation. Thus, depreciation is not chargeable on all
capital assets, but only on the above categories of eligible assets.
Secondly, these assets should be owned by the assesse. Ownership does not only mean legal
ownership. Even lessee, deemed owner, beneficial owner, etc. can be considered owner for the
purpose of claiming depreciation.

Third, these assets should be used in the business or profession in order to claim depreciation. If
an advocate uses one floor for residence and other floor for office, then depreciation can be
claimed only on 1 floor.

Fourth, it is not required that all assets must be actively used, even passive use is allowed. But
the assets must be ready to use. Suppose 90 machines are used and 10 are kept as spare,
depreciation can be claimed on 100 machines.

Section 32(1) In respect of depreciation of—

 (i) buildings, machinery, plant or furniture, being tangible assets;

(ii) know-how, patents, copyrights, trade marks, licences, franchises or any other business or
commercial rights of similar nature, being intangible assets acquired on or after the 1st day of
April, 1998, [not being goodwill of a business or profession,]

owned, wholly or partly, by the assessee and used for the purposes of the business or profession,
the following deductions shall be allowed—

 (i) in the case of assets of an undertaking engaged in generation or generation and distribution of
power, such percentage on the actual cost thereof to the assessee as may be prescribed;

(ii) in the case of any block of assets, such percentage on the written down value thereof as may
be prescribed.

Except for business engaged in generation of power or generation and distribution of power, all
business are required to charge depreciation based on written down value for purpose of IT Act.

Explanation 3—For the purposes of this sub-section, the expression "assets" shall mean—

(a) tangible assets, being buildings, machinery, plant or furniture;

(b) intangible assets, being know-how, patents, copyrights, trade marks, licences, franchises or
any other business or commercial rights of similar nature, not being goodwill of a business or
profession.
To nullify the effect of SC decision of including goodwill for the purpose of depreciation, the
legislature came up with 2021 Amendment to exclude goodwill from the purview of
depreciation.

CIT v. Smifs Securities Ltd., 2012 348 ITR 302 SC – Court allowed depreciation on goodwill.

Techno Shares and Stockbrokers Private Limited v. CIT, 2010 193 Taxmann 248 SC – question
was regarding membership card of BSE. Company claimed this membership card is depreciable
since it gives commercial right to trade on stock exchange. SC allowed this as a
business/commercial right. But SC limited the judgment only to BSE membership card, and
didn’t extend it to any other such license or right to carry on business.

Right of membership is a business or commercial right which gives a non-defaulting continuing

member a right to access the Exchange and to participate therein and in that sense it is a licence
or akin to licence in terms of Section 32(1)(ii) of the 1961 Act. That, such a right vests in the
Exchange only on default/ demise in terms of the Rules and Bye-laws of BSE, as they stood at
the relevant time. Court clarified that the judgment should not be understood to mean that every
business or commercial right would constitute a "licence" or a "franchise" in terms of Section
32(1)(ii) of the 1961 Act.

If there is a license to run a bar, it is also a business right. Similarly, if there is right to collect a
toll, it is also a business right. Thus, business/commercial right has been liberally interpreted by
the Court.

Because of the words ‘business rights or commercial rights of a similar nature’, there has been a
wide interpretation of business and commercial right.

Wear and tear is a traditional understanding of depreciation. Now, it is exploitation for the
purpose of earning revenue. Since revenue is taxable, the expenditure to acquire the asset should
also be allowed depreciation. Here, there is no wear and tear as it is an intangible asset.

Court has allowed depreciation on assets which do not have any lifespan, such as goodwill and
BSE membership card.

If a book is purchased by a professional, it is depreciable as a ‘plant’.

It is difficult to use business purpose or personal use in case of professionals. For instance, in
general provision of section 37, even suits or vehicles purchased can be claimed as deduction, if
they are used for the purpose of profession.

ITAT also allowed advocates’ sponsoring of education of students as it is considered promotion

of profession which is for the purpose of profession.

Skyline Caterers Private Limited v. ITO, 2008 Mumbai ITAT – Court explained business or
commercial rights. Whatever is used as a tool to carry on business are business rights, and it
should be allowed as deduction.

CIT v. Weizmann Forex Ltd., 2012 51 SOT 525 Mumbai ITAT – in case of an intangible asset,
dimunition in the value or physical wear and tear is not an essential condition for admissibility
for depreciation. If an asset is used as a business tool to carry on business, it is sufficient to claim
depreciation. Thus, traditional concept of wear and tear is not applicable to IT Act looking at the
object of the Act.

CIT v. Doomdooma India Ltd., 2009 178 Taxmann 261 SC – composite income under
agricultural income are concerned. How to claim depreciation in case of composite income was
considered. For instance, in case of tea, 40% is commercial, and 60% is agricultural. So whether
only 40% would be allowed to be claimed as deduction for depreciation, or the entire 100%
would be allowed.

Two things essential for depreciation allowance – actual cost and written down value.

In IT Act, the depreciation is there on the block. Depreciation would be deducted from what is
the written down value on the block of assets on 1 st April of Year and what is the written down
value on 31st March. This will be the WDV for the next financial year.

Section 43(6) defies written down value:

(a) in the case of assets acquired in the previous year, the actual cost to the assessee;

(b) in the case of assets acquired before the previous year, the actual cost to the assessee less all
depreciation actually allowed to him under this Act, or under the Indian Income-tax Act, 1922
(11 of 1922), or any Act repealed by that Act, or under any executive orders issued when the
Indian Income-tax Act, 1886 (2 of 1886), was in force:
Provided that in determining the written down value in respect of buildings, machinery or plant
for the purposes of clause (ii) of sub-section (1) of section 32, "depreciation actually allowed"
shall not include depreciation allowed under sub-clauses (a), (b) and (c) of clause (vi) of sub-
section (2) of section 10 of the Indian Income-tax Act, 1922 (11 of 1922), where such
depreciation was not deductible in determining the written down value for the purposes of the
said clause (vi);

Question of ‘actually allowed’ has been discussed by Court in Doomdooma case.

Suppose total income from tea business is 1000. Department says we will charge depreciation at
10%. There are expenses of 300. Both these are deducted. Amount is 600. On this amount, 40%
of tax would be charged.

Assesse claims that income is 1000. But these deductions should be on pro-rata basis. First, we
consider income from business as only 40% i.e., 400. Out of this, 10% depreciation and 120
expenses. Thus, 400 – 40 – 120 = 240. Here, tax is the same i.e., 240. But amount of depreciation
is different. SC has allowed the second method for charging depreciation.

First, we consider what is taxable, and then only, depreciation is deducted. Court in
Doomdooma case followed this method and upheld the HC judgment.

Suppose on April 1, 2022 – March 31, 2023 is the previous financial year. A commercial
building has to be depreciated at 10%. On April 1, company has 4 buildings A, B. C, and D, and
their total WDV of these is 6 lakhs. On December 31, 2022, company has purchased other assets
E and F buildings forming part of the same block. The actual cost of these assets is 8 lakhs.

On January 31, 2023, company has transferred building A, B, C, D, and E for 10 lakhs. As on
March 31, what is the WDV of the block – first, adding all, total value of assets is 14 lakhs. 10
lakhs, which is income from sale of assets, is deducted (as the sold off assets do not form part of
the block). Thus, 4 lakhs is left. Depreciation of 10% is charged. Thus, on April 1, 2023, WDV is
3,60,000 for asset F.

Suppose on March 31, 2023, all 6 buildings are sold for 20 lakhs. Here, 6 lakhs is the capital gain
(as value of assets was 14 lakhs total). Suppose all 6 assets were sold for 10 lakhs. Then, WDV
of 4 lakh is left. This is a situation of capital loss – person has WDV, but no assets.
Special provision for computation of capital gains in case of depreciation – when money paid is
more than WDV.

Actual cost is defined under section 43(1), and (3) defines meaning of plant. Whether factory
building is plant or commercial building – if depreciation is allowed as a plant, then depreciation
is very high and asset can be written off easily. If there is an asset without any book value,
assesse can earn capital gain. This is beneficial to the assesse. While if it is considered a
building, lower depreciation would be charged.

ACIT v. Victory Aqua Farm Limited – Court has said that fish pond would be plant.

CIT v. Karnataka Power Corporation, 2001 247 ITR 268 SC - whether power plant is plant or
building. Court has said it is a plant, since it manufactures plants. Where building has been so
placed and constructed so as to serve an asssesse as a special technical requirement, it
would be a plant.

CIT v. Anand Theatres, 2000 – cinema theatres were not treated as plant.

Even road is considered as building for purpose of depreciation and depreciation allowance can
be made.

Amendment Act 2003-04 tried to make it clear that building is not a plant in any case.

Section 43(1) – it states that actual cost means the actual cost of the assets to the assessee,
reduced by that portion of the cost thereof, if any, as has been met directly or indirectly by any
other person or authority.

Suppose ABC Ltd. has to start manufacturing plant in India. He purchases machinery from
company in US for 10 lakhs. He appointed an agent in US where commission of 50,000 was
given to agent to find out suitable dealers. Machinery was transported to India. transportation had
to be paid. In India, customs, GST, etc. was paid. Total amounted to 2 lakhs. And 50,000 was
domestic cost of transportation. Before actual use, trial run was there, for which expenditure of
50,000 to purchase raw materials. In trial run, products were generated which were sold for 1
lakh.

Once machinery is used in business, depreciation can be claimed. What is the actual cost of
machinery – everything minus the income of 1 lakh from sale of products from trial run. not just
purchase price, but 10 lakh + 2 lakh + 50,000 + 50,000 – 1 lakh. This would be the actual cost, as
actual cost of asset is the actual cost to the assesse.

If property received in gift, or inheritance, what is the actual cost. Here, nothing is paid, but there
is an asset in the block. Actual cost, as per explanation 2, can be actual cost to the previous
owner also.

Suppose A purchase laptop in 2010 for 2 lakhs. A gifted to B, B to C, and C to D in 2022. Earlier
owners didn’t use it in business. But D uses it for business. Here, who is the previous owner – it
means the owner who acquired the asset not by way of gift or inheritance, but by paying some
value. Actual cost is 2 lakhs plus notional depreciation from 2010 to 2022, even though no one
used it in business. As per section 49, previous owner means the owner or person who acquired
the asset not by way of gift, inheritance, but rather, paid something to acquire it.

If holding company has claimed full depreciation on asset, and the entire value is written off.
After that, asset is transferred to subsidiary company at high value to claim more depreciation.
This is wrong as depreciation would reduce profits, and depreciation has already been charged
once.

Actual cost was not previously defined under IT Act. And there was issue of colorable device to
claim more depreciation to reduce profits.

CP Sugar Mills Ltd. v. CIT, 1975 98 ITR 167 SC – Court discussed actual cost. It said that it
should be construed in a sense that no prudent man would misunderstand. The cost incurred to
bring the asset into existence and put it to use is part of actual cost. Here, before the
company started its business, person borrowed money for business and construction of plant and
machinery. But business hadn’t started. Thus, it wasn’t taxable under section 28. Hence,
expenditure couldn’t be claimed as deduction. He capitalized interests in the books of accounts,
and added in the actual cost of assets. Question was whether depreciation can be claimed on
interest amount as well which was part of actual cost. This was allowed by the Court as it was
part of actual cost as expenditure to bring the asset into existence.

CIT v. Bokaro Steel Ltd., 1999 236 ITR 315 SC – in 1964, the company started its business as a
government company. They hired contractors for construction of building. They let out building
for residential purpose of contractors, etc. Certain plant was also hired by contractors for
construction. Thus, expenditure was incurred, and income was earned from this letting out. Some
mining rights were also given out from which income was derived before the business started.

Court said if expenditure can be added to actual cost, income can be deducted from actual cost.
Thus, income was deducted.

Explanation 1—Where an asset is used in the business after it ceases to be used for scientific
research related to that business and a deduction has to be made under clause (ii) of sub-section
(1) of section 32 in respect of that asset, the actual cost of the asset to the assessee shall be the
actual cost to the assessee as reduced by the amount of any deduction allowed under clause (iv)
of sub-section (1) of section 35 or under any corresponding provision of the Indian Income-tax
Act, 1922.

Scientific research expenditures are fully allowed to be claimed as deduction. Suppose, a

company has r&d department, and for that, it has constructed a building and purchased rights.
For such expenditure, 100% deduction is allowed even if it is capital expenditure.

Suppose after some time, some machinery is sought to be shifted from r&d department to
production department. What is the actual cost of this machinery – as full amount has already
been claimed under section 35. There is asset, but without any actual cost (book value) as total
amount has already been claimed as expenditure.

Explanation 1A.—Where a capital asset referred to in clause (via) of section 28 is used for the
purposes of business or profession, the actual cost of such asset to the assessee shall be the fair
market value which has been taken into account for the purposes of the said clause.

If such capital asset is used in business or profession, what would be actual cost to assesse –
since in conversion process under section 28, we have considered fair value for the purpose of
business income, the same fair value would be allowed to be claimed as expenditure.

Suppose stock in trade is converted into capital asset because that business is ceased, then
business income is the fair market value of the converted asset. This FMV is the value of the
capital asset. The actual cost of this capital asset would be the same FMV for the purpose of
depreciation.
Explanation 2—Where an asset is acquired by the assessee by way of gift or inheritance, the
actual cost of the asset to the assessee shall be the actual cost to the previous owner, as reduced
by—

(a) the amount of depreciation actually allowed under this Act and the corresponding provisions
of the Indian Income-tax Act, 1922, in respect of any previous year relevant to the assessment
year commencing before the 1st day of April, 1988; and

(b) the amount of depreciation that would have been allowable to the assessee for any assessment
year commencing on or after the 1st day of April, 1988, as if the asset was the only asset in the
relevant block of assets.

This deals with notional depreciation. Actual cost to the previous owner minus all depreciation,
even if the asset is not actually used by the previous owner.

Explanation 3—Where, before the date of acquisition by the assessee, the assets were at any time
used by any other person for the purposes of his business or profession and the Assessing Officer
is satisfied that the main purpose of the transfer of such assets, directly or indirectly to the
assessee, was the reduction of a liability to income-tax (by claiming depreciation with reference
to an enhanced cost), the actual cost to the assessee shall be such an amount as the Assessing
Officer may, with the previous approval of the Joint Commissioner, determine having regard to
all the circumstances of the case.

If other person is asking for enhanced value, it is taxable under capital gain, and other person has
to pay this amount as capital expenditure. These things happen generally when parties are related
parties. It is a case of transfer pricing.

Explanation 4—Where any asset which had once belonged to the assessee and had been used by
him for the purposes of his business or profession and thereafter ceased to be his property by
reason of transfer or otherwise, is re-acquired by him, the actual cost to the assessee shall be—

  (i) the actual cost to him when he first acquired the asset as reduced by—

(a) the amount of depreciation actually allowed to him under this Act or under the corresponding
provisions of the Indian Income-tax Act, 1922 (11 of 1922), in respect of any previous year
relevant to the assessment year commencing before the 1st day of April, 1988; and
(b) the amount of depreciation that would have been allowable to the assessee for any assessment
year commencing on or after the 1st day of April, 1988, as if the asset was the only asset in the
relevant block of assets; or

 (ii) the actual price for which the asset is re-acquired by him,

whichever is less.

A person uses an asset, transfers that asset, and then re-acquires the same asset – this would be
done to claim more depreciation, as re-acquisition can be at a higher cost to claim more
depreciation. This is normally when parties are related parties, or one party is enjoying some
benefits under IT Act,

Suppose a person acquired asset for 10 lakhs in 2021. In 2020, book value of asset was 2 lakhs
and he transferred it to XYZ for 6 lakhs. Then in 2022, he re-acquired the asset for 10 lakhs.
Now, the actual cost shall be actual cost when he first acquired the asset minus depreciation till
the date of re-acquisition, or actual price of re-acquisition, whichever is less.

Explanation 4A—Where before the date of acquisition by the assessee (hereinafter referred to as
the first mentioned person), the assets were at any time used by any other person (hereinafter
referred to as the second mentioned person) for the purposes of his business or profession and
depreciation allowance has been claimed in respect of such assets in the case of the second
mentioned person and such person acquires on lease, hire or otherwise assets from the first
mentioned person, then, notwithstanding anything contained in Explanation 3, the actual cost of
the transferred assets, in the case of first mentioned person, shall be the same as the written down
value of the said assets at the time of transfer thereof by the second mentioned person.

This is also done generally when parties are related parties. This is a sale and lease transaction.
One party enjoys benefit in the name of payment of rent as expenditure allowed as revenue
expenditure, and other party enjoys benefit in the form of deduction of depreciation.

Explanation 5—Where a building previously the property of the assessee is brought into use for
the purpose of the business or profession after the 28th day of February, 1946, the actual cost to
the assessee shall be the actual cost of the building to the assessee, as reduced by an amount
equal to the depreciation calculated at the rate in force on that date that would have been
allowable had the building been used for the aforesaid purposes since the date of its acquisition
by the assessee.

Suppose an assesse purchased a building in 2010 for 50 lakhs and it is used as self-occupied
building. In 2022, person is qualified to become an advocate/CA. Thus, he uses building for
business or profession. This makes it a capital asset on which depreciation can be deducted.
What would be the actual cost of building – actual cost in 2010 minus notional depreciation till
2022. Thus, rate of depreciation is the same as a commercial building since 2010.

Explanation 6—When any capital asset is transferred by a holding company to its subsidiary
company or by a subsidiary company to its holding company, then, if the conditions of clause
(iv) or, as the case may be, of clause (v) of section 47 are satisfied, the actual cost of the
transferred capital asset to the transferee-company shall be taken to be the same as it would have
been if the transferor-company had continued to hold the capital asset for the purposes of its
business.

Whatever the actual cost in the books of accounts of transferor, the same actual cost would be
forwarded to the transferee company.

Explanation 7—Where, in a scheme of amalgamation, any capital asset is transferred by the

amalgamating company to the amalgamated company and the amalgamated company is an
Indian company, the actual cost of the transferred capital asset to the amalgamated company
shall be taken to be the same as it would have been if the amalgamating company had continued
to hold the capital asset for the purposes of its own business.

It is similar to explanation 6. But this is subject to section 47 and 48 – if amalgamating company

is an Indian company.

Explanation 8—For the removal of doubts, it is hereby declared that where any amount is paid or
is payable as interest in connection with the acquisition of an asset, so much of such amount as is
relatable to any period after such asset is first put to use shall not be included, and shall be
deemed never to have been included, in the actual cost of such asset.

It is a clarification that before business is started, you can capitalize the interest. But after
business has started, interest cannot be capitalized and it has to be deducted as per section 36.
Explanation 9—For the removal of doubts, it is hereby declared that where an asset is or has
been acquired on or after the 1st day of March, 1994 by an assessee, the actual cost of asset shall
be reduced by the amount of duty of excise or the additional duty leviable under section 3 of the
Customs Tariff Act, 1975 in respect of which a claim of credit has been made and allowed under
the Central Excise Rules, 1944.

There are 3 input tax which can be paid:

i. Input tax for raw material consumed in business.

ii. Input taxes for capital goods used in business.
iii. Input tax for services used in business.

Thus, input tax on goods, services, capital goods on which credit can be claimed.

If credit is claimed under any Act, the excise duty or GST paid cannot be capitalized as actual
cost. As double benefit cannot be taken. Person can decide either to claim depreciation or to
claim credit.

Explanation 10—Where a portion of the cost of an asset acquired by the assessee has been met
directly or indirectly by the Central Government or a State Government or any authority
established under any law or by any other person, in the form of a subsidy or grant or
reimbursement (by whatever name called), then, so much of the cost as is relatable to such
subsidy or grant or reimbursement shall not be included in the actual cost of the asset to the
assessee.

Suppose a person has to establish a project in remote area. For this, government has granted 50%
subsidy. Suppose person invested 100 crores on capital structure. Because of subsidy, value
would be reduced to 50 crores, and depreciation can only be claimed on 50 crores.

Provided that where such subsidy or grant or reimbursement is of such nature that it cannot be
directly relatable to the asset acquired, so much of the amount which bears to the total subsidy or
reimbursement or grant the same proportion as such asset bears to all the assets in respect of or
with reference to which the subsidy or grant or reimbursement is so received, shall not be
included in the actual cost of the asset to the assessee.
If the grant, subsidy or reimbursement is relatable to the asset, such as plant, building or
machinery, then there is no problem in claiming. But if subsidy is not relatable to any capital
asset and is in lump sum, then apportionment has to be made how much subsidy is relatable to
capital asset and how much subsidy is not relatable to capital asset.

Explanation 11—Where an asset which was acquired outside India by an assessee, being a non-
resident, is brought by him to India and used for the purposes of his business or profession, the
actual cost of the asset to the assessee shall be the actual cost to the assessee, as reduced by an
amount equal to the amount of depreciation calculated at the rate in force that would have been
allowable had the asset been used in India for the said purposes since the date of its acquisition
by the assessee.

Suppose a non-resident outside India purchases an asset. After 10 years, he returns to India and
wants to start business. He wants to use that capital asset for business. The actual cost would be
actual cost on the date of acquisition minus depreciation. Rate of depreciation would be whatever
is provided in Indian accounting standards.

Explanation 12—Where any capital asset is acquired by the assessee under a scheme for
corporatisation of a recognised stock exchange in India, approved by the Securities and
Exchange Board of India established under section 3 of the Securities and Exchange Board of
India Act, 1992, the actual cost of the asset shall be deemed to be the amount which would have
been regarded as actual cost had there been no such corporatisation.

This provision was inserted in 2001.

Stock exchanges were earlier not a company, but societies, with brokers as the members. But
through corporatization, they were made into companies.

The actual cost would be the same which was before the corporatization. Thus, the cost of the
assets in the hands of the society would be the same in the hands of the company also.

Explanation 13—The actual cost of any capital asset on which deduction has been allowed or is
allowable to the assessee under section 35AD, shall be treated as ‘nil’,—

(a) in the case of such assessee; and

(b) in any other case if the capital asset is acquired or received,—

  (i) by way of gift or will or an irrevocable trust;

 (ii) on any distribution on liquidation of the company; and

(iii) by such mode of transfer as is referred to in clauses (i), (iv), (v), (vi), (vib), (xiii), (xiiib) and
(xiv) of section 47:

Section 35AD is a special provision inserted in 2009 around commonwealth games. Hospitality
industry was sought to be incentivized. If hotels, hospitals, food processing facilities are there,
100% expenditure, both capital and revenue, was allowed to be claimed as deduction. If full
amount is claimed as deduction, then there is no actual cost. Thus, no depreciation can be
claimed on it.

Read all explanations to section 43(6) for written down value.

Section 32 continued

Whether depreciation can be claimed on website development cost – depreciation can be claimed
on intangible assets or commercial rights. It can also be claimed on tangible assets such as plant.
Various judgments have held website development can be claimed in the category of plant and
software. Servers, etc. are subject to 60% depreciation. While intangible assets are subject to
25% flat rate depreciation.

Majority of judgments have held website development should be depreciated as intangible

property at 25% rate. But the specific category of depreciation is not fixed. This has been held in
Make My Trip India v. CIT, 2012 51 SOT 19 Delhi ITAT.

Even if a person is not claiming depreciation as a business strategy to not write off capital assets
(as it reduces the profits). Satyam Scandal happened because they were enjoying tax holidays. As
a result, their profits were inflated. If a company is not taxable on its profits, it wouldn’t charge
depreciation. Such a company’s profits would be inflated.

Section 32 provides that even if depreciation is not claimed while assessing income under IT
Act, the department will mandatorily charge depreciation. Person is free to not charge
depreciation in his books, but for tax purpose, department would mandatorily charge.
Additional depreciation at 20% can be claimed on plant and machinery established, purchased or
acquired after March 31, 2005. This is beneficial to the assesse to write it off.

Depreciation is the only provision in IT Act which can be set off against profits and carried
forward for an indefinite period. Business or capital loss can only be carried forward for 6 years,
and house property can only be carried forward for 8 years.

If new asset is purchased, and is used for less than 180 days in the previous year, only 50%
depreciation can be claimed i.e., if normally 20% depreciation were to be charged, now only
10% can be charged. But even if asset is used for 181 days, full depreciation can be claimed.
Also, active use in business is not required. Even if asset is not actively used for more than 180
days, it is not relevant.

Amortization of preliminary expenses – section 35D

Under section 35D, two things are included – expenses incurred before commencement of
business (pre-incorporation expenses), or expenditure incurred before setting up of a new unit.

(1) Where an assessee, being an Indian company or a person (other than a company) who is
resident in India, incurs, after the 31st day of March, 1970, any expenditure specified in sub-
section (2),—

  (i) before the commencement of his business, or

 (ii) after the commencement of his business, in connection with the extension of his undertaking
or in connection with his setting up a new unit,

Following requirements are there:

i. Only an Indian company can claim it.

ii. If it is not a company, then person has to be resident in India i.e., provisions of
section 6 have to be fulfilled.

The purpose for which these expenditures can be claimed are given in section 35D(2). The
expenditure referred to in sub-section (1) shall be the expenditure specified in any one or more of
the following clauses, namely :—

(a) expenditure in connection with—

  (i) preparation of feasibility report;

 (ii) preparation of project report;

(iii) conducting market survey or any other survey necessary for the business of the assessee;

(iv) engineering services relating to the business of the assessee

(b) legal charges for drafting any agreement between the assessee and any other person for any
purpose relating to the setting up or conduct of the business of the assessee;

(c) where the assessee is a company, also expenditure—

(i) by way of legal charges for drafting the Memorandum and Articles of Association of the
company;

(ii) on printing of the Memorandum and Articles of Association;

(iii) by way of fees for registering the company under the provisions of the Companies Act,
1956;

(iv) in connection with the issue, for public subscription, of shares in or debentures of the
company, being underwriting commission, brokerage and charges for drafting, typing, printing
and advertisement of the prospectus;

(d) such other items of expenditure (not being expenditure eligible for any allowance or
deduction under any other provision of this Act) as may be prescribed.

Section also provides how such expenditure can be claimed. Person can claim 1/5 th of the
expenditure in the previous year. Thus, person can claim expenditure in 5 successive previous
years to write off such expenditure. If expenditure is 50 crore, then 10 crores in the first year of
business, and so on till 5 successive years of business.

But deduction allowed is not unlimited. It can be maximum 5% of cost of the project, or 5% of
the capital employed in that project, whichever is beneficial to the assesse.

Cost of project means all tangible goods such as land, building, etc. Capital employed means
share capital, long term borrowings, debentures, etc.
Suppose expenditure belongs to financial year 2022-23. In financial year 2025-26 (before 5
years) there is a transfer of the company, such as demerger, amalgamation, succession, winding
up, etc., then the other person who acquires the company can claim the expenditure. Thus,
expenditure deduction would be forwarded to the next person or company, or any person who is
the transferee.

Section 36 – treatment of bad debts and treatment of interest deduction under IT Act.

Section 36

It contains various specific expenditures. Section 36(1)(iii) and 36(1)(vii) refer to deduction of
interest and bad debts respectively.

The deductions provided for in the following clauses shall be allowed in respect of the matters
dealt with therein, in computing the income referred to in section 28. These are specific
deductions. Sub-clause iii states that the amount of the interest paid in respect of capital
borrowed for the purposes of the business or profession.

Any interest which is paid for the capital borrowed for business or profession is deductible. For
definition of purposes of business and profession, there are two terms used – one is for the
purposes of earning income, and other is some expenditures made for the purpose of business
and profession. If expenditure is made for earning income, it is very limited. But purpose of
business and profession has a wider connotation. If money has to be paid for CSR, and for that,
capital is borrowed, and interest is paid on it, can it be claimed as deduction. It is not for the
purpose of business, but is mandatory. Although CSR expenditure is not considered a business
purpose, but CSR itself is a business activity as it is statutorily required to be done by all
companies fulfilling a threshold.

Interest is payable for the capital which is for purpose of business. Suppose holding company
borrowed capital and lent it to subsidiary company without any interest. Can it be claimed as
deduction by holding company i.e., can subsidiary’s business be called business of holding
company. Yes, as business of subsidiary is business of holding company. Even if subsidiary is
not paying interest, the holding company is. How much interest is being paid or who is paying
interest cannot be challenged by revenue, unless it is a colourable device.
Suppose employer borrowed capital and used it to distribute 200 cars to employees. It can be
considered as for the purpose of business, as revenue cannot decide what is for the purpose of
business. Intention of legislature is to include expenditures which are not necessary for business,
or are not used for earning income. It is the assesse, and not the department which has to decide
what is required for the purpose of business.

Explanation 8 of section 43(1) said that interest had to be capitalized as part of actual cost. This
was a clarificatory amendment in 1986 with effect from 1974.

Proviso of section 36 has been inserted by Amendment Act of 2003 with effect from 2004. This
proviso is amendatory in nature.

Provided that any amount of the interest paid, in respect of capital borrowed for acquisition of
an asset (whether capitalised in the books of account or not); for any period beginning from the
date on which the capital was borrowed for acquisition of the asset till the date on which such
asset was first put to use, shall not be allowed as deduction.

They provide for almost the same thing. But one provision is clarificatory and one is
amendatory. The proviso overrides the accounting standards also, while explanation does not do
so.

SC has made it clear that this proviso is a prospective provision and not a retrospective one.

DCIT v. Core Healthcare Ltd., 2008 2 SCC 465 – SC has discussed effect of this proviso. There
is no effect of explanation 8 for this proviso. Both are similar provisions.

SA Builders v. CIT, 2007 288 ITR 1 SC – example of holding and subsidiary company. Holding
company borrowed capital and lent to subsidiary company without interest. Revenue argued that
it is not deductible under section 36(1)(iii). Court discussed whether subsidiary’s business is
business of holding company. Court said for the purpose of business is a wide meaning, and
business of sister concern would be included in it. Court also discussed commercial
expediency – where the money is used, how much interest is paid, etc. is decided by the assesse
and cannot be challenged by revenue.

Section 36(1)(iii) has to be read with section 43B – if you want to claim deduction under section
36(1), there has to be an actual payment. If it is not payable, it is not deductible.
Thus, 3 requirements – interest on loan, actually paid, and for the purpose of business and
profession.

Madhav Prasad Jatiya v. CIT, 1979 118 ITR 200 SC –

CIT v. Bharti Televenture Ltd., 2011 51 DTR 98 Delhi HC – revenue cannot challenge cases
where it is said that assesse does not have enough funds for utilization of funds borrowed for
business and profession. Section 40A – expenditure incurred for non-taxable income is not
taxable under IT Act. if assesse has taxable business income, and non-taxable business, there is
no requirement to have a nexus as to whether money is used for taxable or non-taxable business.
Normally, assesse will use own funds for non-business purposes, and borrowed funds for
business purpose to claim deduction of interest. This has been held by the Court.

Bad debts – there is a provision of bad and doubtful debts, and when debt is written off as
irrecoverable, it is a bad debts. The Court has said that under 36(1)(vii), debt is written off as
irrecoverable, and the moment the assesse writes it off, it becomes bad debts, which can be
claimed as deduction. If debt is later recovered, there is separate provision for taxing it.

Conditions:

1. Debt or part thereof.

2. Debt should be revenue in nature.
3. Debt should be for business carried out by assesse.
4. Debt must be taken into account for computing the income of the assesse.
5. Debt must be incidental to the business.
6. Debt must have been written off as irrecoverable in the books of accounts of the assesse.

If these conditions are fulfilled, it can be claimed as deduction under IT Act.

Suppose a person is in business of manufacturing. If he has provided goods to someone, and he

doesn’t pay back, it is not a bad debt, rather it is a trading liability.

If a person is running a grocery store. Person purchases from the store, but doesn’t pay back.
This is not a debt, but a trading liability. In debt, there is consent that one person lends the
money which has to be paid back.
Writing off the liability is one thing and writing off the debt is another. Selling the goods is not a
lending activity, but a business activity.

TRF Ltd. v. CIT, 2010 190 Taxmann 391 SC – SC has said that it is for the assesse to decide
whether the debt has become bad or not. The assessing officer or revenue cannot insist on
production of any evidence or proof as to what basis the debt has been considered irrecoverable.

Savra Impex Ltd v. ITO, Mumbai ITAT – RBI direction cannot override the statutory provision.
Hence, merely because assesse has not obtained approval of RBI to write off the debts, if
conditions of section 36 are fulfilled, deduction can be claimed.

CIT v. Birla Brothers Ltd., 1970 77 ITR 751 SC – Court clarified that only trading debts would
be debts allowable, as only revenue is allowable. If recoverable, the debt should be considered as
profit. A bad debt presupposes existence of a debt and presence of creditor or debtor. Mere fact
that assesse has lost some money on amount which has been taxed is not sufficient.

Thus, not every loss or non-payment would lead to bad debts. There are other provisions where
non-payment or other losses can be claimed, but not under bad debts.

CIT v. New Delhi Hotels Ltd., 2012 345 ITR 1 Delhi HC – Court considered that assesse was in
real estate business. he made advance to purchase property. Person didn’t hand over possession
of property. No transaction happened. Here, Court said this is a case of bad debts.

However, this conclusion is questionable, as relationship was of purchaser and seller here, and
person was in business of real estate only.

CIT v. Times Business Solutions Ltd., 2013 215 Taxmann 261 Delhi HC – here, assesse
company, after scheme of demerger, acquired assets and liabilities of two web portals of holding
company. With these assets and liabilities, some debts also came. In the accounting year after the
demerger, they claimed these as bad debts in hands of the successor company. Revenue argued it
is not bad debts, as it is the debt of the predecessor which cannot be claimed as it didn’t happen
in the accounting year. But Court allowed it since all assets and liabilities were acquired, the
debts also came with them, thus, it could be claimed as bad debts.
PRINCIPLE OF COMMERCIAL EXPEDIENCY

Hero Cycles v. CIT, 2015 379 ITR 347 SC – once it is established that there is nexus between the
expenditure and the purpose of business, revenue cannot cclaim to put itself in the armchair of
businessman or BOD and decide how much is reasonable expenditure. The reasonableness
cannot be decided by the authority. It is for the assesee to decide what is reasonable. Atherton v.
British Insulated and Helswhy Cables Ltd. was discussed where House of Lords discussed
commercial expediency. It was approved in Eastern Investment case also. HOL said that in order
to claim deduction under IT Act, it is enough to show that money is spent not for necessity or
direct or immediate benefit, but voluntarily and on grounds of commercial expediency in order to
facilitate and carry on the business. Thus, such expenditures are considered to be based on
commercial expediency.

Thus, if capital is borrowed to purchase mobile phones for employees – even though it is not out
of necessity, or does not have any direct benefit, still it is allowed, as it is to facilitate the
business and motivate the employees. Interest paid on such capital is deductible under section 37.
But if loan is taken to fulfill personal obligations, such as paying IT liability, it is not a case of
business expenditure and is not deductible. Similarly, interest on overdraft facility taken to pay
income tax cannot be taken as deduction.

Money can be taken from friend or relative also. However, agreement should be there for
payment of principal and interest. If it is a camouflage transaction used as a colourable device
just to claim expenditure, it is not allowed.

Jayesh Rai Chand Shah v. Assistant CIT, 2014 360 ITR 387 Gujarat HC – person gifted some
money to 3 persons. He borrowed the same amount from these persons to claim interest. This
was disallowed as a colourable device.

Section 37

It is a general deduction, also known as provision for a business expenditure. Any expenditure
(not being expenditure of the nature described in sections 30 to 36 and not being in the nature of
capital expenditure or personal expenses of the assessee), laid out or expended wholly and
exclusively for the purposes of the business or profession shall be allowed in computing the
income chargeable under the head ‘Profits and gains of business or profession’.
Following conditions are there:

1. Expenditure should not be covered under section 30-36 (as these are specific
expenditures. This is the first condition.
2. It should be a revenue expenditure.
3. It should be incurred in an accounting year (previous year).
4. It should not be for personal expenses.
5. It should be paid out wholly or exclusively for the purposes of business.
6. It should not have been incurred for the purpose which is an offence or prohibited under
any law for the time being in force (explanation 1 added through 1998 amendment with
retrospective effect since inception).

If all these conditions are fulfilled, it can be claimed as deduction.

Amendment Act of 2013 added explanation 2. For the removal of doubts, it is hereby declared
that for the purposes of sub-section (1), any expenditure incurred by an assessee on the activities
relating to corporate social responsibility referred to in section 135 of the Companies Act, 2013
shall not be deemed to be an expenditure incurred by the assessee for the purposes of the
business or profession.

The legislature wanted to limit the scope of CSR expenditure. Earlier, before 2013, expenditure
incurred by assesse for CSR was claimed as deduction. But after CSR became mandatory, it was
not allowed to be claimed as deduction.

There are certain cases which do not fall under section 30-36, and if they fall under section 37,
they can be claimed.

Difference between capital and revenue expenditure – capital expenditure can be expenditure
incurred to purchase capital goods. However, if any intangible asset, such as non-compete
agreement, whether it is capital expenditure. Whether share in a company is an investment or a
trading asset. Similarly, for a person running hotel business, he has to purchase carpets, furniture
and fittings, etc. It is a capital asset, but Court has allowed it as revenue expenditure in one case.
Even replacement of furniture, fittings, etc. due to fire, etc. has been considered by some courts
to be as revenue expenditure.
Thus, what is capital and revenue expenditure is always subjective. Revenue always tries to
restrict scope of section 37 and assesse always tries to widen the scope of section 37 to allow the
expenditure.

Matter has went to Court to claim expenditure for lunch and dinner as business expenditure.
Also, for a company, being a juristic person, there is no personal expenditure.

In some cases, scholarship is considered as a personal expenditure. However, if there is an

agreement that the scholar would work for the company after graduation, it can be a business
expenditure.

For an individual, from 2020, there is a new tax regime and old tax regime. In new regime, rate
of taxation is low, but no deductions are allowed. While in old regime, although rate is high, all
deductions are available.

Meaning of ‘wholly and exclusively for purpose of business’ is open ended. Court has said it has
a wide meaning, and covers all commercial expediencies. CSR was also considered here only,
even if there is no direct link or no direct or indirect benefit to the company.

Whether payment of fine or penalty upon violation of law is business expenditure – as the
purpose of payment is not an offence. HC has decided that payment of ransom is allowed to be
claimed as deduction as it is not an offence. However, if bribe or protection money is paid to
someone, it is not allowed, as it is against law. There is a case which said that protection money
is not allowed to be claimed as deduction.

Suppose due to mining of marbles, there is damage to railway lines going through the Makrana
Marbles industry. A company undertakes to shift railway line from that place to some other and
incurred 500 crores for that purpose. Here, no capital asset comes into existence, as railway line
always belongs to the government. here, it is not a case of a right, but there was an obstruction in
business which was removed. This is a revenue expenditure. And the quantum of expenditure is
irrelevant.

Thus, traditional concept of deciding revenue and capital expenditure does not always apply.

In a 1980 case, company incurred 50 crores to construct water supply and drainage system in a
city, including company itself. The agreement between company and Nagar Nigam was that NN
would forgo the tax on the company for 50 years, in return of company constructing water
supply system across the city. We need to see what kind of assets come into picture. Assets can
be tangible or intangible (in the form of rights, such as right to restrict person such as a non-
compete).

Test of enduring period (benefit for multiple years) is not relevant. What is relevant is whether a
capital asset is created. The quantum or magnitude of benefits is not important.

National Cooperative Development Cooperation v. CIT, SC 11 September 2020.

Apex Pharmaceuticals Co. Ltd. v. DCIT, on February 21, 2022, Court decided the meaning of
‘prohibited under law’ in relation to pharmaceutical companies claiming freebies given to
doctors as business expenditure. Since the MCI prohibits such freebies, this cannot be allowed to
be claimed as expenditure.

Explanation 3 to section 37 has been added through amendment Act of 2022.

Explanation 3–For the removal of doubts, it is hereby clarified that the expression “expenditure
incurred by an assessee for any purpose which is an offence or which is prohibited by law” under
Explanation 1, shall include and shall be deemed to have always included the expenditure
incurred by an assessee,––

(i) for any purpose which is an offence under, or which is prohibited by, any law for the
time being in force, in India or outside India; or
(ii) to provide any benefit or perquisite, in whatever form, to a person, whether or not
carrying on a business or exercising a profession, and acceptance of such benefit or
perquisite by such person is in violation of any law or rule or regulation or guideline,
as the case may be, for the time being in force, governing the conduct of such person;
or
(iii) to compound an offence under any law for the time being in force, in India or outside
India.

Even rules, by laws, guidelines, etc. given by medical council are required to be followed. This
has been made clear by the Explanation 3. Even to compound an offence under section 37, it
cannot be claimed as a deduction.
Prakash Cotton Mills Pvt. Ltd. v. CIT, AIR 1993 2174 SC – there was an imposition. Wherever
such imposition is of a composite nature which is partly compensatory and partly penal, then
compensatory part may be allowed, but penal part is disallowed. Apportionment has to be made
how much is compensatory and how much is penal.

Kab Scan and Diagnostic Centre v. CIT, 2012 322 ITR 476 Punjab and Haryana HC – various
pathology centres give commission to doctors. The diagnostic centre claimed such commission
as deduction. Court said MCI guidelines prohibit such commission, therefore disallowed claim of
deduction of such commission.

Millenial Developers Pvt. Ltd. v. DCIT, 2010 37 ITR KTK HC – any regulation fees paid to
municipal authority for compounding is not available for deduction under section 37 as the same
is in nature of penalty. But here, the Court didn’t make any apportionment as to how much of
fees is compensatory and how much is penal. Rather, whole payment was disallowed.

CIT v. Neelavati and Others, 2010 322 ITR 643 KTK HC – any payment to police or rowdys for
getting protection from them is illegal and should not be allowed under section 37.

Gold Crest Capital Market v. ITO, 2010 ITAT Mumbai – fine/penalty imposed by NSE on
members because they violated some by laws of NSE. Court allowed the expenditure, as
fine/penalty is regulated by in-house laws, and cannot be termed as violation of statutory law.
Thus, it is allowed under section 37.

Thus, there are various disputes over this.

There is difference between business expenditure and business loss. This has been discussed in
TA Qureshi and CIT v. Kiara Singh.

Indian Molasses Company Ltd. v. CIT, 1959 37 ITR 66 SC – Court said that expenditure is equal
to expense and expense is money led out by calculation and intention. Though this element may
not be present in many usage of word. The idea of spending in the sense of paying out or away is
the primary meaning, and we are only concerned with it. Thus, for expenditure, there is always
an obligation i.e., something that has to be paid out to someone. While in loss, there is no
obligation. Also, if there is a contingency, and for that, there is expenditure which is contingent,
it is not allowed under section 37. As expenditure has to be in the accounting year. This
condition is similar for loss, as loss can also not be contingent.

But difference between loss and expenditure is that for loss, there is no obligation, while there is
obligation in expenditure.

Haji Aziz and Abdul Shakur Brothers v. CIT, 1961 41 ITR – SC held that no expense which is
paid by way of penalty for a breach of law can be said to be an amount wholly and exclusively
for the purpose of business. The distinction sought to be drawn between a personal liability and a
liability of the kind now before us is not sustainable because anything done which is an
infraction of the law and is visited with a penalty cannot on grounds of public policy be said to
be a commercial expense for the purpose of a business or a disbursement made for the purposes
of earning the profits of such business.

Here, assesse was carrying on lawful business of importing dates and selling them in India.
import of dates through steamers was prohibited, but assesse did it. This was considered
smuggling, as import was done through illegal channels. Consignment was confiscated, and was
released after giving fine. Assesse claimed deduction. Court said it was on account of infraction
of law, and infraction of law was not in the normal course of business. At that time, relevant
section was section 10 of 1922 Act.

Here, fine was on the basis of improper imports. Looking at the current situation, such
redemption fine is still not allowed.

Confederation of Indian Pharmaceutical Industry v. CBDT, 2013 Himachal Pradesh HC –

circular issued by the CBDT disallowing freebies given by companies to doctors was challenged
as ultra vires.

Bharat Earth Movers v. CIT, 2000 SC – every month, the employer has to contribute to gratuity.
The employer claimed this as a deduction. Revenue claimed it is a contingent liability, as only
provision is made, and payment would be made only on death, etc. of employee. Court said only
the quantification is contingent – depends on date of death/retirement. Liability is certain. This is
allowed because liability has happened in the financial year, only the actual payment is subject to
the date of retirement. Court also defined what is contingent – something that may or may not
happen. As payment of gratuity and happening of liability is sure, only how much will be paid is
contingent.

Madras Auto Services v. CIT, 1998 233 ITR 468 SC – SC laid down guidelines as to how to
understand whether expenditure is revenue or capital. Court said there are various factors which
need to be analysed. It is not a conclusive list, and depends on facts and circumstances. Assam
Bengal Cement Company v. CIT, 1955 27 ITR 375 SC. They also referred House of Lords
judgment of Atherton.

CIT v. Madras Auto Services Pvt. Ltd., 1998 233 ITR 468 SC – SC laid some guidelines to be
followed while deciding capital and revenue expenditure. A was a lessor and B is lessee. Lease
was for 39 years. As per agreement, B (lessee/assesse) had spent amount for construction of new
building after demolishing old building in which assesse was a lessee. Rent as stipulated in lease
was very low. B wanted to claim expenditure on construction of new building as revenue
expenditure.

Court considered this as revenue expenditure.

As property would go back to lessor, lessor was charging very low rent. Therefore, Court
decided in favour of lessee and held this as revenue expenditure. Court gave following
guidelines:

1. Outlay is deemed to be capital when it is made for initiation, extension of business, or

substantial replacement of equipment.
2. Expenditure is capital when it is made not only once and for all, but with a few to bring
into picture an asset or advantage for enduring/long-lasting benefit of trade.
3. Whether for the purpose of expenditure, any capital was withdrawn i.e., what was taken
was a capital of business i.e., if it is from fixed capital, it is capital expenditure, and if it
denotes to circulating capital, it is revenue expenditure.

These tests have to be considered, but these are not the only tests.

Court also discussed SC case of 1945 – Assam Bengal Cement Company v. CIT. Here, appellant
company acquired from government lease of limestone companies for 20 years for cement
manufacturing. Company, in addition to rent, agreed to pay an annual sum as a protection fees
and in consideration of this, the government of Assam undertook not to grant any other company
similar kind of license for 20 years. Question was whether this is revenue expenditure, and court
discussed it.

Who is the owner is important to be considered. In one case, company constructed electric poles
from factory to . But ultimately, they are owned by power corporation, and company was not the
owner. Thus, even if they are for enduring benefit, it is not a capital expenditure, but a revenue
expenditure.

Thus, decision has to be made based on facts and circumstances of each case.

CIT v. Lake Palace Hotels and Motels Pvt. Ltd., 2002 258 ITR 562 Rajasthan HC – how
enduring benefit test is not applicable in some cases, and how quantum of benefit is also not
applicable. A hotel had to organize a ministerial conference. It purchased wall panels, furniture,
carpets, etc. These were not one time use, but for enduring benefit. Hotel claimed this as revenue
expenditure, and revenue wanted to claim it as capital expenditure.

HC said since it is to organize conference, it is related with the profit. Even if it is for enduring
benefit, it is revenue expenditure and not capital expenditure.

Bikaner Gypsons Ltd. v. CIT, 1991 187 ITR 39 SC – payment was made for shifting railway
tracks. It was considered revenue expenditure, as ownership was with railways, not company.

CIT v. Associated Cement Companies Ltd., 1988 172 ITR 257 SC – expenditure was incurred by
assesse company on water supply system in city in consideration for exemption of municipal
duties. 13 crores was incurred, and was claimed as revenue expenditure. Court allowed the same.
As although it is incurred by company, the owner of the system is the Nagar
Nigam/Municipality.

CIT v. Kodak India Ltd., 2002 229 ITR 445 SC – company incurred expenditure in connection
with issue of shares with a view to increase its share capital. Question was whether this was
capital or revenue. SC considered this as capital expenditure, as it directly relates to the capital of
the company. In CIT v. Group Band India Ltd., and other cases also, it was considered as capital
expenditure.
Sassoon J. David & Co. Pvt. Ltd. v. CIT, 1979 SC – Court interpreted what is meaning of wholly
and exclusively for purpose of business. Question was tested on principle of commercial
expediency. It is always the assesse to decide what is required for purpose of business, and not
the revenue. Even if assesse thinks he has to distribute mobile phones to employees, or provides
travel benefits, it can be claimed as revenue expenditure. Department cannot claim it is not
necessary for business.

SC said that the expression wholly and exclusively used in section 37 does not mean necessarily.
Ordinarily it is for the assessee to decide whether any expenditure should be incurred in the
course of his or its business. Such expenditure may be incurred voluntarily and without any
necessity and if it is incurred for promoting the business and to earn profits, the assessee can
claim deduction under section 10(2) (xv) of the Act even though there was no compelling
necessity to incur such expenditure. The fact that somebody other than the assessee is also
benefited by the expenditure should not come in the way of an expenditure being allowed by way
of deduction.

It is for the assesse to decide in what way they want to promote business. Another fact that
emerges from these cases is that if the expense is incurred for fostering the business of another
only or was made by way of distribution of profits or was wholly gratuitous or for some
improper or oblique purpose outside the course of business then the expense is not deductible. In
deciding whether a payment of money is a deductible expenditure one has to take into
consideration questions of commercial expediency and the principles of ordinary commercial
trading. If the payment or expenditure is incurred for the purpose of the trade of the assessee it
does not matter that the payment may inure to the benefit of a third party. But in every case it is a
question of fact whether the expenditure was expended wholly and exclusively for the purpose of
trade or business of the assessee.

CIT v. Infosys Technology Ltd., 2014 KTK HC – Assesse incurred expenditure on installation of
traffic signals in various parts of city. Assesse claimed it was to promote free movement of
employees. Under CSR, Court allowed it as being for the purpose of business as a way to
promote it.

After 2014, if they claim it as a general deduction under section 37, it would be allowed.
ACIT v. Dhanpur Sugar Mills, 2015 370 ITR 194 All HC – construction of electric poles. Court
said that the true test is whether the expenditure incurred by assesse is for obtaining commercial
advantage in capital field, or increasing profit of the company in revenue field. Power lines and
poles constructed by the assesse is always property of UP Power Ltd. Even though expenditure
was incurred for transmission lines and poles, it doesn’t belong to the company. Therefore, it
would be considered revenue expenditure.

CIT v. Wipro Ltd., 2014 360 ITR 658 KTK HC – company made expenditure on a special
painting. It claimed it wanted to improve the working environment of company, and claimed it as
revenue expenditure. Court allowed this as revenue expenditure.

In a number of cases, Court allowed expenditure incurred by assesse for poojas in the temple,
etc., as it was good for doing a business, even though it was not required for earning profits.

Divyakant C. Mehta v. ITO, 2014 365 ITR 423 Bombay HC – assesse is a firm of advocates. The
daughter of partner was sent for higher education. Expenditure incurred was claimed as business
expenditure of firm. Normally, if there is a bond between the person and company that after
study, he would join the firm, it is considered revenue expenditure. Here, even though there was
a bond, the Court considered this as a colourable device. The claim of scholarship was
disallowed by the Court. as there were more than 20 associates, so why only the daughter of
partner was allowed scholarship.

CIT v. AP Transport Corporation, 2014 110 DTR 44 AP HC – assesse paid secret commission to
someone to provide business to assesse. Question was whether it is prohibited under explanation
1. Court allowed it, but remanded it back to see whether any rule or law prohibits such
commission.

CIT v. Regalia Apples Pvt. Ltd., Bombay HC 2013 – no disallowance should be made for
compensatory payments. Here, apparel export promotion council [AEPC] was concerned. In
consideration for export entitlement, appellant furnished bank guarantee that it will comply to
obligations. Assesse defaulted. The bank guarantee was forfeited by AEPC. Assesse claimed this
as deduction. Court said this is compensatory in nature, and is in business of assesse. So it should
not be considered as offence, and should be allowed as deduction being a compensatory
payment.
But in the light of 2022 amendment, it is not clear, as it is for compounding of offence.

SECTION 40(A), 40A AND 43B

Conditions for allowance under IT Act. Only if conditions under section 40(a) are fulfilled,
deduction can be claimed under section 30 to 38.

Section 40(a) makes it mandatory to deduct taxes at source to claim the benefit under sections
30-38. If any payment is made outside India, or to a non-resident, then it is convenient to deduct
taxes at sources. As otherwise it is difficult to locate the person outside India and to collect taxes
from him.

Thus, section 40(a) makes it mandatory to follow TDS provision while making payments.

Notwithstanding anything to the contrary in sections 30 to 38, the following amounts shall not be
deducted in computing the income chargeable under the head "Profits and gains of business or
profession"—

(a) in the case of any assessee—

  (i) any interest (not being interest on a loan issued for public subscription before the 1st day of
April, 1938), royalty, fees for technical services or other sum chargeable under this Act, which is
payable—

(A) outside India; or

(B) in India to a non-resident, not being a company or to a foreign company,

on which tax is deductible at source under Chapter XVII-B and such tax has not been deducted
or, after deduction, has not been paid on or before the due date specified in sub-section (1)
of section 139.

Section 201 and 195 i.e., Chapter XVII B has to be followed, which provides for TDS.

There is payment of interest from A to B of Rs. 1 lakhs in 2020-21. Suppose tax is 10,000. This
has to be deducted by A, and deposited by the person to the government before the due date
(generally within 10 days of the next month).
Thus, first obligation is to deduct the taxes, and second is to deposit the same before the due
date. Then full deduction of 1 lakh can be claimed, as it is expenditure in section 36.

Earlier, there was disallowance. But now, proviso provides that if in one year, person fails to
deduct TDS, he can still claim deduction in next year.

Amendment Act of 2015 inserted proviso. Provided that where in respect of any such sum, tax
has been deducted in any subsequent year, or has been deducted during the previous year but
paid after the due date specified in sub-section (1) of section 139, such sum shall be allowed as a
deduction in computing the income of the previous year in which such tax has been paid.

Suppose in 2020-21, person fails to deduct taxes. In 2021-22, person receives the amount from B
and then deposits the same with government. Then deductions can be claimed, but only for
financial year 2021-22.

(ia) thirty per cent of any sum payable to a resident, on which tax is deductible at source under
Chapter XVII-B and such tax has not been deducted or, after deduction, has not been paid on or
before the due date specified in sub-section (1) of section 139.

If the receiver is a non-resident, then whole of amount is disallowed. A has to pay interest to B
which is subject to TDS. First provision says that whole of amount would be disallowed to be
claimed as deduction. But if both are residents, then only 30% of the amount is disallowed to be
claimed as deduction. As it is considered that enforcement can be done against resident as he
falls in purview of the Act.

It is argued that this is not discrimination, but it is about enforcement of IT provisions.

(ib) any consideration paid or payable to a non-resident for a specified service on which
equalisation levy is deductible under the provisions of Chapter VIII of the Finance Act, 2016,
and such levy has not been deducted or after deduction, has not been paid on or before the due
date specified in sub-section (1) of section 139.

Suppose advertisement is made on google, then expenditure has to be incurred. This is income
for google, but is not taxable as there is no permanent establishment in India. OECD BEAP 1
gave concept of equalization levy to tax such incomes. This was done not under IT Act, but
under Finance Act, 2016. It is a tax only, but still chargeable under Finance Act as a non-tax
revenue.

But still, the treatment has been given under IT Act only.

Thus, equalization levy, even though it is not charged under IT Act, but if it is not paid, then the
whole amount cannot be claimed as expenditure.

Fringe benefit – benefit which is not individually attributable to a single employee, but is a
common benefit for all. For instance, bus facility available to all employees, or telephone facility
in office.

However, after 2009, fringe benefit is no more.

Section 40(ii) provides any sum paid on account of any rate or tax levied on the profits or gains
of any business or profession or assessed at a proportion of, or otherwise on the basis of, any
such profits or gains. Tax on profits means income tax. Income tax itself is not subject to
deduction. But this is subject to DTAA – as although revenue may consider it as income under
IT Act, but it may not be income under DTAA, as DTAA provides various conditions for
taxability.

If there is a tax on turnover or gross receipt, it is not covered here, and deduction can be claimed
on it.

(iia) any sum paid on account of wealth-tax.

(iib) any amount—

(A) paid by way of royalty, licence fee, service fee, privilege fee, service charge or any other fee
or charge, by whatever name called, which is levied exclusively on; or

(B) which is appropriated, directly or indirectly, from,

a State Government undertaking by the State Government.

This is an anti-avoidance provision. Central and state governments also receive income in form
of royalty, license fees, technical fees, etc. But these are not allowed as deduction in the hands of
the payer. State governments are tax havens. So there can be agreement between state
government and state owned company to enjoy deductions under IT Act. As payer can claim
such payments as deductions.

Therefore, by Amendment Act of 2013-14, provision was inserted. No royalty, license fees, etc.
paid to government can be allowed as deduction. Earlier, as these were allowed to be claimed by
the payer, state government was acting as tax heavens.

(iii) any payment which is chargeable under the head "Salaries", if it is payable—

(A) outside India; or

(B) to a non-resident,

and if the tax has not been paid thereon nor deducted therefrom under Chapter XVII-B.

if any payment of salary is made to any person outside India or any non-resident, TDS has to be
deducted to claim deductions.

For partnership firms, they pay salary to partners, which can be claimed as deduction. But there
is a limitation under section 40(b) as to how much salary or commission can be paid to the
partner.

CIT v. Mark Auto Industries, 2012 Punjab and Haryana HC – payment was made by company to
non-resident. But this was not claimed as deduction, rather it was capitalized in the books of
accounts. Question was whether section 40(a) would be appliable.

Section 40(a) makes it clear that all deductions allowed under section 30-38 are included. This
includes deductions which are capital in nature as well, such as depreciation. Thus, expenditure
is covered, which may be capital or revenue.

But here, the Court said that if amount is not claimed as expense, but is capitalized in books of
accounts, it cannot be included in section 40(a). This is problematic as section 40(a) includes all,
and even if capitalized, it has effect on profits and gains of business.

CIT v. SK Takri Call, 2012 361 ITR Cal HC – where tax is deducted under wrong provision at
lower rate, provision of this section would not apply, as it does not apply to. Court held that
section 40 does not cover the lower deductions. It only covers deductions. This is a wrong
judgment.
HC said this provision does not include shortfall of deduction. Suppose under TDS, deduction of
30% has to be done. But company applied 20% deduction. Then whether 40(a) can be claimed,
or it is disallowed under section 40(a). Court said

But 40(a) clearly says that ‘such tax’ which means genuine and appropriate tax with proper rate.

After that, Kerala HC judgment came. CIT v. PBS Memorial Hospital, 2015 380 ITR 284. This is
a correct judgment. Here, Court said that provision required compliance with TDS, and provision
required such tax to be deducted and paid. This refers to full amount of tax and not the lower rate
of taxation.

There are questions whether cess or surcharge are covered in the meaning of rate or tax in the
profits or gains of business. Courts have said they are not covered under this Chapter, as they are
tax on tax, and hence are not disallowed.

But Amendment Act of 2022 inserted an explanation and included cess and surcharge within the
category of tax for the purpose of section 40(2).

Amendment Act of 2013 added another disallowance as an anti-avoidance provision – when the
state government charges high royalties, privilege fees, etc. State government is a tax heaven,
and therefore profits can be shifted from the state undertaking to the state government. one is tax
free and other can claim deduction. Thus, disallowance was made – any amount paid by state
undertaking to state government as royalty, license fees, privilege fees, etc. cannot be claimed as
deduction. Following cases have held this:

CIT v. Rajasthan State Ganganagar Sugar Mills, 2017 393 ITR 421 SC and CIT v. Karnataka
State Beverages Company Ltd., 2017 395 ITR 444.

CIT v. Kotak Industries, Bombay HC – Court held that where assesse and revenue both held the
position for a decade that tax was not deductible. Now if tax is made deductible because of
change, then provision of section 40(ab) cannot be applied.

Harshad Shantilal Mehta v. Custodian, 1998 SC – question was what is definition of tax and
whether interest levied on non-payment of tax or non-disclosure of income, or non-filing of
returns, or penalty levied on the amount, whether deductions of such interest and penalty for
non-payment or non-disclosure as a penal consequence can be claimed.
Section 2(43) states that tax in relation to assessment year means income tax chargeable under
provisions of the IT Act and in relation to any other assessment year income- tax and super- tax
chargeable under the provisions of this Act prior to the aforesaid date.

Whether payment on non-payment of tax or non-filing of return can be considered as income tax.
If assesse pays any interest over and above his tax liability, can such payment be claimed as
deduction, or whether it is disallowed under section 40(2).

SC has said tax does not include interest or penalty, as it is not a tax.

Pushpa Perfumery Products Pvt. Ltd. v. CIT, 1992 194 ITR 248 Cal HC – where the assesse
company takes over running business of a vendor for certain consideration, the IT liability of the
vendor firm is paid by the assess. Now he wants to claim that as an expenditure under IT Act.
first, we need to see whether this is a capital expenditure or revenue expenditure. This is a capital
expenditure, as a liability is being purchased. Even if it is a revenue expenditure, it does not
affect section 40(2). As section 40(2) provides for where the assesse is paying tax on profits and
business.

Karan Johar Ltd. v. CIT, 2011 – suppose A pays 10 lakh as professional fees to B. A pays 1 lakh
extra which was liability of B. Thus, for B, amount is tax free. Can A claim this as a deduction.
Here, it is not tax on profession of A, rather it is liability of B which is merely incurred by A.
Thus, 1 lakh is kind of TDS which is not hit by A. Section 40(2) does not cover such cases. It
only covers cases when own liability is paid by the assesse and not someone else’s.

NQA Quality Systems Ltd. v. CIT, 2010 2 SOT 249 Delhi – Court made it clear that no
disallowance of payment under section 40(a) can be made for non-deduction of tax from source
when the source is not taxable under DTAA. If DTAA governs a transaction, and while applying
DTAA, transaction is not taxable, then section 40(a) is not applicable. 40(a) applies only when it
is income under IT Act and it is chargeable and assesse is liable to pay.

Arthur Anderson and Co. v. CIT, 2010 190 Taxmann 279 Bombay HC.

Section 40A
It is the second provision which has overriding effect. It is also an anti-avoidance provision to
check the colourable devices and manipulations in various cases. Expenses and payments not
deductible in certain circumstances are provided here.

It is not applicable only under section 30-38. Rather, if there are deductions or payments allowed
under IT Act, then conditions of 40A will have to be fulfilled.

(1) The provisions of this section shall have effect notwithstanding anything to the contrary
contained in any other provision of this Act relating to the computation of income under the head
“Profits and gains of business or profession”.

(2)(a) Where the assessee incurs any expenditure in respect of which payment has been or is to
be made to any person referred to in clause (b) of this sub-section, and the Assessing Officer is
of opinion that such expenditure is excessive or unreasonable having regard to the fair market
value of the goods, services or facilities for which the payment is made or the legitimate needs of
the business or profession of the assessee or the benefit derived by or accruing to him therefrom,
so much of the expenditure as is so considered by him to be excessive or unreasonable shall not
be allowed as a deduction.

Thus, this gives power to department to claim excessive or unreasonable payment. The ground
for this generally includes where parties are related. As it would be presumed that payment is not
required for business, or is not for the needs of business, or is an undue payment.

Suppose raw material has to be purchased. ABC purchases raw materials from XYZ. They pay
INR 1000 per unit. In open market, price of raw material is only INR 500. Here, having regard to
the fair market value, the assessing officer can consider this as excessive or unreasonable
payment.

However, if ABC and XYZ are not related in any manner, and there is no allegation that the
relation or association has influenced the price, then even INR 1000 is fair market value.

The provision talks about over-invoicing i.e., charging higher value, and not under-invoicing.

If company paid fees to the directors, which, as per assessing officer, having regard to fair
market value and legitimate needs of the business, considers excessive or unreasonable, whether
it is correct.
In 2010, SC made observation that section 40A should also cover cases of domestic transfer
pricing. Whatever method is followed for international transfer pricing in section 92, the same
should be done for domestic transfer pricing also. After this, an amendment was made which
accepted this observation.

Section 40A is a case of domestic transfer pricing only – as two parties transact at different
prices.

There are 5 methods prescribed by OCED to determine arms-length price. It is also provided
under section 92C. OECD provides that these methods should be followed in hierarchical order.

1. Controllable uncontrolled price.

2. Resale price method.
3. Profit split method.
4. Cost plus method.
5. Transactional net margin method.

These methods are accepted worldwide. In India, any of these methods which are best suitable
for the transaction can be applied.

These methods can be applied for goods transaction. But how to apply these for service
transactions, which are individualistic in nature, is not clear. As department will always
challenge that person is related to the company.

Another problem is that section 40A does not only cover revenue expenditure, but any
expenditure.

In one case, SC also observed that the provision should also be allowed to non-related parties.
This would mean that every transaction is subject to scrutiny of assessing officer, and entire
payment would be disallowed.

SECTION 41

It is a residuary provision. If income cannot be charged under section 28, but it is considered to
be arising in the course of business, it would be chargeable under section 41 as a deemed profit.
Even if it does not arise in the normal course of business, it is deemed to be arising in course of
business. Section 41 is a charging provision in itself, as even if something is not arising out of
business in that year, something related to business in the previous year can be considered here.

(1) Where an allowance or deduction has been made in the assessment for any year in respect of
loss, expenditure or trading liability incurred by the assessee (hereinafter referred to as the first-
mentioned person) and subsequently during any previous year—

(a) the first-mentioned person has obtained, whether in cash or in any other manner whatsoever,
any amount in respect of such loss or expenditure or some benefit in respect of such trading
liability by way of remission or cessation thereof, the amount obtained by such person or the
value of benefit accruing to him shall be deemed to be profits and gains of business or profession
and accordingly chargeable to income-tax as the income of that previous year, whether the
business or profession in respect of which the allowance or deduction has been made is in
existence in that year or not; or

(b) the successor in business has obtained, whether in cash or in any other manner whatsoever,
any amount in respect of which loss or expenditure was incurred by the first-mentioned person or
some benefit in respect of the trading liability referred to in clause (a) by way of remission or
cessation thereof, the amount obtained by the successor in business or the value of benefit
accruing to the successor in business shall be deemed to be profits and gains of the business or
profession, and accordingly chargeable to income-tax as the income of that previous year.

SC has held that if the successor has received anything relating to the predecessor’s liability, it
would not be chargeable under section 41. Explanation has been added to define successor, and
to nullify the effect of the judgment in Saraswati Industrial Syndicate Ltd. v. CIT, 1991 186 ITR
278 – there was amalgamation, and SC said that benefit derived by an amalgamating company
cannot be received by the succeeding company. only if same person received the benefit allowed
to that person, section 41 can apply. But if other person receives benefit as a successor, it would
not be chargeable. To nullify this effect and to include amalgamated company within successor,
explanation was added.

Explanation 2—For the purposes of this sub-section, "successor in business" means,—

  (i) where there has been an amalgamation of a company with another company, the
amalgamated company;
 (ii) where the first-mentioned person is succeeded by any other person in that business or
profession, the other person;

(iii) where a firm carrying on a business or profession is succeeded by another firm, the other
firm;

(iv) where there has been a demerger, the resulting company.

Thus, even if the identity of the person has become different (in case of amalgamated company),
any benefit received would be taxable as income from business.

Loss/expenditure/trading liability – it was allowed earlier, but then the assesse obtained any
benefit out of it. Any loss claimed by assesse earlier as a deduction, but any profit/benefit
derived in any successive year will be taxable. For instance, if there is robbery in bank and
money is lost. After few years, police recovers the money. bank already claimed it as a loss. Now
it is profit for the bank, and it is a deemed profit under section 4, as it does not come as income
from selling goods. Suppose stock in trade is lost, and claimed as deduction, then insurance
company pays for it. This is deemed profit. Similarly, when salary is paid, it is claimed as
deduction. So if excess salary is recovered later, it is taxable as a deemed profit. Even if a new
company took over the old company and then recovered salary, it is a also taxable as deemed
profit.

Similarly, if a person owes something to another, and the other person is no more in existence,
the liability (which was claimed as deduction earlier) is written off, and it is profit for the person,
which is taxable as a deemed profit. Similarly, any benefit received from the remission or
cessation of the liability of the predecessor company, the successor company is liable to tax
under section 41.

Remission – liability of 1 lakh, but due to decree, only 50,000 has to be paid.

Thus, any benefit from any loss, expenditure or trading liability is chargeable under section 41.

Poly Flex India Ltd. v. CIT, 2002 257 ITR 343 SC – there was a difference of opinion. Suppose
company pays GST. Incidence is on consumer, so GST is collected from consumers and paid to
governenment treasury. It was decided that they paid excess liability, so they claimed refund,
which is allowed by department. The government challenges action of department before the
court. Question arises as to treatment of refund received by assesse – whether department will
wait for the final judgment of Court, or charge the refund as deemed profit in the same
assessment year. SC said that moment refund is received from the government, the refund is
taxable in section 41 in that year itself, irrespective of case pending before SC. If judgment is
later in favour of department, it will be treated accordingly.

This case has been followed in a number of other cases.

CIT v. Chakiat Agencies, 2019 413 ITR 113 Madras HC – case on trading liability. Assesse
collected rent from customers. Assesse was an agency receiving containers on Chennai port.
Here, rent was charged as demurrage charges. This rent was payable to Chennai Port Trust. The
port trust didn’t claim this rent. Assesse wrote off the amount in its books of accounts. Court
considered this as cessation of liability – as it was not claimed by the port trust. Hence, it was
considered as profit under section 41.

CIT v. Tamil Nadu Warehousing Corporation Ltd., 2007 212 CTR 228 Madras HC.

CIT v. Smt Sita Devi Juneja, 2010 Punjab and Haryana HC – for taxability under section 41, the
amount must be written off in the profit and loss account. If amount is not written off, but is
shown as outstanding in the balance sheet, even though since 5-10 years, it would make it
taxable under section 41.

CIT v. Nitin Garg, Gujarat HC.

CIT v. Hotline Electronics Ltd., 2012 Delhi HC. These cases held the same as Sita Devi.

Nectar Beverages Pvt. Ltd. v. DCIT, 2004 267 ITR 385 Bombay HC – suppose company
purchases a capital asset which is subject to depreciation of 100%. Company claims this
depreciation in year 2022-23. In 2023-24, the capital asset is sold as scrap. The treatment of
amount received from sale of capital asset is in question.

Section 41(2) was inserted by amendment Act of 1998. It states that if there is sale of any capital
asset, and money paid is more than written down value, then the amount is taxable as deemed
profit under section 41. As otherwise it would lead to double benefit of depreciation allowance
and sale price received.

(2) Where any building, machinery, plant or furniture,—

(a) which is owned by the assessee;

(b) in respect of which depreciation is claimed under clause (i) of sub-section (1) of section 32;
and

(c) which was or has been used for the purposes of business,

is sold, discarded, demolished or destroyed and the moneys payable in respect of such building,
machinery, plant or furniture, as the case may be, together with the amount of scrap value, if any,
exceeds the written down value, so much of the excess as does not exceed the difference between
the actual cost and the written down value shall be chargeable to income-tax as income of the
business of the previous year in which the moneys payable for the building, machinery, plant or
furniture became due.

This provision is applicable to successor also. Thus, for section 41, there is no requirement that
business has to be in existence. Whosoever received the benefit would be liable.

Section 41(4) refers to bad debts – any amount claimed as bad debts, if recovered later, is
chargeable under section 41.

CAPITAL GAIN

Section 45 is the charging provision for this. Normally, only revenue receipts are taxable, not
capital receipts.

It is not the capital which is taxable, but the capital gain being a deemed income is taxable. In the
1922 Act, capital gain was not taxable. In 1947, capital gain was made taxable.

Naveen Chandra Mafatlal v. CIT, 1955 26 ITR 758 SC – whether tax on capital gain is ultra
vires to entry 54 which is a tax on income. As generally, capital receipt is not considered income,
only revenue receipts are considered income. SC upheld constitutional validity of capital gains
tax. SC gave wide interpretation of income (GR Kartikeya, Bhagwandas Jain cases). Income has
to be understood in its widest ambit and ordinary meaning has to be given to income. We cannot
decide what is income and what is not income. It is for the legislature to decide what is income
and we have determined it in the light of IT Act and fiscal statutes.
Section 45 is a unique provision, and it is not subject to slab system. There is a flat rate of
taxation for capital gain.

Any profits or gains arising from transfer of a capital asset effected in previous year,

It does not talk about what you receive the amount. Person would be liable in the year transfer
took place, even if money is received after say 10 years.

Four conditions to charge any income under section 45:

i. There has to be a capital asset defined in section 2(14).

ii. There has to be a transfer defined in section 2(47) which is different from the
traditional definition of transfer.
iii. It should not fall within the exception of section 54 which provides exemption from
the capital gain liability.
iv. Taxability will be in the previous year when the transfer took place, i.e., taxability
depends on the year of transfer, not on the year of receipt of money.

For instance, person received full consideration for transfer of capital asset in 2021-22, but
transfer took place in 2023-24. In this case, taxability will be in 2023-24 only.

Exception to this is compulsory acquisition of land – here, year of receipt will be the year of
taxability, and not the year of transfer. Earlier, compulsory acquisition, conversion and
extinguishment were not considered as transfer, but they were later considered as transfer under
IT Act.

Suppose a person converts a capital asset into stock in trade. Conversion of stock in trade into
capital asset is business income. But here, this is transfer to oneself. This is also subject to
liability of capital gain.

Suppose in 2010, purchased a plot for 10 lakhs and sold it in 2022 for 80 lakhs. Here, person
himself does not do anything to increase the value. Value has increased due to inflation. There is
cost inflation index. Suppose 10 lakhs becomes 80 lakhs due to inflation in 2022. Then capital
gain is zero, as 80 lakh is just capital, and capital cannot be taxed. Thus, capital gain is share
consideration – inflated cost of acquisition of asset.
Therefore, we say it is deemed income. We only want to tax that portion of gain which is not
because of any inflation. Any gain over and above the inflated value is sought to be taxed. Year
of acquisition index. Thus, cost of acquisition * cost inflation index of year of acquisition / cost
inflation index of year of transfer.

However, this is only for short term capital gain. Long term or short term depends on period of
holding as an owner.

Section 2(14) defines capital asset.

(14) "capital asset" means—

(a) property of any kind held by an assessee, whether or not connected with his business or
profession;

(b) any securities held by a Foreign Institutional Investor which has invested in such securities in
accordance with the regulations made under the Securities and Exchange Board of India Act,
1992;

(c) any unit linked insurance policy to which exemption under clause (10D) of section 10 does
not apply on account of the applicability of the fourth and fifth provisos thereof,

but does not include—

(i) any stock-in-trade [other than the securities referred to in sub-clause (b)], consumable stores
or raw materials held for the purposes of his business or profession;

(ii) personal effects, that is to say, movable property (including wearing apparel and furniture)
held for personal use by the assessee or any member of his family dependent on him, but
excludes—

(a) jewellery;

(b) archaeological collections;

(c) drawings;

(d) paintings;

(e) sculptures; or
(f) any work of art.

There is a negative definition given for this. Any kind of property held by an assesse is a capital
asset. What is property is not defined. Tangible, intangible, movable, immovable, corporeal,
incorporeal, etc. all are included.

Some rights which a person possesses such as tenancy rights, goodwill, right to carry on
business, non-compete right, etc. is also property.

Except for few exclusions, everything is property.

Share held by FII – in this regard, there was confusion. If it was held as trading asset, it was
stock in trade, and if it was investment, it was capital asset. To avoid confusion, legislature said
that any share held by FII would be considered as investment asset only.

Exclusions from capital asset:

1. Any stock in trade treated by the assesse as a trading asset. It does not depend on the
nature of property, but the nature of business carried on by the assesse. Thus, if assesse
treated it as stock in trade, it would be considered as such, otherwise it would be treated
as capital asset.
2. Personal effects – all movable properties, including wearing apparel and furniture held
for personal use by the assesse or any family member dependant on him. Thus, all
movable properties such as clothes, vehicles, etc. which are used on a daily basis.
However, exceptions are jewellery, archaeological collections, drawings, paintings,
sculptures, or any work of art.
3. Agricultural land.
4. Gold bonds, gold deposit bonds, etc.

A wide definition has been given for jewellery. Even furniture or wearing apparel can be
jewellery if any stone, gem, precious metal, etc. is fixed on it.

This is because in case of sale of any personal effects, there can be no capital gain generally, as
price more than the purchase price cannot be charged. Thus, personal effects are not made capital
gain. However, whenever there is a possibility of gain, such as in case of antiques or works of
art, they are considered capital gain.
(iii) agricultural land in India, not being land situate—

(a) in any area which is comprised within the jurisdiction of a municipality (whether known as a
municipality, municipal corporation, notified area committee, town area committee, town
committee, or by any other name) or a cantonment board and which has a population of not less
than ten thousand.

(iv) 6 per cent Gold Bonds, 1977, or 7 per cent Gold Bonds, 1980, or National Defence Gold
Bonds, 1980, issued by the Central Government;

(v) Special Bearer Bonds, 1991, issued by the Central Government;

(vi) Gold Deposit Bonds issued under the Gold Deposit Scheme, 1999 or deposit certificates
issued under the Gold Monetisation Scheme, 2015 notified by the Central Government.

If there is sale of agricultural land, it is not considered capital gain. Even sale of agricultural land
in urban areas has tax exemptions.

Thus, there are only 3 major exclusions. Except these, all properties are capital assets.

Explanation 1—For the purposes of this sub-clause, "jewellery" includes—

(a) ornaments made of gold, silver, platinum or any other precious metal or any alloy containing
one or more of such precious metals, whether or not containing any precious or semi-precious
stone, and whether or not worked or sewn into any wearing apparel;

(b) precious or semi-precious stones, whether or not set in any furniture, utensil or other article
or worked or sewn into any wearing apparel.

Regarding personal effects, we have to also see whether there is one set of items being used
daily. If there is only one set, it is considered as personal effects by Court, and if there is more
than one set, it is considered as capital asset.

Sita Devi and Potdar, 1984 148 ITR 906 Bombay HC.

Maharaja Rana Hemant Singh Ji v. CIT, 1976 103 ITR 61 SC.

LONG TERM AND SHORT TERM CAPITAL ASSETS

Capital assets can be long-term and short-term. Division is based on how long the assets are held.
Section 2(42A) defines short term asset as meaning means a capital asset held by an assessee for
not more than thirty-six months immediately preceding the date of its transfer.

Earlier, the period was 60 months. Now, it is 36 months, and in some cases, it is two years.

In cases of shares listed in recognized stock exchange, period of holding will be 12 months. If
shares are held less than 12 months, then it is short term, and if more than 12 months, then it is
long term.

In case of shares not listed in any recognized stock exchange, or in case of land and building, the
period of holding is 24 months. If less than 24 months holding, then short term, and if more than
24 months, then long term.

In short term and long term, there is only difference in indexation benefit. For long term assets,
indexation benefit can be claimed, and for short term, no indexation benefit can be claimed.

If a person receives any property on January 1, 2022 by way of gift or succession, and he
transfers the property on January 2 itself, whether it is short term or long-term capital asset.
Here, we have to look at previous owner, since actual cost to previous owner has to be looked
into to determine the value. Thus, for the asset, period of holding has to be seen. Suppose person
purchased on January 1, 2010 and transferred on January 1, 2012. And the asset has been a
capital asset throughout. Thus, it would be considered a long term capital asset even though
person held it only for 1 day.

Suppose ABC ltd. purchased 1000 shares on January 15, 2010. There is amalgamation of ABC
with XYZ ltd. on January 15, 2022. ABC transferred 500 shares to XYZ during amalgamation.
Then XYZ sold off the 500 shares on January 31, 2022. The period of holding will be calculated
from January 15, 2010 to January 31, 2022 i.e., more than 12 years. Thus, it is long term.

Thus, origin of asset has to be looked into for period of holding.

Explanation 1 provides how to determine period of holding.

(a) in the case of a share held in a company in liquidation, there shall be excluded the period
subsequent to the date on which the company goes into liquidation;

(b) in the case of a capital asset which becomes the property of the assessee in the circumstances
mentioned in sub-section (1) of section 49, there shall be included the period for which the asset
was held by the previous owner referred to in the said section;

Therefore, there is a saying – inherit today, sell it tomorrow, and keep away tax payments. As
period of holding is since origin of assets, even if sold at high price, the inflation is calculated
from years back.

Suppose assesse purchased land on January 15, 2010. On July 15, 2021, he begins construction
on the land. Suppose construction is completed on 15 August, 2022. He transfers building on 31
August, 2022. Whether asset is short term or long term.

In such cases, we have to make apportionment – when land was purchased, what was the cost of
land, and what was cost of building. Land is long term and building is short term.

ITO v. Narayan 2000 74 ITAT

CIT v. Vimal Chand Golcha, 1993 201 ITR 442 Raj HC.

CIT v. Alps Theatre, 1967 65 ITR 377 SC – Apportionment has been discussed by the SC.

TRANSFER

Section 2(47) defines it. An inclusive definition is given. Thus, it has a wider connotation.
"transfer", in relation to a capital asset, includes—

(i) the sale, exchange or relinquishment of the asset; or

(ii) the extinguishment of any rights therein; or

(iii) the compulsory acquisition thereof under any law; or

(iv) in a case where the asset is converted by the owner thereof into, or is treated by him as,
stock-in-trade of a business carried on by him, such conversion or treatment; or

(iva) the maturity or redemption of a zero-coupon bond; or

(v) any transaction involving the allowing of the possession of any immovable property to be
taken or retained in part performance of a contract of the nature referred to in section 53A of the
Transfer of Property Act, 1882; or

(vi) any transaction (whether by way of becoming a member of, or acquiring shares in, a co-
operative society, company or other association of persons or by way of any agreement or any
arrangement or in any other manner whatsoever) which has the effect of transferring, or enabling
the enjoyment of, any immovable property.

For sale, sale of movable property is under Sale of Goods Act, and sale of immovable property is
defined in Transfer of Property Act. Those definitions are applicable.

Exchange refers to barter of an asset.

Under capital gain, there are two important things – sale consideration, and cost of acquisition.
Only if these two things, capital gain can be charged. If these two are not present, then fair
market value of the good or asset would be considered the full value of consideration (value
which is over and above the face value of asset).

If cost of acquisition is not ascertainable, then fair market value as on the particular date would
be considered. Presently, it is April 1, 2001 which is considered as base year.

But if there is no cost of acquisition, such as self-generated goodwill or other self-generated

rights. Some judgments have been there where it is held that cost of acquisition would be
considered to be nil in these cases.

If a person runs a dairy business, capital assets are livestock, etc. So if say calfs are sold, they are
also capital assets, and there is no cost of acquisition for them. This is not business income,
rather it is a capital gain. And since no cost of acquisition, there would be no tax. There has been
a High Court judgment on this.

Thus, full value of consideration and cost of acquisition are important. If anything of these is
missing, transaction is not subject to tax.

In relinquishment, the rights are given away. Here, asset must be in existence. In extinguishment,
even if asset is not there, extinguishment can be there.
Suppose a license is purchased for 10 years. After 5 years, license is relinquished in favor of
another person who pays a consideration above the face value of license. Here, the benefit would
be chargeable with tax.

In extinguishment, there is complete elimination of asset i.e., asset is no more in existence. For
instance, reduction of share capital through buyback of shares or reduction of face value of
shares is extinguishment of shares. Similarly, in case of amalgamation, there is extinguishment.

If a person purchases capital assets which are insured. Suppose due to a calamity, assets are lost.
Insurance money is received. Whether it is capital gain or not – here, no transfer took place and
asset itself is not in existence for transfer to take place. Here, person received full value of
consideration because assets were insured.

Vania Silk Mills Pvt. Ltd. v. CIT, 1991 59 Taxmann 3 SC – company carried on business of
manufacture and sale of silk cloth. It purchased machinery and gave it on hire to a jasmine mill
on rent. Jasmine mill took an insurance on machinery. Fire broke out and caused extensive
damage to machinery. Insurance claim was received about 6.32 lakhs. Question was whether
insurance money received is subject to capital gain. 6.32 lakhs is full value of consideration, and
cost of acquisition is the book value of machinery (as it is subject to depreciation every year).
Whether a transfer took place here. SC said that no transfer took place. Therefore, it is not
subject to capital gain.

To nullify effect of this judgment, section 45(1A) was inserted as an amendment.

Notwithstanding anything in (1), where any person receives at any time during any previous year
any money or other assets under an insurance from an insurer on account of damage to, or
destruction of, any capital asset, as a result of—

  (i) flood, typhoon, hurricane, cyclone, earthquake or other convulsion of nature; or

 (ii) riot or civil disturbance; or

(iii) accidental fire or explosion; or

(iv) action by an enemy or action taken in combating an enemy (whether with or without a
declaration of war),
then, any profits or gains arising from receipt of such money or other assets shall be chargeable
to income-tax under the head "Capital gains" and shall be deemed to be the income of such
person of the previous year in which such money or other asset was received and for the
purposes of section 48, value of any money or the fair market value of other assets on the date of
such receipt shall be deemed to be the full value of the consideration received or accruing as a
result of the transfer of such capital asset.

This amendment had overriding effect on 45(1). Thus, even if there is no transfer, it is subject to
capital gains tax.

CIT v. Mrs. Grace Collis, AIR 2001 SC 1133 – this was decided after amendment. Here, there
was an amalgamation and the shares of company were given up in favor of amalgamating
company. SC said that whatever decided in Vania Silk Mills case was a wrong interpretation.
And even without amendment, it would be taxable since loss of asset would be considered
extinguishment of asset, and insurance premium would be taxable as capital gain. As
extinguishment itself is covered as a transfer.

It was discussed whether transfer of shares of amalgamated company to amalgamating company

would be a transfer. SC wanted to nullify the effect of Vania Silk Mills case. It was a wrong
interpretation, as even extinguishment i.e., complete destruction is also a transfer. In reduction of
share capital, there is extinguishment of the right to hold shares at a particular face value, and
reduction of right to receive dividend. Even this is considered extinguishment. There is no
requirement of presence of asset for there to be relinquishment. The extinguishment of right is
sufficient

In Vania case, SC said that it is true that definition of transfer is inclusive definition. Therefore,
things which otherwise may not be transfer can be considered transfer here. “It is this aspect of
the definition which has weighed with the High Court and, therefore'; the 'High Court has argued
that if the' words "extinguishment-of any rights therein" are substituted for the 'word "transfer"
in Section 45, the claim or compensation received from the insurance company would be
attracted by the said section. The High Court has, however, missed the fact that the definition
also mentions such transactions as sale, exchange etc. to which the word "transfer" would
properly apply' in its popular and natural import. Since those associated' words and expres- sions
imply the existence of the asset and of the transfer- ee, according to the rule of noscitur a sociis,
the expres- sion' 'extinguishment of any rights therein" would take colour from the said
associated words and expressions, and will have to be restricted t6 the sense analogous to them.
If the legislature intended to extend the definition to any extinguishment of right, it would not
have included the obvious instances of transfer, viz., sale, exchange etc., Hence the expression
"extinguishment of any rights therein" will have to be confined to the 'extinguishment of rights
on account of transfer and cannot be extended 'to mean any extinguishment of right independent
of or otherwise than on account of transfer.”

But in Grace Collins case, SC observed:

“We have given careful thought to the definition of transfer in Section 2(47) and to the decision
of this Court in Vania’s case. In our view, the definition clearly contemplates the extinguishment
of rights in a capital asset distinct and independent of such extinguishment consequent upon the
transfer thereof. We do not approve, respectfully, of the limitation of the expression
extinguishment of any rights therein to such extinguishment on account of transfers or to the
view that the expression extinguishment of any rights therein cannot be extended to mean the
extinguishment of rights independent of or otherwise than on account of transfer. To so read the
expression is to render it ineffective and its use meaningless. As we read it, therefore, the
expression does include the extinguishment of rights in a capital asset independent of and
otherwise than on account of transfer.”

Here, Court said extinguishment of right is independent by itself. There is no requirement of

transferring from one hand to another for it to be called a transfer.

CIT v. G. Narsimhan, AIR 1999 SC 408 – reduction of share capital by reducing the face value
was there. SC said there is extinguishment as you are completely destroying the right to claim
dividend. This is also transfer and subject to capital gain.

Compulsory acquisition thereof [2(47)(iii)] – section 45(5). Here, it is an acquisition. The year
of receipt of compensation is the year of taxability, and not the year of transfer.

Notwithstanding anything contained in sub-section (1), where the capital gain arises from the
transfer of a capital asset, being a transfer by way of compulsory acquisition under any law, or a
transfer the consideration for which was determined or approved by the Central Government or
the Reserve Bank of India, and the compensation or the consideration for such transfer is
enhanced or further enhanced by any court, Tribunal or other authority, the capital gain shall be
dealt with in the following manner

Suppose in 2021-22, land has been acquired. Fixed compensation for that is 80 lakhs which is the
full value of consideration. Cost of acquisition was suppose 10 lakhs in 2010. Value of 10 lakhs
because of inflation is 50 lakhs in 2021. Thus, capital gain is 30 lakhs.

Suppose in 2022-23, there is increase in compensation, and government gives another 20 lakhs
as enhancement in compensation. This is a case of deemed cost of acquisition which would be
considered nil, and entire 20 lakhs would be considered capital gain.

Section 2(47)(iv) – conversion of capital asset into stock in trade is considered transfer. It is
taxable under section 45(2). Notwithstanding anything contained in sub-section (1), the profits or
gains arising from the transfer by way of conversion by the owner of a capital asset into, or its
treatment by him as stock-in-trade of a business carried on by him shall be chargeable to income-
tax as his income of the previous year in which such stock-in-trade is sold or otherwise
transferred by him and, for the purposes of section 48, the fair market value of the asset on the
date of such conversion or treatment shall be deemed to be the full value of the consideration
received or accruing as a result of the transfer of the capital asset.

This was inserted by Amendment Act of 1984, which came to nullify judgment of SC in CIT v.
Bai Shrinbhai Koopa, 1962 46 ITR 86 SC – there is no transfer on conversion of capital asset
into stock in trade, as basic element of transfer is not fulfilled. As it is merely entry in the books
of accouts.

Thus, a separate charging provision for conversion has been created in section 45(2).

In 2010, a piece of land was bought for 10 lakhs as investment. In 2020, person started business
of dealing in land. He converted own land into stock in trade. The fair market value as on 2020
was 30 lakhs. In the same year, the land was transferred to someone for 80 lakhs. Here, there is
capital gain and business income both. Capital gain is 30 lakhs – indexed value (10 lakhs) = 20
lakhs. And 80 – 30 = 50 lakhs is business income.

Conversion is not the year of taxability, rather when the stock in trade is transferred to someone,
that is the year of taxability. Here, as 2020 was year of transfer, it was year of taxability.
Allowing possession under part performance of contract is also a transfer.

Under section 2(47)(vi) – if a person becomes a member of cooperative society and is allotted an
immovable property as a beneficial owner. He is not the legal owner, as legal owner is the
cooperative society. But despite this, the arrangement would be subject to capital gains tax.

Exception to transfer is provided under section 47 i.e., in which cases, there is no transfer under
IT Act. For instance, in gift, it is transfer, but person is not liable. This is because in section 56,
donee is liable, and not donee. Similarly, in inheritance and succession, they are not considered
transfer. Partition of HUF is not considered transfer. Amalgamation, if it fulfils certain
conditions, is not considered transfer.

Section 45(2A) provides that where any person has had at any time during previous year any
beneficial interest in any securities, then, any profits or gains arising from transfer made by the
depository or participant of such beneficial interest in respect of securities shall be chargeable to
income-tax as the income of the beneficial owner of the previous year in which such transfer
took place and shall not be regarded as income of the depository who is deemed to be the
registered owner of securities by virtue of sub-section (1) of section 10 of the Depositories Act,
1996, and for the purposes of—

  (i) section 48; and

 (ii) proviso to clause (42A) of section 2,

the cost of acquisition and the period of holding of any securities shall be determined on the
basis of the first-in-first-out method.

Shares have to be held in demat form. Depositories are the legal owner of shares, and
shareholder is the beneficial owner. If a person transfers shares, then beneficial owner would be
liable for tax, not legal owner. But for shares, how to determine period of holding. For this, first
in first out method will apply.

If a person has 1000 shares and transfers 100 shares, the first 100 shares would be considered as
the ones transferred. Suppose person has 500 shares of ABC purchased in 2010 and 500 shares
of ABC purchased in 2015. Here, the cost of acquisition of first 100 shares purchased in 2010
would be considered and valuation would be done accordingly.
Section 45(3) provides that the profits or gains arising from the transfer of a capital asset by a
person to a firm or other association of persons or body of individuals (not being a company or a
co-operative society) in which he is or becomes a partner or member, by way of capital
contribution or otherwise, shall be chargeable to tax as his income of the previous year in which
such transfer takes place and, for the purposes of section 48, the amount recorded in the books of
account of the firm, association or body as the value of the capital asset shall be deemed to be the
full value of the consideration received or accruing as a result of the transfer of the capital asset.

If ABC is a partnership firm. D wants to become a partner and gives a piece of land as a capital
contribution to ABC. This contribution is considered as a transfer and would be chargeable. The
full value of consideration would be the amount entered in the books of accounts for this
contribution. And cost of acquisition would be the amount for which D purchased the piece of
land.

S. 45(4) was substituted with new sub-section 4 and additional sub-sections 4(a) and 4(b) by
Finance Bill, 2021. The amended provisions are produced below:

“(4) Notwithstanding anything contained in sub-section (1), where a specified person receives
during the previous year any capital asset at the time of dissolution or reconstitution of the
specified entity, which represents the balance in his capital account in the books of accounts of
such specified entity at the time of its dissolution or reconstitution, then any profits or gains
arising from receipt of such capital asset by the specified person shall be chargeable to income-
tax as income of such specified entity under the head "Capital gains" and shall be deemed to be
the income of such specified entity of the previous year in which such capital asset was received
by the specified person and notwithstanding anything to the contrary contained in this Act, for
the purposes of section 48,––

(a) fair market value of the capital asset on the date of such receipt shall be deemed to be the
full value of the consideration received or accruing as a result of the transfer of such capital
asset; and

(b) the cost of acquisition of the capital asset shall be determined in accordance with the
provisions of this Chapter:”
Thus, Capital Gain = Fair Market Value – Book Value at the time of dissolution or reconstitution
(including adjustment for depreciation)

S. 45(5A) was added by Finance Act, 2017. It states that “Notwithstanding anything contained in
sub-section (1), where the capital gain arises to an assessee, being an individual or a Hindu
undivided family, from the transfer of a capital asset, being land or building or both, under a
specified agreement, the capital gains shall be chargeable to income-tax as income of the
previous year in which the certificate of completion for the whole or part of the project is issued
by the competent authority; and for the purposes of section 48, the stamp duty value, on the date
of issue of the said certificate, of his share, being land or building or both in the project, as
increased by the consideration received in cash, if any, shall be deemed to be the full value of the
consideration received or accruing as a result of the transfer of the capital asset”.

Thus, Full value of the consideration (“Capital Gain”) = Stamp Value + Tax charged – Cost of
acquisition.

SECTION 46

S. 46 is an overriding provision overriding S. 45. S. 46 deals with capital gains on distribution of

assets by companies in liquidation. It provides that:

“(1) Notwithstanding anything contained in section 45, where the assets of a company are
distributed to its shareholders on its liquidation, such distribution shall not be regarded as a
transfer by the company for the purposes of section 45.

(2) Where a shareholder on the liquidation of a company receives any money or other assets
from the company, he shall be chargeable to income-tax under the head "Capital gains", in
respect of the money so received or the market value of the other assets on the date of
distribution, as reduced by the amount assessed as dividend within the meaning of sub-clause (c)
of clause (22) of section 2 and the sum so arrived at shall be deemed to be the full value of the
consideration for the purposes of section 48.”

CIT v. Chidambaram (Mad HC) – S. 46(2) is a special provision while S. 45 is a general

provision.
N. Bhagwatammal v. CIT (2003 259 ITR 678 SC) – In the case of liquidation and distribution of
assets to shareholders, even agricultural land given to shareholder must be taken into
consideration as S. 46 does not restrict the nature of asset to capital asset only.

CIT v. Brahmi Investment Pvt. Ltd. (2006 286 ITR 66 Guj HC) – Amalgamation is not
considered as a ‘transfer’. If holding company goes into liquidation, and its assets are
redistributed, then S. 47 won’t apply but S. 46 will, which will also override S. 47.

Buyback of shares is also chargeable for capital gains under S. 46A.

SECTION 47

It is exception to transfer i.e., section 45 would not be applicable i.e., there is no chargeability
under section 45. The transactions are exclusive i.e., only if conditions of section 47 are fulfilled,
it is not considered transfer and not subject to capital gain.

Suppose in 2021-22, transaction happened which was covered in section 47, so it was not
taxable. Section 47 is a conditional benefit. Then in any subsequent case, if characteristics are
changed. For instance, all assets of amalgamating company are transferred to the amalgamated
company. This transaction is not regarded as a transfer, provided amalgamated company is an
Indian company. Capital assets are acquired by amalgamated company. After 3-4 years,
amalgamated company converted capital assets into stock in trade. First, it enjoyed benefits of
section 47 as no tax was paid. But later, nature of capital assets was changed. Then, whatever
benefit was taken under section 47 would be withdrawn, and capital gains tax would have to be
paid in that year based on valuation of the assets.

Thus, in any subsequent year, if characteristics of asset are changed, or if additional conditions of
section 47A are not fulfilled, tax has to be paid.

Conditions of section 47A also have to be fulfilled to retain the benefits granted under section
47.

Section 47 provides various transactions which are not regarded as transfer:

1. If there is partition in HUF and assets are given to individual members, it is a transfer, but
is not regarded as a transfer under section 47.
 2. Gift is taxable in the hands of donee and not doner. Thus, transaction of gift is not
regarded as transfer. Gift is regarded as income from other sources.
3. If there is a 100% holding or 100% subsidiary company, and it is an Indian company,
then any transfer of assets between such companies is not transfer.
4. In scheme of amalgamation, any transfer of assets by amalgamating company to
amalgamated company, provided amalgamated company is an Indian company, such
transfer is not considered transfer.
5. If both amalgamating and amalgamated company are foreign and amalgamating company
held some shares in Indian company which are transferred in the course of amalgamation,
this is also not considered transfer if two conditions are fulfilled – first, at least twenty-
five per cent of the shareholders of the amalgamating foreign company continue to
remain shareholders of the amalgamated foreign company, and second, such transfer does
not attract tax on capital gains in the country, in which the amalgamating company is
incorporated.

Section 47A provides additional conditions which have to be followed after the conditions of
section 47 are fulfilled. It provides withdrawal of exemptions in certain cases. (1) Where at any
time before the expiry of a period of eight years from the date of the transfer of a capital asset
referred to in clause (iv) or, as the case may be, clause (v) of section 47,—

  (i) such capital asset is converted by the transferee company into, or is treated by it as, stock-in-
trade of its business; or

 (ii) the parent company or its nominees or, as the case may be, the holding company ceases or
cease to hold the whole of the share capital of the subsidiary company,

the amount of profits or gains arising from the transfer of such capital asset not charged
under section 45 by virtue of the provisions contained in clause (iv) or, as the case may be, clause
(v) of section 47 shall, notwithstanding anything contained in the said clauses, be deemed to be
income chargeable under the head "Capital gains" of the previous year in which such transfer
took place.

Benefit will be withdrawn if conditions of 47A are not fulfilled.

If subsidiary company is transferor and holding company is transferee. Holding company then
has to treat the same asset as capital asset for 8 years. Company cannot treat capital asset into
stock in trade.

MODE OF COMPUTATION – SECTION 48

First, we have to find out full value of consideration. It is not just sale price. Rather, it is the true
value. If there is some manipulation, and person is deliberately charging lesser price, it is not full
value of consideration. If full value is not ascertainable, the fair market value will be taken as full
value of consideration. This would be considered as deemed full value of consideration.

If there is arrangement between unrelated parties to sell some building for 30 lakhs. The stamp
duty payable on the same is 50 lakhs. 30 lakhs therefore is not full value here, rather it is
undervalued. Here, the stamp duty value would be taken as full value.

Section 50C specifically provides for a special provision for full value of consideration in certain
cases.

(1) Where the consideration received or accruing as a result of the transfer by an assessee of a
capital asset, being land or building or both, is less than the value adopted or assessed or
assessable by any authority of a State Government (hereafter in this section referred to as the
"stamp valuation authority") for the purpose of payment of stamp duty in respect of such
transfer, the value so adopted or assessed or assessable shall, for the purposes of section 48, be
deemed to be the full value of the consideration received or accruing as a result of such transfer.

Whenever there is a suspicion of undervaluation, the stamp duty would be taken into
consideration.

From full value of consideration, following deductions are allowed:

1. Expenditure incurred wholly and exclusively in connection with such transfer.

Even registration charges can be called expenditure. In connection with has a wide connection.
Anything required or related with transfer can be claimed here. Suppose a person has flat in
Mumbai. He has to go there to meet buyers, for that he incurs travel expenditure. This can also
be claimed as deduction, if he shows that he travelled to negotiated with prospective buyers.
Building was subject to sale and purchase. A and B tenants had occupied the building as tenants
and were not vacating it. Buyer said that building had to be vacated from tenants as a pre-
condition to sale. The landlord paid 5 lakhs each to A and B to vacate the property. Whether he
can claim this as an expenditure in connection with transfer – yes, it would be considered as such
if it is paid by the seller. And if buyer pays it, it would be added to the consideration paid by the
buyer.

Here, suppose consideration fixed by seller is 50 lakhs. Buyer says that he will pay 40 lakhs as
consideration, and buyer will also vacate the house from the tenants. Here, what is full value of
consideration for seller – the presence of tenants has an effect on the fixation of consideration.
Thus, full value of consideration is not 40 lakhs, but 40 lakhs plus whatever is required to vacate
the premises from the tenants.

2. The cost of acquisition and the cost of any improvement – cost of acquisition is the price
paid to acquire that asset. Cost of improvement is cost incurred for any improvement to
the asset. For instance, there is one floor and another floor is constructed. There is an
improvement in the already existing asset.

If there is no cost of acquisition, then how to determine capital gain.

CIT v. BC Srinivasa Shetty AIR 1981 SC 972 – suppose net worth of a business is 1500 crores,
out of which 500 crores is charged for self-acquired goodwill. Question was whether 500 crores
is chargeable as capital gain. SC said that in self-generated goodwill, there is no cost of
acquisition.

Court discussed various cases, such as Culton v. Douglas, etc. Court considered what is meant by
goodwill. Goodwill denotes benefit arising from the connections and business. It is the
probability. It is a property and a capital asset, but it is not chargeable with capital gains tax.

Court discussed:

“Section 45 charges the profits or gains arising from the transfer of a capital asset to income-tax.
The asset must be one which falls within the contemplation of the section. It must bear that
quality which brings s. 45 into play. To determine whether the goodwill of a new business is
such an asset, it is permissible, as we shall presently show, to refer to certain other sections of the
head, "Capital gains". Section 45 is a charging section. For the purpose of imposing the charge,
Parliament has enacted detailed provisions in order to compute the profits or gains under that
head. No existing principle or provision at variance with them can be applied for determining the
chargeable profits and gains. All transactions encompassed by s. 45 must fall under the
governance of its computation provisions. A transaction to which those provisions cannot be
applied must be regarded as never intended by s. 45 to be the subject of the charge”.

Thus, if section 48 is not applicable because of no cost of acquisition, section 45 also cannot be
applied.

What is contemplated is an asset in the acquisition of which it is possible to envisage a

cost. There are some cases where it is not possible at all as there is no cost.

The intent goes to the nature and character of the asset, that it is an asset which possesses the
inherent quality of being available on the expenditure of money to a person seeking to acquire it.
It is immaterial that although the asset belongs to such a class it may, on the facts of a certain
case, be acquired without the payment of money. 

This judgment of SC has been nullified by an amendment under section 55. Transactions related
to self-acquired assets such as self-generated goodwill, tenancy rights, right to carry on business,
right to manufacture, etc. have been made taxable. But this is an exhaustive list and not an
inclusive list. If cases are covered under section 55, BC Srinivasa would not apply. But in all
other cases, BC Srinivasa would apply as the reasoning has not been nullified. Thus, if in a
transaction, the computation provision is not applicable, the charging provision would also not
apply.

In MP HC case, a person was running a dairy business. For him, livestock was capital asset, and
their sale was capital gain. But calves are produced, and if they are sold, what is cost of
acquisition. Here, BC Srinivasa was applied and since there was no cost of acquisition, Court
decided that no capital gain would be charged.

Also, if goodwill is generated which is acquired goodwill i.e., purchased from someone else, it is
not self-generated, and on that, capital gain would be charged.
Section 55 has been amended in 2021 also. Earlier also, it was amended to nullify the effect of
Srinivasa case. The amended section is:

“(a) in relation to a capital asset, being goodwill of a business or profession, or a trade mark or
brand name associated with a business or profession, or a right to manufacture, produce or
process any article or thing, or right to carry on any business or profession, or tenancy rights, or
stage carriage permits, or loom hours,—

(i) in the case of acquisition of such asset by the assessee by purchase from a previous
owner, means the amount of the purchase price; and
(ii) in the case falling under sub-clauses (i) to (iv) of sub-section (1) of section 49 and
where such asset was acquired by the previous owner (as defined in that section) by
purchase, means the amount of the purchase price for such previous owner; and
(iii) in any other case, shall be taken to be nil.

Provided that where the capital asset, being goodwill of a business or profession, in respect of
which a deduction on account of depreciation under sub-section (1) of section 32 has been
obtained by the assessee in any previous year preceding the previous year relevant to the
assessment year commencing on or after the 1st day of April, 2021, the provisions of sub-clauses
(i) and (ii) shall apply with the modification that the total amount of depreciation obtained by the
assessee under sub-section (1) of section 32 before the assessment year commencing on the 1st
day of April, 2021 shall be reduced from the amount of purchase price;”.

Section 55 has nullified the judgment of Srinivasa case, but only in respect of the specific items
provided in the exhaustive list.

First situation is in relation to the activities mentioned here. In case of acquisition of these assets
by purchase from previous owner, the amount of purchase price would be taken as cost of
acquisition.

Second situation discusses cases of inheritance, succession, etc. Here, cost to previous owner
would be the cost of acquisition.

In any other case i.e., if it is self-generated, i.e., neither purchased from someone, nor gift,
inheritance, succession, etc. In such case, cost of acquisition would be considered to be nil. Any
other case does not mean any other transaction, rather any case which is not covered by the first
or second situation.

Even after amendment, following cases applied Srinivasa case:

Deputy CIT v. Smt. , 2008 299 ITR 183 MP HC – selling of calves.

PNB Finance Ltd. v. CIT, 2008 307 ITR 75 SC.

Thus, reasoning of the case is still valid.

For full value of consideration:

Vaijanath Chaturbhuj v. CIT, 1957 31 ITR 643 Bombay HC – Court said it is erroneous to
suggest that full value is necessarily the value which the parties place upon a capital asset. Full
value must be the true value and not any artificial value assigned.

CIT v. Jaikrishna Hari Vallabh Das, 1998 231 ITR 108 Gujarat HC.

CIT v. George Henderson and Co. Ltd., 1967 66 ITR 622 SC.

Expenditures allowed under capital gain:

CIT v. A. Venkat Raman, 1982 Madras HC – asset was in possession of two tenants and amount
had to be paid to vacate the premises. This expenditure was considered as expenditure in
connection with transfer.

Expenditure incurred in removing a mortgage without which property could not be sold.

Expenditure incurred in removing an encumbrance.

Expenditure in connection with any transfer related matter such as commission to agent, travel
expenditure, etc.

Court has given a wide connotation, as legislature has used expenditure in connection with
transfer, and not expenditure for transfer.

Cost of improvement and cost of acquisition – cost of acquisition is arrived at by determining at

what value person is purchasing the asset. But it is not purchase price. All the things and
expenditures required to purchase the asset would be considered cost of acquisition. This is
similar to actual cost for the purpose of depreciation. For instance, litigation expenditure on title
suit, or registration charges are included in cost of acquisition.

Assesse succeeded to the assets which had a mortgage. Assesse paid money to discharge
mortgage debt. This was considered as part of cost of acquisition in RM Arunachalam v. CIT.

Reverse mortgage – suppose there is mortgage of property during the lifetime of the parents.
They enjoyed the benefits from property. They died and person succeeded to property. he was
required to redeem the property i.e., discharge the mortgage debt. This discharge was considered
part of cost of acquisition, as without that, person cannot succeed to property.

In some cases, there is deemed cost of acquisition. Section 49 provides for this. Cost may not be
ascertainable, or if previous owner, how to determine cost. Gift, inheritance, succession,
amalgamation, demerger, etc. can lead to transfer of property, which are discussed here.

Section 49(1) states that where the capital asset became the property of the assessee—

  (i) on any distribution of assets on the total or partial partition of a Hindu undivided family;

 (ii) under a gift or will;

(iii) (a) by succession, inheritance or devolution, or

(b) on any distribution of assets on the dissolution of a firm, body of individuals, or other
association of persons, where such dissolution had taken place at any time before the 1st day of
April, 1987, or

(c) on any distribution of assets on the liquidation of a company, or

(d) under a transfer to a revocable or an irrevocable trust, or

(e) under any such transfer as is referred to in clause (iv) or clause (v) or clause (vi) or clause
(via) or clause (viaa) or clause (viab) or clause (vib) or clause (vic) or clause (vica) or clause
(vicb) or clause (vicc) or 32[clause (viiac) or clause (viiad) or clause (viiae) or clause (viiaf)
or] clause (xiii) or clause (xiiib) or clause (xiv) of section 47;

(iv) such assessee being a Hindu undivided family, by the mode referred to in sub-section (2)
of section 64 at any time after the 31st day of December, 1969,
the cost of acquisition of the asset shall be deemed to be the cost for which the previous owner of
the property acquired it, as increased by the cost of any improvement of the assets incurred or
borne by the previous owner or the assessee, as the case may be.

If no payment was made for such acquisition, the cost to previous owner would be taken.

Explanation—In this sub-section the expression "previous owner of the property" in relation to
any capital asset owned by an assessee means the last previous owner of the capital asset who
acquired it by a mode of acquisition other than that referred to in clause (i) or clause (ii) or clause
(iii) or clause (iv) of this sub-section.

Thus, the last person who acquired the property by purchasing it would be considered previous
owner.

Suppose even for the previous owner, cost of acquisition cannot be ascertained. Then section
55(3) would apply. It provides that where the cost for which the previous owner acquired the
property cannot be ascertained, the cost of acquisition to the previous owner means the fair
market value on the date on which the capital asset became the property of the previous owner.

In section 55(2)(b), some other issues have also been resolved. If date of acquisition cannot be
ascertained, then fair market value as on April 1, 2001 would be considered.

SECTION 51

Section 54 is an exemption provision. If there is a capital gain, and the gain is invested in some
other capital assets such as buildings, land, shares, bonds, etc., it would be exempted. If a person
sold a house for capital gain of 10 lakhs, and then purchases another house from this 10 lakh,
then capital gains tax is exempted.

Section 51 is a special provision. If at any time, parties A and B agree to sale and purchase land
respectively. B paid 1 lakh as advance money to A and said that other amount would be paid
after some time, and then possession of land would be taken. But B could not pay the
consideration amount, therefore A forfeited the advance payment as the clause provided for the
same. Then A entered into agreement with C, who pays full amount and A sells the land to C. we
have to compute capital gain. Suppose sale consideration between A and C is 50 lakhs.
Cost of acquisition is the price at which A purchased the land. Here, 1 lakh received as advance
from B has to be reduced from the cost of acquisition. Thus, if any advance received or forfeited
by the assess, it would reduce the value of the capital asset while calculating the cost of
acquisition.

Where any capital asset was on any previous occasion the subject of negotiations for its transfer,
any advance or other money received and retained by the assessee in respect of such negotiations
shall be deducted from the cost for which the asset was acquired or the written down value or the
fair market value, as the case may be, in computing the cost of acquisition.

Proviso has been added by amendment Act of 2004 which shows how legislature wants to tax
advance as revenue receipt.

In CIT v. Travancore, 2000, SC said that advance money received with respect to capital asset is
a capital receipt. However, legislature wanted to treat the advance as a revenue receipt as well in
section 56. Legislature wanted to keep both options open – either reduce the value of capital
asset, or tax it as revenue receipt.

Provided that where any sum of money, received as an advance or otherwise in the course of
negotiations for transfer of a capital asset, has been included in the total income of the assessee
for any previous year in accordance with the provisions of clause (ix) of sub-section (2)
of section 56, then, such sum shall not be deducted from the cost for which the asset was
acquired or the written down value or the fair market value, as the case may be, in computing the
cost of acquisition.

Thus, either it is taxable as revenue receipt under section 56(2), and if not, it would reduce the
capital asset value by reducing the cost of acquisition.

This is relevant when assesse later decides that he does not want to sell to anyone. As in such
case, it is a capital receipt which is not taxable, and since there is no question of capital gain, it
would not be deducted from the cost of asset.

SECTION 54

(1) Subject to the provisions of sub-section (2), where, in the case of an assessee being an
individual or a Hindu undivided family, the capital gain arises from the transfer of a long-term
capital asset, being buildings or lands appurtenant thereto, and being a residential house, the
income of which is chargeable under the head "Income from house property" (hereafter in this
section referred to as the original asset), and the assessee has within a period of one year before
or two years after the date on which the transfer took place purchased, or has within a period of
three years after that date constructed, one residential house in India, then, instead of the capital
gain being charged to income-tax as income of the previous year in which the transfer took
place, it shall be dealt with in accordance with the following provisions of this section, that is to
say,—

  (i) if the amount of the capital gain is greater than the cost of the residential house so purchased
or constructed (hereafter in this section referred to as the new asset), the difference between the
amount of the capital gain and the cost of the new asset shall be charged under section 45 as the
income of the previous year; and for the purpose of computing in respect of the new asset any
capital gain arising from its transfer within a period of three years of its purchase or construction,
as the case may be, the cost shall be nil; or

 (ii) if the amount of the capital gain is equal to or less than the cost of the new asset, the capital
gain shall not be charged under section 45; and for the purpose of computing in respect of the
new asset any capital gain arising from its transfer within a period of three years of its purchase
or construction, as the case may be, the cost shall be reduced by the amount of the capital gain.

Provided that where the amount of the capital gain does not exceed two crore rupees, the
assessee may, at his option, purchase or construct two residential houses in India, and where such
option has been exercised—

(a) the provisions of this sub-section shall have effect as if for the words "one residential house
in India", the words "two residential houses in India" had been substituted;

(b) any reference in this sub-section and sub-section (2) to "new asset" shall be construed as a
reference to the two residential houses in India.

Provided further that where during any assessment year, the assessee has exercised the option
referred to in the first proviso, he shall not be subsequently entitled to exercise the option for the
same or any other assessment year.
Suppose in FY 2021-22, there is capital gain of 50 lakhs.

1. First, provision is applicable to HUFs or individual. Thus, it is considered to be a

residential property.
2. It has to be a long-term capital asset being a residential property. Capital gain must arise
from sale of house property i.e., building or land appurtenant thereto taxable under
section 22.

Suppose in year 2021 (within 1 year before the date of transfer), assesse had already purchased a
building for 40 lakhs, or assesse purchased a new building within 2 years after the date on which
transfer took place. Or assesse constructed a new building within 3 years of the date of transfer.
If assesse invested 40 lakhs in another building by purchase or construction within the time
durations given, then the amount so invested would be exempted from capital gain. Here, 40
lakhs would be exempted and 10 lakhs would be capital gain.

There was a Finance Act 2014 amendment. ‘One residential house in India’ has been inserted by
this Act. Earlier, it was only constructed ‘a residential house’. This was interpreted by Court to
mean that not just 1 residential house, but multiple. A does not denote singular or 1 residential
house. To nullify this, a has been substituted with 1.

Secondly, ‘in India’ was not mentioned. So people sold property in India while purchased
property in tax haven countries. To avoid this, ‘in India’ was added.

Now, multiple houses can be sold, but only 1 house can be purchased.

Even after this amendment, there have been judgments which say 1 does not have to be single.
Even if in one building, 3 floors are purchased, it can be taken as 1.

Section 54 also covers only building, and land which is necessary for enjoyment of building, and
not merely for a piece of land.

Suppose capital gain is 50 lakhs, and new building is purchased for 40 lakhs and claimed as
exemption. Within 3 years of date of purchase, this new building is transferred. Then, whatever
value which was claimed as exemption, the entire value would be treated as capital gain. Thus,
condition is that if new asset is purchased, that asset would have to be held for minimum 3 years.
Otherwise, entire value would be treated as capital gain because there would be no cost of
acquisition. As the whole 40 lakhs was cost of acquisition of building which was claimed as
exemption. As entire amount was capital gain, cost of acquisition would be zero.

Suppose new building is sold within 3 years for 60 lakhs. In such case, cost of acquisition is nil,
and not 40 lakhs, as the whole amount was claimed as exemption. Assesse would not be given
double benefit relating to the same asset.

From 2016, the period of holding to declare any capital asset as long term or short term as per
section 2(42A) is only 2 years. But here, period of holding property is 3 years. Thus, there is a
mismatch between the definitions. The whole provision was based on whether asset is short term
or long term. 3 years or 2 years was relevant for declaration as long-term capital asset. When
period for long term capital asset is made 2 years, it should be made 2 years in section 54 also.
But that hasn’t been done.

Filing of return has to be made in that year only. Sub-section 2 states that the capital gains
amount can be deposited in the capital gain deposit account and benefit can be enjoyed.

Suppose in FY 2021-22, there was capital gain of 50 lakhs. But in that year, amount couldn’t be
used. So amount would be deposited in such an account, and within the provided duration, the
amount would be invested. If not, the entire amount would be taxed.

Thus, provision is provided as a tax planning measure.

CIT v. PN Arvinda Reddy, 1979 120 ITR 46 SC – definition of purchase was interpreted by SC.
Even settlement or adjustment between the parties is considered purchase. Here, assesse was
eldest of the 4 brothers who formed a coparcenary. He sold his own house, and acquired the
common house from the 3 brothers, who executed release deeds of 30k each in favour of elder
brother. This release deed was considered a purchase by the SC, and benefit of section 54 was
granted. Thus, liberal interpretation has been there with respect to purchase.

Mrs. Prema P. Shah v. ITO, 2006 100 ITT Mumbai Tribunal – for purpose of availing benefit of
section 54, the residential house may not be in India, but can be outside India also.

To nullify effect of this judgment, in 2014, the word ‘in India’ was added.

CIT v. Geeta Duggal, Delhi HC, Feb 21, 2013 – ‘a residential house’ was interpreted, and
Amendment in 2014 was made to nullify effect of this judgment. ‘A’ was replaced with ‘one’.
CIT v. V. Natarajan, 2006 287 ITR 271 – scope of section 54 was expanded and wide
interpretation was given. Assesse sold his property and invested that money in another property.
But he purchased new property in name of his wife. Court allowed claim of exemption and held
that even if property is purchased in name of wife or children, exemption can be allowed. As we
have to look at the purpose of section 54 to allow exemption in case of purchase of residential
property.

Sanjeev Lal v. CIT, SC, July 1, 2014 – liberal interpretation has been made by SC to provide
claim of exemption under section 54.

INCOME FROM OTHER SOURCES

FILING OF RETURNS AND ASSESSMENT OF INCOME

Section 139(1) discusses this. Being a company or firm, the return has to be mandatorily filed.
But in case of any other person, return has to be filed only when income exceeds the thresholds.

Every assesse is under an obligation to file return on or before the due date. But he is liable for
taxation only till previous year. Suppose April 1, 2021 – March 31, 2022 is previous year. Then
assessment year is 2022-23 for previous year 2021-22. By July 31, 2022, return has to be filed
for financial year 2021-22. Thus, in the assessment year, there is 4 months’ time to file return.

Due date can be different for different categories of persons. For instance, for individuals, due
date is 31st July. This can be extended by notification. In case of company, it is 30 th September. If
company has arms-length transaction, transfer pricing, etc., then it is 30th November.

Once return is submitted, assessment process starts. Section 139(1) talks about original return. If
a person fails to file original return before due date, then return can be filed under section 139(4)
which is called belated return. This can be filed by the end of the assessment year. Also, there
can be best judgment assessment under section 144 – return is not filed, and department has
started assessment of income. On the basis of information the department has, and prior income
and liability, department can assess income of a person. If best judgment assessment has been
done by the department, the belated return cannot be filed. This is because non-filing is
considered an evasion exercise.
Thus, there can be two possibilities in case of non-filing of return – belated return or best
judgment assessment.

As belated return is filed after the due date, penal consequences in the form of fines are attracted.

Third category of return is revised return under section 139(5). Here, original return has already
been filed. So there are no penal consequences for filing revised return. If any omission is
discovered, then person can file the revised return before the end of assessment year, or
assessment of income by the department.

There can be more than one revised return. Revised return would substitute the original return.
Any profit or loss an be claimed under the revised return.

In Finance Act, 2021, amendment was made in this provision. In sub-section (4), for the words
“return for any previous year at any time before”, the words “a return for any previous year at
any time within three months prior to” shall be substituted.

In Finance Act, 2022, sub-section 8A was inserted wherein a timeline of 24 months was
provided to file the original, belated and revised return.

“(8A) Any person, whether or not he has furnished a return under sub-section (1) or sub-section
(4) or subsection (5), for an assessment year (herein referred to as the relevant assessment year),
may furnish an updated return of his income or the income of any other person in respect of
which he is assessable under this Act, for the previous year relevant to such assessment year, in
the prescribed form, verified in such manner and setting forth such particulars as may be
prescribed, at any time within twenty-four months from the end of the relevant assessment year.

Provided that the provision of this sub-section shall not apply, if the updated return,––

(a) is a return of a loss; or (b) has the effect of decreasing the total tax liability determined on the
basis of return furnished under subsection (1) or sub-section (4) or sub-section (5); or (c) results
in refund or increases the refund due on the basis of return furnished under under sub-section (1)
or sub-section (4) or sub-section (5), of such person under this Act for the relevant assessment
year.”

Provided further that a person shall not be eligible to furnish an updated return under search and
seizure cases.
If new return will increase the liability, then only 8A would be applicable, otherwise not.

Section 139(9) provides for defective return. The assessing officer will intimate the defect to
assesse, and give him 15 days’ time to rectify the defect. If assesse fails to rectify the defect in 15
days, or within the additional period allowed by the assessing officer based on the application by
the assesse, it would be considered an invalid return, and all penal consequences for non-filing of
return would apply.

Ram Vilas Kedarnath v. ITO, 1963 47 ITR 586 All HC.

CIT v. Radhe Shyam, 1980 All HC – if the department shows that person was aware about the
wrong statement in the return, then revised return cannot be filed.

CIT v. Rajesh Javeri Stock Brokers Pvt. Ltd., 2007 161 Taxmann 316 SC.

C. Kumar Jagadish Chandra Sinha v. CIT, 1996 86 Taxmann 122 SC.

CIT v. Samsung Distilleries Pvt. Ltd., Bangalore ITAT 2006.

Goetze India Ltd. v. CIT, 2006 157 Taxmann 1 SC.

After 2016 Amendment, revised return can be filed even after belated return.

Department has the power to assess income even if return is not filed. But still, department will
issue a notice to the assesse. If assess has filed a return after best judgment assessment, and
assesse has challenged the validity of best judgment assessment, and Court has declared best
judgment assessment invalid, then the return would be considered belated return.

Once revised return is filed, original return becomes invalid. Whatever is the status as per the
revised return would be computed as the tax liability, and assesse cannot revert back to original
return.

Types of assessment

1. Self-assessment [section 140A] – person has to mention a long list in the return. Filing of
return is considered to be a self-assessment. Thus, it is made by the assesse himself.
2. Summary assessment [section 143(1)]
3. Scrutiny assessment – these are based on the return.
4. Best judgment assessment [section 144]
 5. Income escaping assessment/Re-assessment [section 147 and 148]
6. Search assessment [153A and 158BC]

Section 140A defines self-assessment. Where any tax is payable on the basis of any return
required to be furnished under 3 [ 4 [section 115WD or section 115WH or section 139] or
section 142 5 [or section 148 or 6 [section 153A or, as the case may be, section 158BC]]], 7
[after taking into account,— (i) the amount of tax, if any, already paid under any provision of
this Act; (ii) any tax deducted or collected at source; (iii) any relief of tax or deduction of tax
claimed under section 90 or section 91 on account of tax paid in a country outside India; (iv) any
relief of tax claimed under section 90A on account of tax paid in any specified territory outside
India referred to in that section; and (v) any tax credit claimed to be set off in accordance with
the provisions of section 115JAA 8 [or section 115JD],] 9 [the assessee shall be liable to pay
such tax, together with interest 10[and fee] payable under any of this Act for any delay in
furnishing the return or any default or delay in payment of advance tax, before furnishing the
return and the return shall be accompanied by proof of payment of such tax interest and fee.

Thus, whenever assesse files return, it is considered self-assessment. After self-assessment, the
assessment is started by the department and they see everything.

Summary assessment – department looks into calculation mistakes, errors, etc. The department
assesses only on the basis of the return. Notice is served to the assesse if there is an incorrect
claim, so that there can be reassessment of liability. Thus, on the basis of own statement and
information disclosed by assesse, assessment is done by department. Nothing else is required. At
the time of filing return also, no evidence or submission is required.

It is up to the department which assessment they want to make summary assessment and which
assessment is scrutiny assessment. Generally, assessment of salaried employees is summary
assessment as there are very little things they can hide about their income. As for salaried
employees, the proof of salary is taken from the employer. While assessment of businessmen is
scrutiny assessment.

Scrutiny assessment – they ask for further evidence and documents to be submitted by the
assesse. Documents, bills, books of accounts can be asked to be submitted. In section 142(1),
there is first an inquiry before assessment. Under this, they have power to issue notice for
submitting return. They can ask assesse to submit fresh return.

They can also ask an audit of the books of accounts. This is called second audit. Before 2007,
fees for such auditor appointed under section 142 was payable by the assesse. This led to a lot of
controversy as they charged huge fees and auditor reports didn’t come on time. So after 2007,
this fees is payable by the central government.

In self-assessment, the filing of return itself is a complete assessment in every aspect. There is no
need for a summary or scrutiny assessment.

All returns are subject to summary assessment.

In scrutiny assessment, all proofs, evidences can be called. They also gather evidence from their
own sources.

Best judgment assessment – if the person has not filed the original, belated or revised return
(because of wrong statement or information), then best judgment assessment can be filed. If the
assesse fails to comply with the notice requirement under section 142(1), or if he fails to comply
with second audit requirement, then also best judgment assessment can be done. Even in the
absence of any return, or in absence of any documents filed, best judgment assessment can be
done.

Assessing officer has to gather all evidence based on information which he has. This is based on
all material on record (such as previous returns filed by him) and information gathered by
assessing officer from various sources.

Brijbhushan Lal Pradyumn Kumar v. CIT, 1998 SC – best judgment assessment must have
reasonable nexus to available material. But here, guesswork is necessary. Since there is no
document or evidence available from assesse’s side, some plus minus is allowed and the amount
need not be the exact numbers.

But basis of

Ganga Prasad Sharma v. CIT, MP HC – basis of assessment has to be disclosed by the assessing
officer to the CIT i.e., how the income and expenditure was taken as it was.
Swadeshi Polytecs Ltd. v. ITO, 1983 144 ITR 171 SC.

In one case, department issued notice under section 142(1), and 142(2)(a) for second audit. But
the auditor report wasn’t submitted by assesse in due time. But this was fault of auditor and not
assesse. Department started best judgment assessment. This was set aside by the Court, as it was
not fault of assesse.

Best judgment assessment is a residuary assessment where all other assessment opportunities
have lapsed.

In 2021, Amendment was made where both sections 147 and 148 were replaced.

“147. If any income chargeable to tax, in the case of an assessee, has escaped assessment for any
assessment year, the Assessing Officer may, subject to the provisions of sections 148 to 153,
assess or reassess such income or recompute the loss or the depreciation allowance or any other
allowance or deduction for such assessment year (hereafter in this section and in sections 148 to
153 referred to as the relevant assessment year).

Explanation—For the purpose of assessment or reassessment under this section, the Assessing
Officer may assess or reassess the income in respect of any issue, which has escaped assessment,
and such issue comes to his notice subsequently in the course of the proceedings under this
section, irrespective of the fact that the provisions of section 148A have not been complied
with.”

Earlier, section provided that if assessing officer has reason to believe. This was controversial, as
on what ground could it be said. Reason to believe has been interpreted by SC. Assessing officer
can act on direct and circumstantial evidence, and not on the basis of suspicion, gossip or
rumour. Thus, department can reopen the assessment only when there is a reason to believe.
Reopening of assessment means it is open for all purposes, and not just for the reasons served
with the notice.

GKN Bribe Shops v. ITO, 2003 259 ITR 19 SC – reason to believe has been discussed.

Calcutta Discounts Company Ltd. v. ITO, AIR 1961 SC 372.

Trustee of HEM Nizam v. CIT, 2000 242 ITR 381 SC – regarding reopening of assessment.
ITO v. Biju Patnaik, SC.

In these cases, SC stated various guidelines that are to be followed by the department before
reopening assessment.

1. Assesse can file a fresh return if notice is issued under section 148. Thus, department as
to first issue a notice under section 148.
2. All the processes, formats, etc. of section 139(1) return has to be followed by the assesse.
3. If assessing officer has any information to suggest escaping assessment, he can reopen
assessment, provided prior approval of the assesse is taken.

The last point was not there before 2021 Amendment.

Section 148A was also inserted.

“148A. The Assessing Officer shall, before issuing any notice under section 148, — (a) conduct
any enquiry, if required, with the prior approval of specified authority, with respect to the
information which suggests that the income chargeable to tax has escaped assessment;

(b) provide an opportunity of being heard to the assessee, with the prior approval of specified
authority, by serving upon him a notice to show cause within such time, as may be specified in
the notice, being not less than seven days and but not exceeding thirty days from the date on
which such notice is issued, or such time, as may be extended by him on the basis of an
application in this behalf, as to why a notice under section 148 should not be issued on the basis
of information which suggests that income chargeable to tax has escaped assessment in his case
for the relevant assessment year and results of enquiry conducted, if any, as per clause (a);

(c) consider the reply of assessee furnished, if any, in response to the show-cause notice referred
to in clause (b);

(d) decide, on the basis of material available on record including reply of the assessee, whether
or not it is a fit case to issue a notice under section 148, by passing an order, with the prior
approval of specified authority, within one month from the end of the month in which the reply
referred to in clause (c) is received by him, or where no such reply is furnished, within one
month from the end of the month in which time or extended time allowed to furnish a reply as
per clause (b) expires.”
If some income has escaped assessment, then show cause notice can be issued.

Section 149 was also substituted.

“149. (1) No notice under section 148 shall be issued for the relevant assessment year,— (a) if
three years have elapsed from the end of the relevant assessment year, unless the case falls under
clause (b); (b) if three years, but not more than ten years, have elapsed from the end of the
relevant assessment year unless the Assessing Officer has in his possession books of accounts or
other documents or evidence which reveal that the income chargeable to tax, represented in the
form of asset, which has escaped assessment amounts to or is likely to amount to fifty lakh
rupees or more for that year.”

Section 158 – block assessment. In case of search and seizure, there are various expenditures and
incomes from bullion, etc., for which the assessment is called block assessment.