TAX LAW NOTES

[Document subtitle]

HRIDEJA SHAH
BA LLB 2012
Hrideja Shah
BA LLB 2012

TAX LAW NOTES

Canons of Taxation

Taxes are a compulsory contribution of wealth levied upon persons, natural or corporate, to defray the
expenses incurred in conferring a common benefit upon the residents of the state.
Greater the rate of tax, higher the revenue of the government. But, higher tax rates may impede investment,
lead to tax evasion, etc. Hence, the search for the optimal rate of taxation!
Economists have identified some canons / principles of taxation with an aim to design a good tax system.
These are of two types:
 Adam Smith’s canons of taxation
 Other canons of taxation

Adam Smith’s four canons of taxation:

o Ability to pay: ‘The subjects of every State ought to contribute towards the support of the
government as nearly as possible, in proportion to their respective abilities, i.e. in proportion to the
revenue which they respectively enjoy under the protection of the state’.
Pay as nearly as possible in proportion to your income
o Certainty: ‘The tax which each individual has to pay ought to be certain and not arbitrary. The time
of payment, the amount to be paid, ought to be clear and plain to the contributor and to every other
person’. There needs to be a strict interpretation of tax statutes. Every tax needs to be backed by
relevant statute. Every tax needs to have a legislation. Time of payment, amount to be paid has to be
clear.
o Convenience: ‘Every tax ought to be levied at the time or in the manner in which it is most
convenient for the contributor to pay it’. – it should be most convenient for the contributor to pay it.
o Canon of economy: ‘Every tax ought to be so contrived as both, to take out and keep out of the
pockets of the people as little as possible over and above what it brings into the public treasury of the
state’.

The last canon implies that the expenses of collection of taxes should not be excessive. They should be kept
to the minimum, consistent with the administrative efficiency.

Contrast Adam Smith with JS Mill

‘The rule of equality and of fair proportion seems to me to be that people should be taxed in an equal ratio
on their superfluities, necessaries being untaxed, and surplus paying in all cases an equal percentage.’

Meade adds international considerations to these concepts of what is a good tax. Globalisation makes it
essential for tax systems to be integrated to some extent

Other Canons of Taxation

o Productivity: Taxes should bring an ample amount of money to the State. Therefore, a tax, which
does not yield a fair income, is useless. Example: Wealth tax
o Elasticity: If government requires more funds, it can increase its revenue from the same taxes
without incurring any additional costs of collection and reducing the incentive to production. Income
tax is a very good example of an elastic tax. Example: Income tax, increasing the percentage bracket
of people in a certain group. So if currently Rs. 2-4 lakh earning people pay 10%, then the bracket
can be changed to 1.5 L to 4L.
o Simplicity: The tax system should be fair, simple and logical.
2
Hrideja Shah
BA LLB 2012

o Diversity: Taxation should be broad based. It must cover all persons who can afford to contribute to
the government revenue.
o Development: Taxation intends to bring socio-economic development in the country as a whole.
o Flexibility: A flexible tax quickly adjusts to the new conditions. Presence of flexibility is a pre-
condition for elasticity. Lack of flexibility in a tax can cause financial trouble to the state. Elasticity
is the subset of flexibility.

SOURCES OF DOMESTIC TAX LAW

o Primary legislation: It creates the chargeability of the tax, who is to pay it, when it becomes payable,
when and how it is to be collected.
o Judicial and quasi-judicial decisions
o Administrative decisions: Decisions of CBDT and Settlement Commission (which are both
administrative agencies) are facts specific and may not be relevant factually or legally to decide other
cases.
o Statutory notifications
o CBDT Circulars: (as opposed to statutory notifications) are explanatory only and have no legal
effect. However, both circulars and press notes are reliable, being indicative of official policy.
o Constitution of India: as some of the Articles have a direct bearing on the tax statute (Part XIII and
Schedule VII, for example)
o Other legislations like Companies Act, Partnership Act, Hindu and other Personal Laws etc. which
affect the levy and incidence of tax.

Indian Income Tax: Timeline

o Aftermath of the 1857 Mutiny: financial crunch which led to introduction of the first Income Tax
Act in February, 1860 by James Wilson. The tax system was modelled largely on the lines of the
British system.
o The Act received the assent of the Governor General on July 24, 1860, and came into effect
immediately. It was divided into 21 parts consisting of no less than 259 sections.
o Income was classified under four schedules: i) income from landed property; ii) income from
professions and trade; iii) income from securities, annuities and dividends; and iv) income from
salaries and pensions.
o The legislation lapsed in 1865 and was re-introduced in 1867.

o Income Tax Act, 1886: Anglo-Russian War - Governer General Lord Dufferin. The first
comprehensive Act of its kind in modern India that was a combination of 'Licence Tax' and 'Income
Tax'.
o 1916 - graduated rates of taxation on income above Rs. 2,000 introduced
o 1917 - super tax introduced
o 1922 - Indian Income Tax Act passed
o 1939 - substantial amendments made
o 1961 - A new act was drafted which came into force from April 1, 1962 and is currently in force.

Objectives of Tax-

 Raising Revenue
 Regulation of Consumption and Production
 Encouraging Domestic Industries
3
Hrideja Shah
BA LLB 2012

 Stimulating Investments
 Reducing Income Inequalities
 Promoting Economic Growth
 Development of Backward Regions
 Ensuring Price Stability

A tax may be defined as a "pecuniary burden laid upon individuals or property owners to support the
government, a payment exacted by legislative authority. A tax "is not a voluntary payment or donation, but
an enforced contribution, exacted pursuant to legislative authority". Taxes consist of direct tax or indirect
tax

DIRECT TAX AND INDIRECT TAX

Direct Tax

A Direct tax is a kind of charge, which is imposed directly on the taxpayer and paid directly to the
government by the persons (juristic or natural) on whom it is imposed. A direct tax is one that cannot be
shifted by the taxpayer to someone else.
It is imposed on the income and property of a person. Thus, income tax, corporation tax, property tax, death
tax, capital gains tax etc. are all the direct taxes. Impact and incidence is on the same person.

Merits

 The larger burden of the direct taxes falls on the rich people who have capacity to bear these and the
poor people with less ability to pay have to bear less burden.
 Direct taxes are important instrument of reducing inequalities of income and wealth.
 Unlike indirect taxes, direct taxes do not cause distortion in the allocation of resources. As a result
these leave the consumers better off as compared to indirect taxes.
 Revenue elasticity of direct taxes, especially if they are of progressive type is quite high. As the
national income increases, the revenue on these taxes also rises a great deal.

 Economical: cost of collecting these taxes is relatively less as they are usually collected at the source
and are paid directly to the government.
 Certainty: Tax payers know how much they have to pay and on what basis they have to pay. The
government also knows fairly the amount of tax it is going to collect.
 Equity: ability to pay – progressive tax slabs in income tax
 Aids in redistribution
 Civic consciousness: knowledge of contribution

Demerits

 In the direct taxation, people are aware of their tax liability and therefore they would try to avoid or
even evade the taxes. The practice and possibility of tax evasion and avoidance is more in direct
taxes than in case of indirect taxes.
 Direct taxes are generally payable in lump sum or even in advance and become quite inconvenient.
 Another demerit of direct taxes is their supposed effect on the will to work and save. It is assessed
that work (given Income) and leisure are two alternatives before any taxpayer. If therefore, a tax is
imposed say on income, the taxpayer will find that the return from work has decreased as compared
with return from leisure. He therefore tries to substitute leisure for work.
 Unpopular: cannot be shifted
4
Hrideja Shah
BA LLB 2012

 Possibility of tax evasion

 Adverse effects on the will to work and save: Higher rates of income tax may discourage people to
work hard or work overtime. Similarly, the taxes may reduce their willingness to save.
 Inconvenience: to the tax payers. Sometimes, the tax payers are required to pay the entire tax in a
lump sum. Besides, the tax payers have to give elaborate documents on their income and
expenditure.

Indirect Tax

An indirect tax is a tax collected by an intermediary (such as a retail store) from the person who bears the
ultimate economic burden of the tax (such as the customer). An indirect tax is one that can be shifted by the
taxpayer to someone else. An indirect tax may increase the price of a good so that consumers are actually
paying the tax by paying more for the products.
Indirect taxes are those whose burden can be shifted to others so that those who pay these taxes to the
government do not bear the whole burden but pass it on wholly or partly to others. Indirect taxes are levied
on production and sale of commodities and services and small or a large part of the burden of indirect taxes
are passed on to the consumers. Excise duties on the product of commodities, sales tax, service tax, customs
duty, tax on rail or bus fare are some examples of indirect taxes.

Merits

 Indirect taxes are usually hidden in the prices of goods and services being transacted and, therefore
their presence is not felt so much.
 If the indirect taxes are properly administered, the chances of tax evasion are less.
 Indirect taxes are a powerful tool in moulding the production and investment activities of the
economy i.e. they can guide the economy in its resource allocation.
 Convenience: paid in small amounts and in installments instead of lump sum -included in the price
of the commodity and hence burden is not felt
 Elastic: when imposed on essential goods and services like edible oils, flour etc. whose demand is
inelastic, government can get adequate revenue by increasing the tax rate
 Less chances of tax evasion: difficult to be evaded as they are included in the price of the
commodity.
 Wide coverage: imposed on a large variety of goods so that the purview is wide
 Equity: can be equitable by differentiating between luxury goods and essential commodities.

Demerits

 Regressive and unjust: Indirect taxes are generally imposed on the consumption of the goods. They
are unjust in the sense that poor people have to pay as much as rich people. They negate the principle
of ability to pay and therefore their burden is more on poor people.
 Inflationary impact: Leads to an increase in ultimate price of a commodity. This may lead to rise in
the cost of production as a result of which the workers union demands more of wages that again
increases the price of the commodity and this spiral goes on.
 Uneconomical: administrative cost of collecting indirect taxes is generally high as they have to be
collected from a large number of persons.
 Uncertain: rise in the price of the commodity – effect on demand cannot be predicted with certainty
 No civic consciousness: disguised - through market prices - indifference towards their responsibility

5
Hrideja Shah
BA LLB 2012

 It is claimed and very rightly that these taxes negate the principle of ability- to-pay and are therefore
unjust to the poor. Since one of the objectives is to collect enough revenue, they spread over to cover
the items, which are purchased generally by the poor. This makes them regressive in effect.
 If indirect taxes are heavily imposed on the luxury items, then this will only help partially because
taxing the luxuries alone will not yield adequate revenue for the State.
 indirect taxes are added to the sale prices of the taxed goods without touching the purchasing power
in the first place. The result is that in their case inflationary forces are fed through higher prices,
higher costs and wages and again higher prices.

Sources of Tax Law

 Taxation Statutes
 Constitution of India
 Other Statutes
 Judicial Decisions
 Decisions by Administrative Bodies
 Circulars issued by CBDT

6
Hrideja Shah
BA LLB 2012

INTERPRETATION OF TAX STATUTES

Important Terms

Surplus When the Government receives more than it spends

Deficit When the Government spends more than it receives
Inflation Excessive printing of money leads to inflation
Debt Crisis If the government borrows too much from abroad
BOP Crisis If the government draws down on its foreign exchange reserves
Crowding Out Excessive domestic borrowing by the government may lead to higher real interest rates
and the domestic private sector being unable to access funds resulting in crowding out
Regressive Tax It is a tax where lower-income entities pay a higher fraction of their income in taxes than
do higher-income entities
Proportional Is a tax where everyone, regardless of income, pays the same fraction of income in taxes
Tax
Progressive Is a tax where lower-income entities pay a lower fraction of their income in taxes than do
Tax higher-income entities

A regressive tax is a tax where lower-income entities pay a higher fraction of their income in taxes than do
higher-income entities.

A proportional tax (sometimes called a flat tax) is a tax where everyone, regardless of income, pays the
same fraction of income in taxes.

A progressive tax is a tax where lower-income entities pay a lower fraction of their income in taxes than do
higher-income entities.

The result of a regressive tax is that the lower-income taxpayer pays a larger percentage of his or her income
in taxes than does the higher-income taxpayer. The opposite of the regressive tax is the progressive tax.
With progressive taxes, such as the federal Income Tax, the effective tax rates increase as the taxpayer's
income increases.
The proportionate tax rate, also referred to as a flat tax rate, remains constant as income rises. Under a
proportionate tax system, higher-income individuals pay a greater amount of taxes than lower-income
individuals pay, but the ratio is identical.

Financial year
Period of 12 months beginning on April 1 every year and ending on immediately following March 31.

Finance Act
The finance bill is commonly referred to as budget and is presented generally on the last day of February
every year. The finance bill when signed by the President becomes the Finance Act.

Assessment year
means the period starting from April 1 and ending on March 31 of the next year.
Example- Assessment year 2006-07 which will commence on April 1, 2006, will end on March 31, 2007.
Income of previous year of an assesse is taxed during the next following assessment year at the rates
prescribed by the relevant Finance Act

7
Hrideja Shah
BA LLB 2012

Previous Year
Income earned in a year is taxable in the next year. The year in which income is earned is known as
previous year and the next year in which income is taxable is known as assessment year. In other words,
previous year is the financial year immediately preceding the assessment year.
Illustration 1.1 - For the assessment year 2006-07, the immediately preceding financial year (i.e., 2005-06)
is the previous year. Income earned by an individual during the previous year 2005-06 is taxable in the
immediately following assessment year 2006-07 at the rates applicable for the assessment year 2006-07.
Similarly, income earned during the previous year 2006-07 by a company will be taxable in the assessment
year 2007-08 at the rates applicable for the assessment year 2007-08.

Previous Year in the case of newly set up Business/Profession

In the case of a newly set up business/profession or in the case of a new source of income, the previous year
is determined as follows:
The first previous year commences on the date of setting up of the business/profession and ends
immediately following March 31. Thus, in the case of a newly set up business or new source of income, the
first previous year is a period of 12 months or less than 12 months.
The second and subsequent previous years are always financial years i.e. 12 months each (April to March)

FISCAL POLICY

Fiscal policy deals with the taxation and expenditure decisions of the government.
Monetary policy deals with the supply of money in the economy and the rate of interest.
In most modern economies, the government deals with fiscal policy while the central bank is responsible for
monetary policy.

 Fiscal policy is composed of several parts. These include:

 tax policy,
 expenditure policy,
 investment or disinvestment strategies and
 debt or surplus management.

Fiscal policy is an important constituent of the overall economic framework of a country and is therefore
intimately linked with its general economic policy strategy.

Fiscal policy also feeds into economic trends and influences monetary policy. When the government
receives more than it spends, it has a surplus.

If the government spends more than it receives it runs a deficit. To meet the additional expenditures, it needs
to borrow from domestic or foreign sources, draw upon its foreign exchange reserves or print an equivalent
amount of money. This tends to influence other economic variables.

 On a broad generalization, excessive printing of money leads to inflation.

 If the government borrows too much from abroad it leads to a debt crisis.
 If it draws down on its foreign exchange reserves, a balance of payments crisis may arise.
 Excessive domestic borrowing by the government may lead to higher real interest rates and the
domestic private sector being unable to access funds resulting in the “crowding out” of private
investment. Sometimes a combination of these can occur.

In any case, the impact of a large deficit on long run growth and economic well-being is negative. Therefore,
there is broad agreement that it is not prudent for a government to run an unduly large deficit.
8
Hrideja Shah
BA LLB 2012

However, in case of developing countries, where the need for infrastructure and social investments may be
substantial, it sometimes argued that running surpluses at the cost of long-term growth might also not be
wise (Fischer and Easterly, 1990).
The challenge then for most developing country governments is to meet infrastructure and social needs
while managing the government’s finances in a way that the deficit or the accumulating debt burden is not
too great.
The Indian Constitution provides the overarching framework for the country’s fiscal policy.

India has a federal form of government with taxing powers and spending responsibilities being divided
between the central and the state governments according to the Constitution. There is also a third tier of
government at the local level.
Since the taxing abilities of the states are not necessarily commensurate with their spending responsibilities,
some of the Centre's revenues need to be assigned to the state governments.

To provide the basis for this assignment and give medium term guidance on fiscal matters, the Constitution
provides for the formation of a Finance Commission (FC) every five years.

Based on the report of the FC the central taxes are devolved to the state governments. The Constitution also
provides that for every financial year, the government shall place before the legislature a statement of its
proposed taxing and spending provisions for legislative debate and approval. This is referred to as the
Budget. The central and the state governments each have their own budgets.

RULES OF INTERPRETATION

a. Whitney v. Commissioner of Inland Revenue

Once that it is fixed that there is a liability it is antecedently highly improbable that the statute should not go
on to make that liability effective. A statute is designed to be workable, and the interpretation thereof by a
Court should be to secure that object, unless crucial omission or clear direction makes that end unattainable.
Now, there are three stages in the imposition of a tax:
 there is the declaration of liability, that is the part of the statute which determinies what persons in
respect of what property are liable.
 Next, there is the assessment. Liability does not, depend on assessment. That, 'ex hypo'hesi' has
already been fixed. But assessment particularises the exact sum which a person liable has to pay.
 Lastly, come the methods of recovery, if the person taxed does not voluntarily pay.

b. Govind Saran Ganga Saran vs Commr Of Sales Tax And Ors AIR 1985 SC 1041

This appeal by special leave is directed against the judgment and order of the High Court of Delhi
dismissing the appellant's writ petition questioning the liability imposed in him on a sales tax assessment.

The appellant carries on business as a dealer in the re-sale of cotton yarn. As a dealer he has been registered
under the Bengal Finance (Sales Tax) Act, 1941 as applied to the Union Territory of Delhi (hereinafter
referred to as the 'State Act'). The appellant says that he purchases cotton yarn and sells it to registered
dealers, unregistered dealers and consumers. For the assessment year 1968-69 the appellant submitted his
return of turnover under the state Act and claimed exemption in respect of the turnover of sales of cotton
thread on the ground that it was an exempted item under Entry No. 21 of the Second Schedule. The Sales
Tax Officer, by his order dated October 29,1970, held that the sales were effected in respect of cotton yarn
and, therefore, they were liable to tax at one per cent on appeal, the Assistant (commissioner of Sales Tax

9
Hrideja Shah
BA LLB 2012

took a contrary view and on his finding that the transactions were in respect of cotton thread he allowed the
appeal and struck the assessment down.

In the instant case, we are concerned with the taxation of goods which under s. 14 of the Central Sales Tax
Act have been declared to be of special importance in inter-State trade or commerce. Where the turnover of
such goods is subjected to tax under the sales tax law of a State, s. 15 prescribes the maximum rate at which
such tax may be imposed and requires that such tax shall not be levied at more than one point. The two
conditions have been imposed in order to ensure that inter-State trade or commerce in such goods is not
hampered by heavy taxation within the State occasioned by an excessive rate of tax or by multi point
taxation.

The single point at which the tax may be imposed must be a definite ascertainable point so that both the
dealer and the sales tax authorities may know clearly the point at which the tax is to be levied.

The components which enter into the concept of a tax are well known.
 The first is the character of the imposition known by its nature which prescribes the taxable event
attracting the levy,
 the second is a clear indication of the person on whom the levy is imposed and who is obliged to pay
the tax,
 the third is the rate at which the tax is imposed, and the fourth is the measure or value to which the
rate will be applied for computing the tax liability.
If those components are not clearly and definitely ascertainable, it is difficult to say that the levy exists in
point of law. Any uncertainty or vagueness ill the legislative scheme defining any of those components of
the levy will be fatal to its validity.

Held:

Accordingly, we hold that the assessment of the turnover of cotton yarn for the assessment year 1968-1969
under the Bengal Finance (Sales Tax) Act, 1941 as applied to the Union Territory of Delhi cannot be
sustained. In the result, the appeal is allowed, the judgment and order of the High Court of Delhi are set
aside and the assessment of the turnover of cotton yarn is quashed. The appellant is entitled to its costs.

In Cape Brandy Syndicate v. IRC, Rowlatt J. famously said :

“... in a taxing Act one has to look merely at what is clearly

said. There is no room for any intendment. There is no equity
about a tax. There is no presumption as to a tax. Nothing is to
be read in, nothing is to be implied. One can only look fairly at
the language used” (my emphasis).”

Indian Courts and Interpretation of Taxation Statutes

Statutes imposing taxes or monetary burdens are to be strictly construed. The logic behind this principle is
that imposition of taxes is also a kind of imposition of penalty which can only be imposed if the language of
the statute unequivocally says so.
Any kind of intendment or presumption as to tax does not exist.

10
Hrideja Shah
BA LLB 2012

Rules of Interpretation

1. Charging Section

Charging section has to be construed strictly. If a person has not been brought within the ambit of the
charging section by clear words, he cannot be taxed at all.
The section that charges the tax must have clear words. Before taxing any individual it must be clearly
established that the person to be taxed falls within the purview of the charging section by clear words.
There is no implication of the law. If a person cannot be brought within the four corners of the law, he is
free from tax liability.
a. Calcutta Jute Manufacturing Co. v Commercial Tax officer

The question raised in all these appeals is whether an assessee is liable to pay interest under section 10A of
the Bengal finance (Sales Tax) Act 1941, on the turnover tax for the period during which recovery of the tax
amountwas stopped by orders of the High Court. West Bengal Taxation Tribunal answered the said question
against the appellants and hence these appeals by special leave.

For dealing with the aforesaid question, only necessary e facts need be mentioned. A new provision (section
6B) was included in the Bengal Finance (Sales Tax) Act 1941, (hereinafter referred to as the `Act' for short)
and an identical provision was included in the West Bengal Sales Tax Act 1954 as Section 4AAA. The
effect of the new provision was that they imposed a tax on the turnover of a dealer whose annual aggregate
gross turnover exceeded Rs. Fifty lakhs. The provisions came into force on 1.4.1979. These appellants were
concerned with section 6B of the Act and hence, they filed writ petitions before the Calcutta High Court
challenging the validity of the aforesaid provision. The High Court, on admission of the writ petitions,
granted interim relief by injuncting West Bengal Government from collecting such tax on the turnover, but
ultimately the writ petitions were dismissed. thus, liability of the appellants to pay tax on the turnover
became conclusive and appellants remitted the tax amount accordingly. But in the meanwhile, Government
of West Bengal yet another provision as Section 10A in the Act by which interest at the rate of 2% per
month was charged on the tax amount payable by the dealer during the period of default. So demands were
made on the appellants to pay interest on the tax amount.

Appellants disputed their liability to pay such interest mainly on two grounds. First is that since appellants
have furnished the returns and paid full tax as per such returns they are not liable to pay interest under
section 10A of the Act. Second is, even otherwise they are not liable to pay interest on the tax amount as its
non- recovery was the effect of the injunction order granted by the High Court.

Held:

When interpreting such a provision in a taxing statute a construction which would preserve the purpose of
the provision must be adopted. It is well settled that in interpreting a taxing statute normally, there is no
scope for consideration of principles of equity. There is no room for searching the intentions, presumptions
or equity.

b. Mathuram Agarwal v State of Madhya Pradesh

The appellant and respondents 4 to 7 are joint owners of 13 separate items of house properties bearing No.
56/2(1) to 56(2)/13 situated in ward No. 15 of Raigarh Municipal area. The assessment proceeding for the
purpose of levying property tax was initiated under the provisions of the Madhya Pradesh Municipalities Act,
1961 (M.P. Act No. 37 of 1961) (hereinafter referred to as 'the Act') by the Municipal Council, Raigarh,
respondent no.2 herein. The Municipality purporting to invoke the proviso to the section 127-A(2) of the Act
aggregated the annual letting value of all the buildings and levied property tax on the deemed annual letting
11
Hrideja Shah
BA LLB 2012

value so aggregated. The assessment order was followed by the demand notice.
Feeling aggrieved by the levy and collection of property tax in the manner aforementioned, the appellant and
respondents 4 to 7 preferred appeal under Section 139 of the Act before the Civil Judge Class-II, Raigarh. The
appellate authority allowed the appeal and quashed the assessment order and the demand notice. On a revision
petition being filed by the Municipality the District Judge, Raigarh allowed the revision, set aside the order of
the appellate authority and confirmed the order of assessment made by the concerned authority.
The appellant and the respondents 4 to 7 filed the Writ Petition in the High Court of Madhya Pradesh
challenging the order of assessment, inter alia, on the grounds that it was not in conformity with the
provisions of the Act. They also challenged the constitutional validity of the proviso to sub-clause (b) of
Section 127(A) (2) of the Act. By the impugned judgment a Division Bench of the High Court rejected the
contentions raised by the petitioners including the challenge to the constitutional validity of the proviso to
Section 127(A)(2) and confirmed the assessment order of the municipality and dismissed the writ petition.

Held:

It is that the subject is not to be taxed unless the words of the taxing statute unambiguously impose the tax
on him. words cannot be added or substituted to find a meaning in a statute so as to serve the intention of the
legislature. Every taxing statute must contain three aspects; subject of tax, person to be taxed and the rate of
tax.
Equally impermissible is an interpretation which does not follow from the plain, unambiguous language of
the statute. Words cannot be added to or substituted so as to give a meaning to the statute which will serve
the spirit and intention of the legislature. The statute should clearly and unambiguously convey the three
components of the tax law i.e., the subject of the tax, the person who is liable to pay the tax and the rate at
which the tax is to be paid. If there is any ambiguity regarding any of these ingredients in a taxation statute
then there is no tax in law. Then it is for the legislature to do the needful in the matter.

2. Strict and favourable construction

Taxing enactment should be strictly construed and the right to tax should be clearly established. Equitable
construction should not be taken into account. Courts should not strain words and find unnatural meaning to
fill loopholes.
If the provision can be interpreted in two ways, then the one favoring the assesse must be taken into
consideration.

a. Saraswati Sugar mills v Haryana State Board

Issue: whether the industries which manufacture sugar from sugar cane are covered by Entry 15 of Schedule
I to the Water (Prevention and Control of Pollution Cess Act), 1977?

Held: The Act must be strictly construed in order to find out whether a liability is fastened on a particular
industry. The subject is not to be taxed without clear words for that purpose, and also that every Act of
Parliament must be read according to its natural construction of words.

3. Clear Intention to impose or increase tax

The intention to impose or increase tax or duty must be clear and in unambiguous language.

4. Prospective operation

12
Hrideja Shah
BA LLB 2012

The cardinal principle of tax laws is that the law to be applied to assesse is the law in force in the assessment
year unless otherwise provided expressly or by necessary implication.
No retrospective effect to fiscal statute is possible unless the language of the statute is very clear and plain.

a. Reliance Jute Industries Ltd v Commercial Tax officer

It is a cardinal principle of the tax law that the law to be applied is that in force in the assessment year unless
otherwise provided expressly or by necessary implication. Fiscal Statute are generally not retrospective
otherwise expressly provide by necessary implications.

5. Meaning in common parlance

In finding out the meaning of a taxing statute, the meaning in common usage, parlance special in
commercial and trade circles must be considered.

a. Annapurna Biscuit Manufacturing Co. v Commissioner of Sales tax

It is a well settled rule of construction that the words used in a law imposing a tax should be construed in the
same way in which they are understood in ordinary parlance in the area in which the law is in force. If an
expression is capable of a wider meaning as well as narrower meaning the question whether the wider or the
narrower meaning should be given depends on the context and the background of the case.

b. Dunlop India Ltd V Union of India

Facts:
In these appeals by special leave the only question that is raised is whether the substance known as pyratex-
Vinyl Pyridine Latex (for short, V. P. Latex) is not rubber raw classifiable under item No. 39 of the Indian
Tariff Act 1934 (hereinafter referred to as I.C.T.) .
The appellants are manufacturers of automotive tyres. V. P. Latex is required in the process of
manufacturing of tyres. V. P. Latex is not manufactured in India and has to be imported from outside the
country. The tyre industry uses V. P. Latex as one of the essential ingredients in the course of manufacture
of automotive tyres.

Held:
“latex” comes within the meaning of “rubber” for the purpose of tax.

6. Imposition of Tax by authority of law

The taxes and assessment can only be imposed by an authority established under a statute. The tax can be
levied only by an Act of the parliament.

In Atlas Cycles Industries Ltd v State of Haryana, the Supreme Court held that notification imposing a tax
cannot be deemed to be extended to new areas in the municipality.

7. No presumption as to tax

As regards to imposition of tax, no presumption exists. It cannot be drawn by implication or analogical

extensions. The presumption for equality and against partiality of taxation exists.

In Mohammed Ali Khan v Commissioner of Wealth Tax, it was held that no tax can be imposed by inference,
analogy or probing into the intention of the legislature.
13
Hrideja Shah
BA LLB 2012

8. Fiscal statute to be read as a whole

The entire provisions of a fiscal statute has to be read as a whole and not in piecemeal to find out the intent
of the legislature.
In Grasim Industries Limited v State of Madhya Pradesh, the Supreme Court held that any exemption
notification in a fiscal statute must be read in its entirety and not in parts to find out the meaning.

14
Hrideja Shah
BA LLB 2012

CONSTIITUTIONAL ASPECTS AND TAXATION

Fiscal Policy – Monetary Policy

• Finance Commission – Planning Commission
• Fiscal Federalism
• Indian Constitution and Taxation Law
• Tax, fee and the conundrum of compensatory taxes

Fiscal Policy

Fiscal policy - dealing with the government’s taxation and expenditure decisions (Budget – government)
• Monetary policy - policy dealing with the supply of money in the economy (central bank – rates of
interest)
• Receipts - revenue and capital
• Expenditure - revenue and capital
• Fiscal Deficit = Total Expenditure (that is, Revenue Expenditure + Capital Expenditure) – (Revenue
Receipts + Recoveries of Loans + Other Capital Receipts (that is all Revenue and Capital Receipts other
than loans taken))

Capital Expenditure and Revenue Expenditure

Expenditure incurred by an assesse may be of two types – Capital Expenditure and Revenue Expenditure.
The distinction between the two is vital because capital expenditure, even if incurred for the purpose of
earning income, is not deductible while computing taxable income, unless the law expressly so provides.
Revenue expenditure, on the other hand, is deductible while computing taxable income unless the law
provides specific rules to disallow such expenditure wholly or partly.

Capital Expenditure is incurred is incurred in acquiring, extending or improving a fixed asset. Revenue
expenditures is incurred in the normal course of a business as a routine business expenditure.
Capital expenditure produces benefits for several previous years. Revenue expenditure is consumed within a
previous year.
Capital expenditures makes improvements in earning capacity of a business. Revenue expenditure on the
other hand, maintains the profit making capacity of a business.

Finance Commission – Planning Commission

• Fiscal Responsibility and Budget Management Act, 2003

• Planning Commission – plan and non-plan expenditure – five year plans
(note this government’s plan to do away with the body)
• Finance Commission (Art.280)
• Power to make grants
• First FC: Revenues of States fell short 15% of required revenues
• Fourteenth FC: Chairman, Dr. Y.V. Reddy (first report due by Oct 2014 and term covered is 2015 to 2020)
• Why are revenues distributed? - Vertical imbalance, fiscal inequality

Co-operative Federalism
 Art.265 – No tax shall be levied or collected except by authority of law
 There must be a law;
 The law must authorize the tax; and
 The tax must be levied and collected according to the law.

15
Hrideja Shah
BA LLB 2012

 Distribution of powers – legislative competence – doctrine of repugnancy (Art.246, Seventh

Schedule)
 Division of taxing powers – levy, collection and retention / distribution
 Union taxes can be classified into 4 categories
 Levied, collected and retained by the Union (corporation tax, customs duty, etc.)
 Levied, collected by Union but revenues shared with the States (income tax and excise duties
- exceptions) – Art.270
 Levied and collected by Union but wholly assigned to the States (succession and estate duties) –
Art.269
 Levied by Union but collected by States (stamp duties and excise duties on medicinal preparations) –
Art.268
 State taxes – land revenue, agricultural income tax, excise duties on narcotics and alcohol, sales
taxes (Art.286, entry 92A)
 Consolidated Fund of India

 Stamp duty example (stamp duty on share certificates – paid to central government, claim made by
the concerned state government)
 Service Tax – consequent amendment made

Parliamentary debates around Fiscal Federalism

 Demands of the richer provinces (West Bengal, Madras and Bombay) – should reflect collection
 Debate regarding the sales tax provisions and how the present structure came to be
 Reasons for the centralization of powers – lack of sovereign power, unstable financial period, limited
financial resources
 Compromise: basic taxes and revenues left to the States while the most lucrative heads were left to
the Union

Part XIII of Indian Constitution

 Art.301 - Subject to Part XIII, trade, commerce and intercourse throughout the territory of India shall
be free.
 Art.302 – Parliament is empowered to impose such restrictions on trade, commerce as may be
required in public interest.
 Art.303 – Neither Parliament nor any State legislature is empowered to make any law giving
preference to one State over another. Exception: if declared by law that it is necessary to do so for
dealing with a situation of scarcity.
 Art.304 - Notwithstanding 301 or 303, a State may impose a tax on imported goods, but this should
not amount to a discrimination between manufactured and imported goods.
 Proviso: State legislature can impose reasonable restrictions on freedom of trade and commerce with
or within the state as may be required in public interest. However, such bill cannot be introduced in
the State Legislature without previous sanction of the President.
 Entry taxes and the importance of Art.304(b)
 Difference between powers of Parliament (Art.302) and State legislature: (Art.304) reasonableness
and Presidential sanction

Is tax a restriction?

 Language in Art.304(a)
 Atiabari – Art.301 grants protection from ‘direct and immediate’ restrictions on the ‘movement of
trade’ (pith and substance + effect and operation)
16
Hrideja Shah
BA LLB 2012

 Automobile
 Das J. propounded the theory of compensatory taxes as a clarification to the Atiabari test
 Regulatory measures or compensatory taxes – outside Art.301 purview
 Example of a regulatory measure – one which actually facilitated trade, though it appeared to
harm it (eg. traffic rules)
 Compensatory tax – toll or tax which charges for use of trading facilities and is not a barrier,
burden or deterrent for a trader
 Quantum of levy cannot be much more than the benefit to trade

Beyond Automobile

Stage One
 Bolani Ores – subsequent dilution (Entry 57, List II)
 International Tourist Corporation
 dropped the requirement of proportionality
 If the tax were to be proportionate to the expenditure on regulation and service it would not be a
tax but a fee’
 Is a compensatory tax comparable with a fee?

Stage Two

 Bhagatram
 Concept of compensatory taxes has been widened
 Even some link, direct or indirect, sufficient
 Bihar Chamber
 Some connection sufficient – judicial notice of the various facilities provided by the State
 Hansa Corporation and Geo Miller
 Compensatory taxes were described as measures compensating the
 municipalities for loss of revenue
 Who is to be compensated – trader or the State?

Stage Three

• Jindal Stainless
1. Distinction between taxing (revenue generation) and regulatory (enforce
discipline / regulation of conditions or incidents of trade) powers
2. Fall out of Automobile : Compensatory tax as a sub-class of fee
3. Distinction between a tax and fee
 Underlying principle: Tax - burden (ability to pay, as part of common burden and any benefit is
incidental and not capable of direct measurement) vs. Fee: equivalence (quantifiable or measurable
benefit)
 Structure: Tax: may be progressive or proportional vs Fee: broadly proportional
4. Distinction between fee and compensatory tax – capacity of bearer (individual vs. individual as a member
of a class)

5. Features of a compensatory tax:

‘In the context of Article 301, therefore, compensatory tax is a compulsory contribution levied broadly in
proportion to the special benefits derived to defray the costs of regulation or to meet the outlay incurred for
some special advantage to trade, commerce and intercourse. It may incidentally bring in net-revenue to the
government but that circumstance is not an essential ingredient of compensatory tax.’ (para 37)
17
Hrideja Shah
BA LLB 2012

6. How does one determine the compensatory nature?

 Act must facially indicate the quantifiable benefit
 If provisions are ambiguous / do not spell out the benefit, burden upon State

7. Ultimate ruling: Atiabari and Automobile restored; Bhagatram and Bihar Chamber bad law

Fee

• Ram Chandra v State of UP – fee must be earmarked for rendering some special (not indirect or remote)
benefit /services to licensees in the notified market – substantial portion must be shown to be spent for the
requisite purpose
• M Chandru - levy of Infrastructure Development Charges by the Chennai Municipal Development
Authority for planning permission issued to builders
 HC finding: levy was to strengthen water and sewage infrastructure; SC: principle of equivalence not
satisfied
 Of course the quid pro quo need not be understood in mathematical equivalence but only in a fair
correspondence between the two. A broad co-relationship is all that is necessary.”
 “A charge fixed by statute for the service to be performed by an officer, where the charge has no
relation to the value of the services performed and where the amount collected eventually finds its
way into the treasury of the branch of the government whose officer or officers collect the charge is
not a fee but a tax” (Coole’s exposition quoted in M Chandru)

Cess

 Ordinarily, a cess is a tax which raises revenue which is applied for a specific purpose
 “it means a tax and is generally used when the levy is for some special administrative expense which
the name (health cess, education cess, road cess, etc.) indicates. When levied as an increment to an
existing tax, the name matters not for the validity of the cess must be judged of in the same way as
the validity of the tax to which it is an increment.” (Hidayatullah, J. in Shinde Brothers v.
Commissioner Raichur & Ors)
 Appears in the tax revenues of the government – may be levied on various tax bases

Tolls

 Entry in List II, distinct from tax and fee

 Kamaljeet Singh v Municipal Board (AIR 1987 SC 56) – Toll tax levied by Municipal Board on
vehicles entering the municipal limits was challenged. It was contended as being a compensatory tax.
 ‘Usually, the consideration for a toll is some amenity, service, benefit or advantage which the person
entitled to the toll undertakes[sic] to provide for the public in general, or the persons liable to pay the
toll[sic].’
 Decision: The Municipal Board provides no facilities whatever to the owners of vehicles...Even
assuming that the Municipal Board has to incur expenditure on maintenance of the connecting road
and the allay, but they are facilities provided for the residents for which it recovers various taxes.
Hence, the toll tax must be struck down as ultra vires.

Compensatory and Regulatory Taxes

For a tax to be considered ‘compensatory’ for the purposes of Article 301 of the Constitution, it must be
broadly proportionate to the special benefits derived as a result of it. a tax whose quantum is approximately
equal to the benefit conferred on trade as a result of the tax will not attract Article 301, as it is
18
Hrideja Shah
BA LLB 2012

‘compensatory’ in nature. In other words, if the proceeds of a tax are used to improve trade facilities
through, for instance, building infrastructure, and the extent of this benefit to trade is not disproportionate to
the levy itself, the tax will be beyond the pale of Article 301.

Regulatory measures or measures imposing compensatory taxes for the use of trading facilities do not come
within the purview of the restrictions contemplated by Article 301 and such measures need not comply with
the requirements of the proviso to Article 304(b) of the Constitution

Since a compensatory tax actually benefits trade, there is no question of it violating a provision that states
that trade shall be free. It follows that the crux of a compensatory tax is the robust relationship between the
quantum of the levy, and the benefit to trade as a result of the levy.
The concept of compensatory nature of tax has been widened and if there is substantial or even some link
between the tax and the facilities extended to such dealers directly or indirectly the levy cannot be impugned
as invalid.
It is of the essence of compensatory tax that the service rendered or facility provided should be more or less
commensurate with the tax levied. A ‘specific, identifiable object behind the levy’ and a ‘nexus between the
subject and the object of the levy’ are required.

Cases: Atiabari, Automobile, Bolani Ores, Jindal Stainless Steel - IMP

Difference between Fee and Compensatory Tax

The fact that a fee is a proportionate levy does not prove the converse, that every proportionate levy is a fee.
Briefly, a fee is levied on an individual as such, while a compensatory tax is levied on him as a member of a
class.
The difference between a compensatory tax and a fee was explained on the basis of the ‘principle of
equivalence’. The principle behind a tax, the Court said, was the ability or capacity to pay, or the ‘principle
of burden’. A fee, on the other hand, was based on the ‘principle of equivalence’, which required that the
exaction approximate the benefit flowing from the exaction. The Court held that the basis for a
compensatory tax was also the principle of equivalence.
A fee is ‘compensatory’ if that particular fee improves the flow of trade, and if so, it will be outside the
purview of Article 301. But that does not make it a compensatory tax, because a fee is not a tax in the first
place. In other words, equivalence is a necessary but not sufficient condition for a levy to be considered a
fee. A tax is generally not compensatory. However, that does not mean that a tax which is compensatory
becomes a fee. It continues to be a compensatory tax, and is outside the purview of Article 301 for that
reason. A fee, on the other hand, usually has elements of quid pro quo, but will not be ‘compensatory’ unless
it improves trade.

19
Hrideja Shah
BA LLB 2012

INCOME: INDIAN INCOME AND FOREIGN INCOME

As per the definition in section 2(24), the term income means and includes:

• Profits and Gains and Dividends

• Voluntary contributions received by a trust created wholly or partly for charitable or religious
purposes or by an institution established wholly or partly for such purposes
• Any special allowance or benefit, other than those included above
• Any allowance granted to the assessee either to meet his personal expenses at the place where the
duties of his office or employment of profits are ordinarily performed by him or at a place where he
ordinarily resides or to compensate him for the increased cost of living (city compensatory allowance/
dearness allowance)
• Any benefit or perquisite to a director or to a representative assessee
• Capital gains and Insurance profit
• Banking income of a co-operative society
• Amount exceeding Rs. 50,000 by way of gift received by an individual or a Hindu Undivided Family
• Any sum chargeable to income tax under Section 28 (Profits and gains from Business and
Profession), Section 41 (Profits chargeable to tax), and Section 59 (Deemed Profit under Income from other
sources) of the Income Tax Act.
• Any winnings from lotteries, crossword puzzles, races, including horse races, card games and games
of any sort or from gambling or betting of any form or nature whatsoever
• Any sum received as contribution to the assessee's provident fund or superannuation fund or any
fund for the welfare of employees or any other fund set up under the provisions of the employee’s state
insurance act
• Profits on sale of a license granted under the Imports (control) order, 1955 made under the imports
and Exports (control) act, 1947

The definition of the term ‘income’ starts with the word includes: the list is inclusive and not exhaustive.

CIT v Karthikeyan (G.R) [(1993) 201 ITR 866 (SC)]-

The SC has held that the purpose of the inclusive definition is not to limit the meaning but to widen its net,
and the several clauses therein are not exhaustive of the meaning of income; even if a receipt does not fall
within the ambit of any of the clauses, it might still be income if it partakes of the nature of the income.

Bhagwan Das Jain v Union of India (1981) 5 Taxman 7 (SC)-

Entry 82 of List I of the Seventh Schedule, which empowers the parliament to levy ‘taxes on income other
than agricultural income’, should not be read in a narrow or restricted sense.

Illegal Income-

Income is Income, though tainted. For purposes of Income tax, there is no difference between legal and
tainted income. Even illegal income is taxed just like any legal income. By taxing such income, the State is
not taking part in the crime or condoning it, nor it would become a principal or sharer in the illegality. The
revenue merely looks at an accomplished fact, viz, on profit being earned and assesses the same. The
assessee may be prosecuted for the crime and yet be charged on the profit. For example, the income earned
from smuggling activities would also be taxable under the Act. If it were not so, then the illegal activity
would be put at a premium because a person carrying on this activity would get immunity from payment of
taxes, while an honest tax payer carrying on a legal business would be paying taxes on his income.

20
Hrideja Shah
BA LLB 2012

CIT v Chunilal B. Mehta (1938) 6 ITR 521 (PC)-

Profits from wagering contracts

Neroth Oils Mills Co. Ltd. V CIT (1987) 116 ITR 418 (Ker)

A sum received in connection with an illegal transfer of a license

CIT v Troilakya Chandra Bora (2003) 261 ITR 299 (Gau)

The amount embezzled could not partake of the character of a loan. The basic and fundamental
characteristic of a loan is the consent and knowledge of the lender at the time of advancement of money.
Money embezzled is a gain to the embezzler and therefore, falls within the wider definition of ‘Income’
under the Indian Income Tax Act.

Important Pointers

Tax is imposed on real income - not on notional income except when the Act allows so
Taxable income is the income upon which tax can be imposed. It excludes income that is not taxable
(Ex: Income from Agriculture, Foreign income in the hands of a resident / non-resident etc.)
Income is taxable whether or not it is legal or illegal. Earning illegally will be punished by other Acts
but the income is taxed by the Income Tax Act
Income is taxed whether it is received by way of Money or Kind (Example: A Car won in a lottery)
Income Tax does not differentiate if the income is received in lump sum or periodically.
Income is taxable as long it is not already taxed. i.e. Double Taxation is avoided.
The taxable Income and the tax liability shall be rounded off to the nearest multiple of ten rupees.

Indian Income-
Any of the following three is an Indian income —
1. If income is received (or deemed to be received) in India during the previous year and at the same time it
accrues (or arises or is deemed to accrue or arise) in India during the previous year.
2. If income is received (or deemed to be received) in India during the previous year but it accrues (or arises)
outside India during the previous year.
3. If income is received outside India during the previous year but it accrues (or arises or is deemed to
accrue or arise) in India during the previous year.
Foreign Income-
If the following two conditions are satisfied, then such income is “foreign income” —
a. Income is not received (or not deemed to be received) in India; and
b. Income does not accrue or arise (or does not deemed to accrue or arise) in India.

The following broad conclusions can be drawn —

Indian Income - Indian income is always taxable in India irrespective of the residential status of the
taxpayer.
Foreign Income - Foreign income is taxable in the hands of resident (in case of a firm, an association of
persons, a joint stock company and every other person) or resident and ordinarily resident (in case of an
individual and a Hindu undivided family) in India. Foreign income is not taxable in the hands of non-
resident in India.

21
Hrideja Shah
BA LLB 2012

In the hands of resident but not ordinarily resident taxpayer, foreign income is taxable only if it is (a)
business income and business is controlled from India, or (b) professional income from a profession which
is set up in India. In any other case, foreign income is not taxable in the hands of resident but not ordinarily
resident taxpayers.

Key Terms-

Receipt of Income- The “receipt” of income refers to the first occasion when the recipient gets the money
under his control. Once an amount is received as income, any remittance or transmission of the amount to
another place does not result in “receipt” at the other place.

Remittance- Remittance is transmission of income after its first receipt.

Deemed Receipt- It is not necessary that an income should be actually received in India in order to attract tax
liability. An income deemed to be received in India in the previous year is also included in the taxable income
of the assessee. The Act enumerates the following as income deemed to be received in India.

Accrual of Income- Income accrued in India is chargeable to tax in all cases irrespective of residential status
22
Hrideja Shah
BA LLB 2012

of an assessee. The words “accrue” and “arise” are used in contradistinction to the word “receive”. Income is
said to be received when it reaches the assessee; when the right to receive the income becomes vested in the
assessee, it is said to accrue or arise.

Deemed to accrue or arise in India- In some cases, income is deemed to accrue or arise in India under section
9 even though it may actually accrue or arise outside India. Section 9 applies to all assessees irrespective of
their residential status and place of business.

23
Hrideja Shah
BA LLB 2012

INCOME TAX: INTRODUCTION

Source of legislative power to levy an income tax

Income tax is payable on the total income of every person for the previous year, as assessed in the
assessment year (at the rates applicable in the assessment year).
Total income is to be computed as per the provisions of the Act.
The tax is to be deducted at source or paid in advance wherever required under the provision of the Act.

Sources of Income Tax Law

1. The Income Tax Act, 1961

 The legislation came into force w.e.f. 1.4.1962 and it contains 298 sections, XIV Schedules and an
Appendix
 The Law provides for determination of taxable income, tax liability and procedure for assessment,
appeal, penalties and prosecutions.
2. Finance Act – Finance Bill
 Finance Bill consists of two parts: Part A contains proposed policies of the Government in fiscal
areas and Part B contains detailed tax proposals and once approved, it becomes known as the
Finance Act.
 Income tax rates are prescribed in the Schedule I to the Finance Act.
3. Subordinate legislation
 Administration of direct taxes is vested with the Central Board of Direct Taxes (CBDT).
 CBDT is empowered to frame rules from time to time to carry out the purpose and proper
administration of the Act (Section 295, IT Act) - The Income Tax Rules, 1962.
 All forms, procedures and principles of valuation of perquisites prescribed under the Act are
provided in the Rules framed by CBDT.
 Statutory notifications
4. Circulars
 CBDT issues circulars and notifications under Section 119 of the Act
 Circulars clarify doubts regarding the scope and meaning of the various provisions of the Act.
They act as guidance for officers and assesses and are binding on Assessing Officers but not on
assesses and Courts.
 Circulars issued by CBDT shall not be contrary to the Act.
5. Case laws – decisions of various courts and tribunals

Key Concepts

Basic principle: Income of PY is taxed during the following AY at the rates prescribed for such AY by the
relevant Finance Act. However, there are some exceptions :

a. Income of non-residents from shipping (Sec.172);

b. Income of persons leaving India either permanently or for a long period of time - no present intention of
coming back to India (Sec.174);
c. Income of bodies formed for short duration – when it appears that the body will be dissolved due to the
fulfilment of the purpose or completion of the event (Sec.174A);
d. Income of a person trying to alienate his assets with a view to avoiding payment of tax (Sec.175); and
e. Income of a discontinued business or profession (Sec.176) – discretion of officer.

24
Hrideja Shah
BA LLB 2012

a-d: income must be taxed in the PY to ensure smooth collection from the taxpayers who may not otherwise
be traceable if assessment is postponed to AY, unlike in (e).

Charge (Section 4)

Income tax is chargeable on an annual basis at the rate applicable in the AY (exceptions discussed above)

Rates of tax are fixed by the annual Finance Act.

If on April 1st of the AY, new Finance Bill has not been placed on the statute books, the provisions in the
preceding AY or those in the Finance Bill before the Parliament, whichever is more beneficial to the assesse
will apply until new provisions become effective.

Total income is calculated in accordance with the provisions of the Act, as they stand on the April 1st of the
AY (with the exception of provisions that have been given a retrospective effect).
Procedural provisions are applicable from the date of the amendment.

The following principles are followed while charging tax:

1. Annual Tax
2. Tax Rate of Assessment Year
3. Rates fixed by Finance Act
4. Tax on Person
5. Tax on total income
6. Provisions as on April 1 of the assessment year applicable for computing income for the assessment
year

Income Tax shall be charged at the rates fixed for the year by the Annual Finance Act.
The First Schedule to the Finance Act provides the following rates of taxation:
 Part I: The tax rates applicable to income of various types of assesses for the AY
 Part II: Rates of TDS for the current financial year (in certain cases)
 Part III: Rates of TDS for salary and advance tax (which becomes Part I of the First Schedule in the
next AY)

Person

Person u/s 2(31) includes:

• an individual,
• HUF,
• company,
• firm,
• an association of persons (common purpose or action) or body of individuals (conglomeration of
individuals), whether incorporated or not,
• a local authority and
• every other artificial juridical person (deities, bar council, etc.)

Explanation: 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 it is established with an objective of deriving income,
profits or gains.

25
Hrideja Shah
BA LLB 2012

Assesse

u/s 2(7) means

(a) a person by whom income tax or any other sum of money (penalty or interest) is payable under the Act;
(b) every person in respect of whom any proceeding under the Act has been taken for the assessment of his
income or loss or the amount of refund due to him;
(c) a person who is assessable in respect of income or loss of another person or who is deemed to be an
assesse; or
(d) an assesse in default under any provision of the Act.
Every assesse is a person but every person need not be an assesse.

Gross Total Income and Total Income

As per section 14, the income of a person is computed under the following five heads:
1. Salaries
2. Income from house property
3. Profits and gains of business or profession
4. Capital gains
5. Income from other sources
Gross Total Income: the aggregate income under these heads in accordance with the provisions of the Act
before making any deduction under Sec.s 80C to 80U.
Total Income: it is the Gross Total Income as reduced by the amount permissible as deduction under Sec.s
80C to 80U.

Exemptions (Sec.10):
 income that qualifies as an exemption is not included in the computation of income
Deductions (Chapter VIA):
 generally given from income chargeable to tax
 deduction can be less than or equal to or more than amount of income
 If amount deductible is more than income, then the resulting amount will be shown as loss

Capital-Revenue Receipts

Receipts are of two types – Capital and Revenue. The distinction between the two is vital.
Capital Receipts are exempt from tax unless they are expressly taxable. (for example, capital gains are
taxable under Section 45 even if they are capital receipts)
Revenue receipts are taxable unless they are expressly exempt from tax. For instance, incomes exempt under
Section 10.

Difference between Circulating and Fixed Capital

A receipt on account of circulating capital is revenue receipt. A receipt on account of fixed capital is capital
receipt.
Fixed capital is what the owner turns to profit by keeping it in his own possessions for making profits. It
may be in the form of tangible assets or in the form of intangible assets.
Circulating capital is what he makes profit of by parting with it and letting it change matters. It is turned and
in the process of being turned over yields income or loss.
Sometimes the same asset may be fixed capital in one business and circulating capital in another business.
Therefore, the nature of a receipt may vary according to the nature of trade in connection with which it
arises.
26
Hrideja Shah
BA LLB 2012

Receipt in the hands of recipient is material

In order to determine whether a receipt is capital or revenue in nature, one has to go by its nature in the
hands of the recipient. The source from which the payment is made has no bearing on the question. It
therefore, follows that even if the amount is paid (wholly or partly), out of capital, it may partake of the
character of a revenue receipt in the hands of the recipient.
Payment received on the redemption of debentures, held as investment, is a capital receipt in the hands of
the recipient, even if the company makes payment out of its profits.

Payers motive irrelevant

The motive of payer is not relevant while deciding whether a particular receipt is revenue or capital in
nature.

Receipt in Lieu of source of income

A receipt in lieu of source of income is a capital receipt. A receipt in lieu of income is revenue receipt. For
instance, compensation for loss of employment is a capital receipt, as it is in lieu of source of income.
Sale proceeds of trees removed from land together with their roots, leaving behind no prospect of
regeneration, is a capital receipt as the receipt is in lieu of source of income.
Where, however, trunks of trees of spontaneous growth are cut so that the stumps are allowed to remain in
the hand with the bark adhering to the stumps to permit regeneration of the trees, receipts from the sale of
trunks would be revenue receipt.

Lump sum payment

In order to determine whether a receipt is capital or revenue in nature, the fact that it is a lump sum payment,
large payment or periodic payment, is not relevant. It is not necessary that a revenue receipt should be
recurring or a capital receipt should be a single receipt.

RESIDENTIAL STATUS

Citizenship and Residential Status are separate concepts.

Residential Status impacts the incidence of taxation – Section 5
Section 5- Scope of total income
There are different tests for different assesses
It is to be determined for each PY – because the status may change from year to year
A person may be a resident of more than one country for any previous year. If this happens, then we need to
look at resolving the possibility of a double taxation.

Section 6 lays down the test of residence for the following entities:
o An individual
o A hindu undivided family
o A firm or an association of persons or a body of individuals
o A company
27
Hrideja Shah
BA LLB 2012

o Every other person

Assesses are either:

a. Resident in india
b. Non resident in india

As far as resident individuals and Hindu undivided families are concerned, they can be divided into two
categories
a. Resident and Ordinarily resident
b. Resident but not ordinarily resident
All other assesses can simply be either a resident or a non resident.

It is not necessary that a person who is resident in India, cannot become resident in any other country for the
same assessment year. A person may be a resident in more than one country at the same time for tax
purposes, though he cannot have two domiciles simultaneously. It is therefore not necessary that a person
who is resident in India, will be non resident for all other countries for the same assessment year.

Residential Status of an individual (sec. 6)

An individual may be:

a. Resident and ordinarily resident
b. Resident but not ordinarily resident
c. Non resident

An individual is said to be resident in India if he satisfies any one of the following two conditions under Sec.
6(1):
(a) He is in India for a period or periods amounting to 182 days or more in the relevant PY; or
(c) He is in India for 60 days or more during the relevant PY and has been in India for 365 days or more
during four PYs immediately preceding the relevant PY.
Exceptions:
(1) Indian citizen who leaves India in any PY as a member of the crew of an Indian ship or for purposes of
employment outside India, the period of 60 days in condition 2 supra, shall be substituted by 182 days.
(2) Indian citizen or Person of Indian Origin, who comes on a visit to India in any PY, the period of 60 days
in condition 2 supra, shall be substituted by 182 days.
In effect, condition 2 becomes redundant for the assesses covered in the exceptions.

Employment outside India

The requirement is not leaving India for employment but its is leaving India for purposes of employment
outside India. Consequently, an individual need not be an unemployed person who leaves India for the
employment outside India.
For instance, a private sector company in India employs X, an Indian citizen. He leaves India for the first
time on September 27,2008 for Tokyo for completing an overseas project of the employer company. He will
come back after 6-7 months. X can take the benefit of the exception given above. Since his total stay in
India during the previous year 2008-09 is less than 182 days, he will be non resident in India for the
previous year 2008-09.

28
Hrideja Shah
BA LLB 2012

Person of Indian Origin

A person is deemed to be of Indian origin if he, or either of his parents or any of his grand parents, were
born in undivided India. It may be noted that grand parents include both maternal and paternal grand
parents.

Sec.115 C (e) “non-resident Indian” means an individual, being a citizen of India or a Person of Indian
Origin who is not a “resident”.
Explanation: A person shall be deemed to be of Indian origin if he, or either of his parents or any of his
grand-parents, was born in undivided India

While determining the residential status of an assesse, it is not essential that the stay should be at the same
place. It is also not necessary that the stay should be continuous. Similarly, place of stay or purpose of stay
is not material.
A stay by an individual on a yacht moored in the territorial waters of India would be treated as his presence
in India for the purpose of this section.
Where a person is in India only for a part of the day, the calculation of physical presence in India in respect
of such broken period should be made up on an hourly basis. A total of 24 hours of stay spread over a
number of days is to be counted as being equivalent to the stay of one day.
The day of entering and exiting the Indian territory should be counted in the 182 day period.

Resident but not ordinarily resident

Sec. 6(6): 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
(b) 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.
• If a person who satisfies either of the basic tests and fulfills either or both of (a) or (b), he will be
classified as resident but not ordinarily resident in India.

Under Section 6(6), a resident individual is treated as resident and ordinarily resident in India if he satisfies
the following two additional conditions. The law has not prescribed the conditions but the test can be
derived by looking at Sec.6(6) which refers to the condition to be satisfied for proving that an individual is
not ordinarily resident in India. The conditions are as follows:

a. He has been a resident in India in at least 2 out of 10 previous years immediately preceding the
relevant previous year
b. He has been in India for a period of 730 days or more during 7 years immediately preceding the
relevant previous year

The above test is known as the flip test. It can be stated that an individual becomes resident and ordinarily
resident in India if he satisfies at least one of the basic conditions and the two additional conditions.

Non-resident

A person can be termed as being not resident in India when none of the conditions mentioned in Section 6(1)
[182 days’ test along with the exceptions] is satisfied.
29
Hrideja Shah
BA LLB 2012

Resident and ordinarily resident
Must satisfy at least one of the
basic conditions and the two
additional conditions i.e. one of
(a) or (b) and both of (i) and (ii)
Resident but not ordinarily Non resident
resident
Must satisfy at least one of the Should not satisfy any of the
basic conditions and one or none basic conditions
of the additional conditions i.e.
one of (a) or (b) and none of (i)
or (ii)

In the case of an Indian citizen
who leaves India during the
previous year for the purpose of
employment or who leaves India
as a member of the crew of an
Indian Ship
(1)
a. Presence of at least 182
days in India during the
previous year
b. Not functional
In the case of an Indian Citizen or In the case of an individual (other
a person of Indian origin( who is than not mentioned in column 1
abroad) who comes to India on a and 2
visit during the previous year
(2) (3)
a. Presence of at least 182 a. Presence of at least 182
days in India during the days in India during the
previous year previous year
b. Not functional b. Presence in India for at
least 60 days during the
previous year and 365
days during 4 years
immediately preceding the
previous year

Basic Conditions u/s 6(1):

a) must be in India for a period of 182 days or more during the PY or
b) must be in India for a period of 60 days or more during the PY and 365 days or more during the 4
years immediately preceding PY.

Additional Conditions u/s 6(6):

a) must be a non-resident in India in nine out of the ten PYs preceding that year or
b) must be in India during 7 preceding PYs for an aggregate of 729 days or less.

30
Hrideja Shah
BA LLB 2012

Residential Status of a HUF

Sec. 6 (2) :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.

A Hindu undivided family is non resident in India if control and management of its affairs is wholly situated
outside India.

Place of Control Residential Status of family

Control and management of the affairs of a hindu
undivided family is:
a. Wholly in India ----------------------------------------- Resident
b. Wholly out of India ------------------------------------ Non-resident
c. Partly in India and partly outside India ------------- Resident

In order to determine whether a hindu undivided family is resident or non resident, the residential status of
the karta of the family during the previous year is not relevant. Residential Status of the karta during the
preceding years is considered for whether a resident family is ordinarily resident. Test of residence of a HUF
is tied to the location of control and management of affairs
If a HUF is resident in India then it must be further seen whether or not it is ordinarily resident. This
depends on the residential status of the karta.

If the karta of a resident Hindu undivided family does not satisfy the two additional conditions mentioned
under section 6(6)(b), the family is treated as resident but not ordinarily resident in India.

The residential status of HUF depends upon the control and management of its affairs.
 Non-Resident: If the control and management of the affairs of HUF is situated wholly outside India.
 Resident: If the control and management of the affairs of HUF is situated wholly or partly in India.
 Not Ordinarily Resident: A resident HUF is said to be ‘Not Ordinarily Resident’ in India if Karta or
manager thereof, satisfies any of the additional conditions under Sec.6(6).

V.V.R.N.M. Subbayya Chettiar v. Commissioner of Income Tax, Madras (AIR 1951 SC 101)

31
Hrideja Shah
BA LLB 2012

Facts: Karta of a HUF domiciled in Ceylon with his family and he carries on business in Colombo – he
owns a house, some immovable property and investments as well as shares in two firms in British India. In
the year of account, 1941-42, which is the basis of the present assessment, the appellant is said to have
visited British India on seven occasions for a total period of 101 days.

Finding of the Asst Commr of IT: no correspondence or other evidence was produced which would show
that any instructions were issued from Colombo as regards the management of the affairs in British India.

The following broad propositions can be stated on the basis of Subbaya Chettiar case and Narasimha Rao
case:
a. Generally, HUF shall be taken to be resident in India unless control and management of its affairs is
situated wholly outside india
b. HUF may be residing in one place and doing business in other place.
c. Occasional visit of a non resident karta to the place of HUF’s business in India would be insufficient
to make HUF ordinarily resident in India

Residential Status of a Company

Sec.6 (3): A company is said to be resident in India in any previous year, if—
(i) it is an Indian company; or
(ii) during that year, the control and management of its affairs is situated wholly in India.
 A company’s residential status depends on incorporation and control and management of affairs.
 Control and management must be wholly in India

Place of Control Residential status for Indian A company other than an

company Indian comapny
Control and management of the affairs of a
company is:
a. Wholly in India Resident Resident
b. Wholly outside India Resident Non resident
c. Partly in India and partly outside Resident Non resident
India

A company can never be ordinarily or not ordinarily resident in India.

Control and Management test

The term control and management refers to head and brain which directs the affairs of policy, finance,
disposal of profits and vital things concerning the management of a company. Control is not necessarily
situated in country in which the company is registered. Under the tax laws, a company may have more than
one residence. The mere fact that a company is also resident in a foreign country, would not necessarily
displace its residence in India.
Usually control and management of a company’s affairs is situated at the place where meetings of board of
directors are held. Moreover, control and management referred to in section 6 is central control and
management and not the carrying on of day to day business by servants, employees or agents.

32
Hrideja Shah
BA LLB 2012

UK Common law test which draws its origin from Lord Loreburn’s ratio in DeBeers ([1906] A.C. 455).
Lord Loreburn opined that a company is resident where its real business is carried on, which he explained as
being the place where the company’s ‘central management and control’ abides.

Narottam (AIR 1954 Bom 67) – Facts: Company is a subsidiary of the Scindia Steam Navigation Co. Ltd.
incorporated in Bombay with its registered office in Bombay. Business is stevedoring in Ceylon. Two
managers in Ceylon, acting under wide powers-of-attorney look after all the affairs of the company in
Ceylon. However, all board and shareholder meetings are held in Bombay.

It was sought to be argued that the whole of the company’s business is done in Ceylon and that the whole of
the income which is liable to tax has been earned in Ceylon. But is this the relevant factor?

It is entirely irrelevant where the business is done and where the income has been earned. What is relevant
and material is from which place has that business been controlled and managed…It is that authority to
which the servants, employees and agents are subject, it is that authority which controls and manages them,
which is the central authority, and it is at the place where the central authority functions that the company
resides.

On facts, the PoAs could be cancelled at any moment, the officers had to carry out any orders given to them
from Bombay and were required to submit an explanation of what they have been doing, and a vigilant eye
was kept over their work from the directors’ board room in Bombay. Bombay exercised not only a ‘de jure’
control and management, but also a ‘de facto’ control and management.

Control and Management does not mean carrying on a day to day business. Even a partial control of the
company outside India is sufficient to hold a foreign company as a non resident.

Radha Rani case- IMP

Difference in the residence test : HUF and a company

In this connection it is perhaps necessary to look at the converse definition of an Hindu undivided family,
firm or other association of persons. In their case they are resident unless the control and management of its
affairs is situated wholly without the taxable territories. Therefore, whereas in the case of an Hindu
undivided family or firm or association of persons any measure of control and management within the
taxable territories would make them resident, in the case of a company any measure of control and
management of its affairs outside the taxable territories would make it non-resident.’ - Narottam and Parekh
Ltd. v Commissioner of Income Tax, Bombay City (AIR 1954 Bom 67)

Place of effective management test

Alternate test for corporate residence proposed in the Draft Direct Tax Code which has been spelt out as
follows:
The place where the board of directors of the company or its executive directors, as the case maybe, make
their decisions; or
In a case where the board of directors routinely approve the commercial and strategic decisions made by the
executive directors or officers of the company, the place where such executive directors or officers of the
company perform their functions.

Residential Status of Other persons

33
Hrideja Shah
BA LLB 2012

Sec.6 (4) Every other person is said to be resident in India in any previous year in every case, except where
during that year the control and management of his affairs is situated wholly outside India.

Resident: If the control and management of the affairs of a firm or AOP or other person is situated wholly or
partly in India then such a firm or AOP or other person is said to be resident in India.

Non-Resident: If the control and management of the affairs of a firm or AOP or other person is situated
outside India then such a firm or AOP or other person is said to be non-resident in India

Capital – Revenue Receipts

 Consideration received or loss of earnings or profits – revenue receipt; compensation for extinction,
partly or fully, of a profit earning source not being in the ordinary course of business – capital receipt
 Non-compete fees – what is the nature? Gillanders Arbuthnot & Co. Ltd. v CIT [1964] 53 ITR 283
(SC)
 Sale of a business as a going concern – what is the nature? CIT v West Coast Chemicals & Industries
Ltd. [1962] 46 ITR 135 (SC)
 Burden of proof: on department to show that a particular receipt is in the nature of a revenue receipt

Draft Direct Tax Code

• Need for DTC: numerous amendments to IT Act and Wealth Tax Act, 1957 and several conflicting
judgments by different HCs
• Draft Code of 2009 - sought to consolidate and amend the law relating to all direct taxes so as to
establish an economically efficient, effective and equitable direct tax system which would facilitate
voluntary compliance and also reduce the scope for disputes and minimize litigation
• Suggestions received from various stakeholders was used to draft a DTC Bill, 2010 – was referred to
the Standing Committee on Finance on 9th September, 2010
• Kelkar Committee observed that the DTC Bill, 2010 is likely to result in considerable unacceptable
loss – need for comprehensive review
• Amendments made in the meanwhile by way of FA, 2011, 2012 and 2013 could not have been easily
incorporated into DTC Bill, 2010 – led to revised DTC, 2013

The first draft bill of DTC was released by GOI for public comments along with a discussion paper on 12
August 2009 (DTC 2009) and based on the feedback from various stakeholders, a Revised Discussion Paper
(RDP) was released in 2010. DTC 2010 was introduced in the Indian Parliament in August 2010 and a
Standing Committee on Finance (SCF) was specifically formed for the purpose which, after having a broad-
based consultation with various stakeholders, submitted its report to the Indian Parliament on 9 March 2012.
Recent action: As a follow-up on this initiative and as stated by the Finance Minister (FM) in his Interim
Budget Speech in February 2014, after taking into account the recommendations of the SCF, a “revised”
version of DTC (DTC 2013) was released on 31 March 2014. But in 2015, the Finance Minister has
dropped the DTC all together suggesting that it was a dated bill and some of its provisions had already been
incorporated in the Income Tax Act, while most others were incorporated in the Budget 2015 itself.
The DTC 2013 proposed to introduce:
• General Anti Avoidance Rules (GAAR),
• Taxation of Controlled Foreign Companies (CFC),
• Place of Effective Management (POEM) rule as a test to determine residency and tax indirect
transfer of Indian assets.
• Also contains expanded source rules for taxation of royalty, fees for technical services (FTS) and
interest.

34
Hrideja Shah
BA LLB 2012

Further certain novel provisions were also included such as additional tax levy on certain persons having
high net worth such as dividend tax levy on dividend income earned by resident shareholders in excess of
INR10 million.
It also proposed a tax rate of 35% for individuals/HUFs where the total income exceeds INR100 million.

35
Hrideja Shah
BA LLB 2012

TRANSFER PRICING

In the present age of globalization, diversification and expansion, most of the companies are working under
the umbrella of group engaged in diversified fields/sectors leading to large number of transactions between
related parties.

Related Party transaction means the transaction between/among the parties which are associated by reason
of common control, common ownership or other common interest.

The mechanism for accounting, the pricing for these related transactions is called Transfer Pricing.
Transfer Price refers to the price of goods/services which is used in accounting for transfer of goods or
services from one responsibility center to another or from one company to another associated company.

Transfer price affect the revenue of transferring division and the cost of receiving division. As a result, the
profitability, return on investment and managerial performance evaluation of both divisions are also
affected.

This may be understood well by the following example:

1. Arihant & Companies is a group of Companies engaged in diversified business. One of its units i.e.
Unit X is engaged in manufacturing of automotive batteries. Another Unit Y is engaged in
manufacturing of Industrial Trucks. Unit X is supplying automotive batteries to Unit Y. In such cases
transfer price mechanism is used to account for the transfer of automotive batteries.

2. XYZ Co. is expert in providing electrical and electronic services. It is engaged in providing support
to its associated company as well as it is engaged in outsourcing contract. If XYZ Co. provides some
services to its associated company, the transaction should be accounted at price calculated using
transfer price mechanism.

IMPORTANCE OF TRANSFER PRICING

Transfer pricing mechanism is very important for following reasons:

1. Helpful in correct pricing of Product/Services - An effective transfer pricing mechanism helps an

organization in correctly pricing its product and services. Since in any organization, transaction between
associated parties occurs frequently, it is necessary to value all transaction correctly so that the final product/
services may be priced correctly.

2. Helpful in Performance Evaluation: For the performance evaluation of any entity, it is necessary that all
economic transactions are accounted. Calculation of correct transfer price is necessary for accounting
of inter related transaction between two Associated enterprises.

3. Helpful in complying Statutory Legislations: Since related party transaction have a direct bearing on the
profitability or cost of a company, the effective transfer pricing mechanism is very necessary. For example,
if the related party transactions are measured at less value, one unit may incur loss and other unit may earn
undue profit. This will result in income tax imbalances at both parties end. Similarly, wrong transfer pricing
may lead to wrong payment of excise duty, custom duty /sales tax (if applicable) as well.

36
Hrideja Shah
BA LLB 2012

TRANSFER PRICING PROVISIONS IN INDIA

Relevant provisions

 Computation of income from international transaction having regard to arm’s length price - Section
92 of the Income tax Act, 1961 (‘the Act’)
 Meaning of associated enterprises - Section 92A of the Act
 Meaning of international transaction - Section 92B of the Act
 Computation of arm’s length price - Section 92C of the Act
 Reference to transfer pricing officer - Section 92CA of the Act
 Power of Board to make safe harbour rules - Section 92CB of the Act
 Maintenance and keeping of information and document by person entering into an international
transaction - Section 92D of the Act

International Transfer Pricing provisions are covered under:

• Section 92 to 92F in the Indian Income Tax Act, 1961;
• Rule 10A to Rule 10T of the Income Tax Rules;
• Sections 271(1)(c), 271 AA, 271 BA and 271 G.

The Finance Act, 2001 introduced law of transfer pricing in India through Sections 92 to 92F of the Income
Tax Act, 1961 which guides computation of the transfer price and suggests detailed documentation
procedures. Year 2012 brought a big change in transfer pricing regulations in India whereby government
extended the applicability of transfer pricing regulations to specified domestic transactions which are
enumerated in Section 92BA. This would help in curbing the practice of transferring profit from a taxable
domestic zone to tax free domestic zone.

As stated earlier, the fundamental of transfer pricing provision is that transfer price should represent the
arm’s length price of goods transferred and services rendered from one unit to another unit.

The provisions under sections 92 to 92F have been enacted with a view to provide statutory framework
which can lead to computation of reasonable, fair and equitable profit and tax in India so that the profits
chargeable to tax in India do not get diverted elsewhere by altering the prices charged and paid in intra
group transactions leading to erosion of Indian tax revenue. Any income arising from an international
transaction shall be computed having regard to arm’s length price.

Provision Section of the IT Act

Report from an accountant to be furnished by person Section 92E of the Act

entering into international transaction
Definitions of various terms Section 92F of the Act

Penalty consequent to re-determination of arm’s length Explanation 7, Section 271(1)(c) of

price the Act
Penalty for failure to keep and maintain information and Section 271AA of the Act
document in respect of international transaction

37
Hrideja Shah
BA LLB 2012

Penalty for failure to furnish report under section 92E Section 271BA

Penalty for failure to furnish information or document under Section 271G

section 92D
Provision Section of the IT Rules

Meaning of certain expressions Rule 10A of the Income tax Rules,

1962 (‘the Rules’)
Determination of arm’s length price under section 92C Rule 10B of the Rules

Most appropriate method Rule 10C of the Rules

Information and documents to be kept and maintained under Rule 10D of the Rules
section 92D
Report from an accountant to be furnished under section Rule 10E of the Rules
92E
Advance Pricing Agreements Rule 10F to 10S of the Rules

Safe Harbour Rules Rule 10T of the Rules

The economics of Transfer Pricing

 Where tax rates are different between tax jurisdictions,

 there is a strong incentive to shift
 income to a lower tax jurisdiction
 and deductions to a higher tax jurisdiction
 so that the overall Tax Rate is minimized.

What it means to the Jurisdiction

• As the aggregate tax payable by MNCs is reduced, tax authorities across the world incur significant
losses.
• To guard against such losses, many countries have introduced transfer pricing legislation to govern
the pricing of cross border transactions between related parties.

Transfer Pricing Regulations ("TPR") are applicable to the all enterprises that enter into an 'International
Transaction' with an 'Associated Enterprise'.
Therefore, generally it applies to all cross border transactions entered into between associated enterprises.

The aim is to arrive at the comparable price as available to any unrelated party in open market conditions
and is known as the Arm's Length Price ('ALP').

38
Hrideja Shah
BA LLB 2012

ARM’S LENGTH PRICE

In general arm’s length price means fair price of goods transferred or services rendered. In other words, the
transfer price should represent the price which could be charged from an independent party in uncontrolled
conditions. Arm’s length price calculation is very important for a company. In case the transfer price is not
at arm’s length, it may have following consequences
A. Wrong performance evaluation
B. Wrong pricing of final product (In case where the goods/services are used in the manufacturing of final
product)
C. Non compliances of applicable laws and thus attraction of penalty provisions.

“The concept of associated enterprises and International transaction are very important for applying the
transfer pricing provisions. Section 92A and Section 92B deals with these two important concepts of chapter
X of Income Tax Act, 1961.”

Arm’s length price as per section 92 F is the price applied (or proposed to be applied) when two unrelated
persons enter into a transaction in uncontrolled conditions.
Persons are said to be unrelated if they are not associated or deemed to be associated enterprise according to
Section 92 A.
Uncontrolled conditions are conditions which are not controlled or supressed or moulded for achievement of
a pre-determined results are said to be uncontrolled conditions. If a buyer is related to a seller, or where the
prices are governed by the government policy then transaction is said to be taking place under controlled
conditions.

Therefore, to constitute arm’s length price:

a. The price should be applied or proposed to be applied in a transaction
b. The transaction is between unrelated person
c. The transaction is taking place in uncontrolled conditions

ASSOCIATED ENTERPRISES (AE)

Associated Enterprises has been defined in Section 92A of the Act. It prescribes that “associated enterprise”,
in relation to another enterprise, means an enterprise–
(a) Which participates, directly or indirectly, or through one or more intermediaries, in the management or
control or capital of the other enterprise; or
(b) In respect of which one or more persons who participate, directly or indirectly, or through one or more
intermediaries, in its management or control or capital, are the same persons who participate, directly or
indirectly, or through one or more intermediaries, in the management or control or capital of the other
enterprise.
The basic criterion to determine an AE is the participation in management, control or capital (ownership) of
one enterprise by another enterprise.
The participation may be direct or indirect or through one or more intermediaries.

Clause (a) of Section 92A(1) is about participation by one enterprise into other enterprise. While clause(b)
of the said section is about participation by a third enterprise into both the enterprises. Clause (a) of Section
92 A(1) provides that the enterprise which participates in management, control or capital is an associated
39
Hrideja Shah
BA LLB 2012

enterprise for the other enterprise. The language of the provision should be construed harmoniously such
that both the participating enterprise and the other enterprise are regarded as associated enterprises.

The word control is of wider ambit than the word management and therefore, even if a person is not
managing the other but only able to control him, then he will fall within the ambit of phrase control or
management.
Participation in Management

Appointment of more than half of Board of Directors/ Board of Members/ one or more Executive Directors/
Executive Members by:
● - The other Enterprise
● - The same person(s) in both the enterprises.

Participation through Capital

Holding not less than 26% of the voting power directly or indirectly
– - in the other enterprise
– - in each of such enterprise

Participation through Control

• Loan not less than 51% of Book value of Total Assets

• Guarantee not less than 10% of Total borrowings
• Use of Know how, patents, copy right, etc., of which other enterprise is owner or has exclusive rights
• Purchase of 90% or more Raw Materials and Consumables for which prices and other conditions are
influenced
• Sale of goods manufactured or processed to other enterprise or person specified by it for which
prices and other conditions are influenced or Controlled by same person
• Apart from these, any relationship of mutual interest, as may be prescribed shall also be considered
as Associated enterprise.

Thus, from above definition we may understand that the basic criterion to determine an AE is the
participation in management, control or capital (ownership) of one enterprise by another enterprise whereby
the participation may be direct or indirect or through one or more intermediaries, control may be direct or
indirect.

DEEMED ASSOCIATED ENTERPRISES

Mere fact of participation by one enterprise in the management or control or capital of the other enterprise,
or the participation of one or more persons in the management or control or capital of both the enterprises
shall not make them enterprises, unless the criteria specified in section 92A(2) are fulfilled.
For instance, where one enterprise is holding preference shares in other enterprise then they shall not be
regarded as associated enterprise because though one is participating in the capital of other enterprises but
still they are not satisfying any of the thirteen categories mentioned in Section 92A(2).

As per Section 92(2), two enterprises shall be deemed to be associated enterprises if, at any time during the
previous year,–
(a) one enterprise holds, directly or indirectly, shares carrying not less than twenty-six per cent of the voting
power in the other enterprise; or

40
Hrideja Shah
BA LLB 2012

(b) any person or enterprise holds, directly or indirectly, shares carrying not less than twenty-six per cent of
the voting power in each of such enterprises; or
(c) a loan advanced by one enterprise to the other enterprise constitutes not less than fifty-one per cent of
the book value of the total assets of the other enterprise; or
(d) one enterprise guarantees not less than ten per cent of the total borrowings of the other enterprise; or
(e) more than half of the board of directors or members of the governing board, or one or more executive
directors or executive members of the governing board of one enterprise, are appointed by the other
enterprise; or
(f) more than half of the directors or members of the governing board, or one or more of the executive
directors or members of the governing board, of each of the two enterprises are appointed by the same
person or persons; or
(g) the manufacture or processing of goods or articles or business carried out by one enterprise is wholly
dependent on the use of know-how, patents, copyrights, trade-marks, licences, franchises or any other
business or commercial rights of similar nature, or any data, documentation, drawing or specification
relating to any patent, invention, model, design, secret formula or process, of which the other enterprise
is the owner or in respect of which the other enterprise has exclusive rights; or
(h) ninety per cent or more of the raw materials and consumables required for the manufacture or processing
of goods or articles carried out by one enterprise, are supplied by the other enterprise, or by persons
specified by the other enterprise, and the prices and other conditions relating to the supply are influenced by
such other enterprise; or
(i) the goods or articles manufactured or processed by one enterprise, are sold to the other enterprise or to
persons specified by the other enterprise, and the prices and other conditions relating thereto are
influenced by such other enterprise; or
(j) where one enterprise is controlled by an individual, the other enterprise is also controlled by such
individual or his relative or jointly by such individual and relative of such individual; or
(k) where one enterprise is controlled by a Hindu undivided family, the other enterprise is controlled by a
member of such Hindu undivided family or by a relative of a member of such Hindu undivided family or
jointly by such member and his relative; or
(l) where one enterprise is a firm, association of persons or body of individuals, the other enterprise holds
not less than ten per cent interest in such firm, association of persons or body of individuals; or
(m) there exists between the two enterprises, any relationship of mutual interest, as may be prescribed

In Summary, two enterprises will be deemed as Associated Enterprises if Quantum of Interest Criteria
applied for Associated Enterprises is:

26% or more Shareholding with voting power – either direct or indirect

51% or more -Advancement of loan by one entity to other constituting certain percentage of the book value
of the total assists of the other entity

51% or more- Based on the board of directors appointed by the governing board of the entity in the other

90% or more- Based on the quantum of supply of raw materials and consumables by one entity to the other

10% or more -Total Borrowing Guarantee by one enterprises for other

10% or more- Interest by a firm or association of Person (AOP) or by a body of Individual (BOI) in other
firm AOP or firm or BOI

MEANING OF INTERNATIONAL TRANSACTION

41
Hrideja Shah
BA LLB 2012

International Transaction have been defined vide Section 92B of Income Tax Act. It provides that
“International Transaction” means a transaction between two or more associated enterprises, either or both
of whom are non residents, in the nature of purchase, sale or lease of tangible or intangible property, or
provision of services, or lending or borrowing money, or any other transaction having a bearing on the
profits, income, losses or assets of such enterprises, and shall include a mutual agreement or arrangement
between two or more associated enterprises for the allocation or apportionment of, or any contribution to,
any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to
be provided to any one or more of such enterprises.

An international transaction should be carried out by the associated enterprises. To constitute an

international transaction, it should be:
1. A transaction between two or more associated enterprises (either or both are non residents) in nature
of (a) purchase, sale or lease of intangible property or (b) provision of services, or (c) lending or
borrowing money.
2. A transaction between two or more associated enterprises (either or both are non residents) having a
bearing on the profits, income, losses or assets of such associated enterprises.
3. Mutual agreement or arrangement between two or more associated enterprises for (a) allocation or
appointment, or (b) contributing to, any cost or expense incurred (or to be incurred) regarding a
benefit, service or facility provided (or to be provided) to any one or more of such associated
enterprise.

‘International transaction’ means any of the following nature of transactions between two or more
“Associated enterprise” where, either or both of whom are non-residents
● (a) purchase,
● (b) sale,
● (c) lease of tangible or intangible property,
● (d) provision of services,
● (e) lending or borrowing money, or
● (f) any other transaction having a bearing on the profits, income, losses or assets of such enterprise.
● (e) Mutual agreement between AEs for allocation/apportionment of any cost, contribution or expense.

DEEMED INTERNATIONAL TRANSACTION

As per Section 92B(2) of Income Tax Act, A transaction entered into by an enterprise with a person other
than an associated enterprise shall, for the purposes of sub-section (1), be deemed to be a transaction entered
into between two associated enterprises, if there exists a prior agreement in relation to the relevant
transaction between such other person and the associated enterprise, or the terms of the relevant transaction
are determined in substance between such other person and the associated enterprise.

Section 92B (2) provides that the transactions between an enterprise and another person is deemed as
transactions entered into between associated enterprises if either of the following exists:
a. There is a prior agreement in relation to the relevant transaction between such other person and the
associated enterprise; or
b. The terms of the relevant transaction are determined in substance between such other person and the
associated enterprise.

Finance Act, 2012 has added an explanation for the purpose of Definition 92B and it provides that the
expression “international transaction” shall include –
(a) the purchase, sale, transfer, lease or use of tangible property including building, transportation vehicle,
42
Hrideja Shah
BA LLB 2012

machinery, equipment, tools, plant, furniture, commodity or any other article, product or thing;
(b) the purchase, sale, transfer, lease or use of intangible property, including the transfer of ownership or
the provision of use of rights regarding land use, copyrights, patents, trademarks, licences, franchises,
customer list, marketing channel, brand, commercial secret, know-how, industrial property right, exterior
design or practical and new design or any other business or commercial rights of similar nature;
(c) capital financing, including any type of long-term or short-term borrowing, lending or guarantee,
purchase or sale of marketable securities or any type of advance, payments or deferred payment or
receivable or any other debt arising during the course of business;
(d) Provision of services, including provision of market research, market development, marketing
management, administration, technical service, repairs, design, consultation, agency, scientific research,
legal or accounting service;
(e) A transaction of business restructuring or reorganization, entered into by an enterprise with an associated
enterprise, irrespective of the fact that it has bearing on the profit, income, losses or assets of such
enterprises at the time of the transaction or at any future date.

The term Intangible assets have also been elaborated and explanation to Section 92B provides that the
expression Intangible shall include :
(a) Marketing related intangible assets, such as, trademarks, trade names, brand names, logos;
(b) Technology related intangible assets, such as, process patents, patent applications, technical
documentation such as laboratory notebooks, technical know-how;
(c) Artistic related intangible assets, such as, literary works and copyrights, musical compositions,
copyrights, maps, engravings;
(d) Data processing related intangible assets, such as, proprietary computer software, software copyrights,
automated databases, and integrated circuit masks and masters;
(e) Engineering related intangible assets, such as, industrial design, product patents, trade secrets,
engineering drawing and schematics, blueprints, proprietary documentation;
(f) Customer related intangible assets, such as, customer lists, customer contracts, customer relationship,
open purchase orders;
(g) Contract related intangible assets, such as, favourable supplier, contracts, licence agreements, franchise
agreements, non-compete agreements;
(h) Human capital related intangible assets, such as, trained and organized work force, employment
agreements, and union contracts;
(i) Location related intangible assets, such as, leasehold interest, mineral exploitation rights, easements,
air rights, water rights;
(j) Goodwill related intangible assets, such as, institutional goodwill, professional practice goodwill,
personal goodwill of professional, celebrity goodwill, general business going concern value;
(k) Methods, programmes, systems, procedures, campaigns, surveys, studies, forecasts, estimates,
customer lists, or technical data;
(l) Any other similar item that derives its value from its intellectual content rather than its physical
attributes.’

The above explanation has added a vide range of Intangibles and the purpose of the explanation is to extend
the applicability of Transfer pricing code to all International transaction involving the exchange of
Intangibles which are not expressly available for trade.

TRANSFER PRICING – APPLICABILITY TO DOMESTIC TRANSACTIONS

Honourable Supreme court in the case of CIT v. Glaxo SmithKline Asia (P) Ltd., (2010) 195 Taxman 35
(SC) has advised that it needs to be considered whether the regulations should be applied to domestic
transactions in cases where such transactions are not revenue-neutral. The facts and ruling of Honourable
Supreme Court is following:
43
Hrideja Shah
BA LLB 2012

CIT v. Glaxo SmithKline Asia (P) Ltd., (2010) 195 Taxman 35 (SC)

Facts

1. Glaxo SmithKline Asia (P) Ltd (GSK) entered into an agremeent with Glaxo Smith Kline Consumer
Healthcare Ltd (“GSKCH”) whereby GSKCH would provide all administrative services relating to
marketing, finance, Human Resource (HR) to GSK for cost +5% markup.
2. The AO disallowed a part of the charges reimbursed on the ground that they were excessive and not for
business purposes. On appeal by GSK, CIT (Appeals) upheld the decision of AO.
3. GSK appeal to Income Tax Appellate Tribunal (ITAT) and ITAT ruled that AO has no power to disallow
any expenditure as excessive or unreasonable unless the case falls within the scope of Section 40A(2).
The revenue appeal to high court and revenue appeal was dismissed by High court.
4. For subsequent years AO continued to follow the same approach and GSK continued to get relief from
ITAT. Having regard to the delay on the part of revenue to give effect to ITAT order GSK filled a writ
petition before the High Court and High court issued direction to the Revenue to issue refund of taxes
along with applicable interest.

Supreme Court Ruling

1. The revenue filed a Special Leave Petition (SLP) before the Honorable supreme court and supreme
court held that since the exercise is revenue neutral and both the parties are not related parties in terms
of Section 40A(2) of Income tax act, no interference is called for and the SLP filled by the Revenue is
dismissed.
2. The honourable Supreme then stated that the larger issue is whether Transfer Pricing provisions should be
limited to cross-border transactions or whether the Transfer Pricing Regulations be extended to
domestic transactions. In domestic transactions, the under-invoicing of sales and over-invoicing of
expenses ordinarily will be revenue neutral in nature, except in two circumstances having tax arbitrage
such as where one of the related entities is (i) loss making or (ii) liable to pay tax at a lower rate and the
profits are shifted to such entity;
3. The Supreme court further held that the complications arise in cases where the fair market value is
required to be assigned to transactions between related parties u/s 40A(2). The Central Board of Direct
taxes (CBDT) should examine whether Transfer Pricing provisions can be applied to domestic transactions
between related parties u/s 40A(2) by making amendments to the Act. The AO can be empowered to make
adjustments to the income declared by the assesse having regard to the fair market value of the transactions
between the related parties and can apply any of the generally accepted methods of determination of arm’s
length price, including the methods provided under Transfer Pricing provisions.

The law can also be amended to make it compulsory for the taxpayer to maintain Books of Accounts
and other documents on the lines prescribed in Rule 10D and obtain an audit report from his Chartered
Accountant (CA) that proper documents are maintained;

4. Finally it was held that though the Court normally does not make recommendations or suggestions, in
order to reduce litigation occurring in complicated matters, the question of extending Transfer Pricing
regulations to domestic transactions require expeditious consideration by the Ministry of Finance and
the CBDT may also consider issuing appropriate instructions in that regard.
44
Hrideja Shah
BA LLB 2012

SPECIFIED DOMESTIC TRANSACTIONS

Finance Act, 2012 has made a very important change and it has extended the applicability of Transfer
Pricing Provisions to specified domestic transaction w.e.f. 1st April, 2012.

The specified domestic party transactions would essentially include payment made by a company to a
related person referred to in Section 40A(2)(b) of the Act including payment to a director of the company or
any person who has a substantial interest in the company (that is, has a beneficial ownership of shares
carrying not less than 20 per cent of voting power); transactions referred to in Section 80A(6) of the Act (for
example, transfer of goods or services from a tax-incentivised unit/entity to a non-tax-incentivised
unit/entity and vice-versa); and transactions referred to in Section 80IA(8), 80IA(10) and 10AA(9) of the
Act (carried out by industrial undertakings, infrastructure companies and units operating in special economic
zones).

Section 92BA has been added in Transfer Price Code by Finance Act, 2012 which provides that –
“Specified domestic transaction” in case of an assesse means any of the following transactions, not being an
international transaction, namely:–
(i) Any expenditure in respect of which payment has been made or is to be made to a person referred to
in clause (b) of sub-section (2) of section 40A;
(ii) Any transaction referred to in section 80A;
(iii) Any transfer of goods or services referred to in sub-section (8) of section 80-IA;
(iv) Any business transacted between the assesse and other person as referred to in sub-section (10) of
section 80-IA;
(v) Any transaction, referred to in any other section under Chapter VI-A or section 10AA, to which
provisions of sub-section (8) or sub-section (10) of section 80-IA are applicable; or
(vi) Any other transaction as may be prescribed, and where the aggregate of such transactions entered into
by the assesse in the previous year exceeds a sum of five crore rupees.’

Thus a specified domestic transaction means a transaction which is covered by criteria as given in section
92BA and the aggregate value of such transactions exceeds `5 crore in a year.

TRANSFER PRICING – METHODS

Section 92C of Income Tax Act defines the methods which are to be used in determination of Arm's Length
prices for International Transaction and specified domestic transaction. The arm's length price in relation to
an international transaction/specified domestic transaction shall be determined by any of the following
methods, being the most appropriate method, having regard to the nature of transaction or class of
transaction or class of associated persons or functions performed by such persons or such other relevant
factors as the Board may prescribe, namely :-
(A) Comparable Uncontrolled Price Method (CUP)
(B) Resale Price Method (RPM)
(C) Cost Plus Method (CPM)
(D) Profit Split Method (PSM)
(E) Transactional Net Margin Method (TNMM)
(F) Such other method as may be prescribed by the Board.

Where an assesse has entered into various types of international transactions with associated enterprises,
arm’s length price should be determined on a transaction by transaction basis and not on an aggregate basis.

45
Hrideja Shah
BA LLB 2012

The Arm’s Length Price shall be taken to be the arithmetic mean of such prices, or, at the option of the
assessee, a price which may vary from the arithmetical mean by an amount not exceeding 3% of such
arithmetical mean.
Where during the course of any proceedings for the assessment of income, the Assessing Officer on the
basis of Material of Information or Document in his possession, is of the Opinion that:-

 The price charged or paid has not been determined in accordance with the above or
 Any Information and Document relating to an International Transaction have not been kept and
maintained by the Assessee in accordance with the provisions, or
 The Information or data used in Computation of the Arm’s Length Price is not reliable or correct, or
 The Assessee has failed to furnish, within the specified time, any information or document which he
was required to furnish

The Assessing Officer may proceed to determine the arm’s length price in relation to the said International
Transaction on the basis of such Material or Information or Document available with him.

Provided that an opportunity shall be given by the Assessing Officer by serving a notice calling upon the
Assessee to show cause on a date and time to be specified in the notice, why the arm’s length price should
not be so determined on the basis of material or information or a document in the possession of the
Assessing Officer.

Various transfer pricing methods which are prescribed by Income Tax Act, 1961 are as under:

(A) COMPARABLE UNCONTROLLED PRICE METHOD

Comparable Uncontrolled Price (“CUP”) method compares the price charged for property or services
transferred in a controlled transaction to the price charged for property or services transferred in a
comparable uncontrolled transaction in comparable circumstances.
In this method, price charged in an uncontrolled deal between comparable entities is recognized and
evaluated with the verified entity price to determine the Arm’s Length Principle. The CUP method offer the
finest evidence of ALP.

An Uncontrolled price is the price agreed between the unrelated parties for the transfer of goods or services.
If this uncontrolled price is comparable with the price charged for transfer of goods or services between the
Associated Enterprises, then that price is Comparable Uncontrolled Price (CUP). This is the most direct
method for the determination of the Arms’ length price.

Methods of CUP

CUP can be either

(a) Internal CUP or
(b) External CUP

Internal CUP is available, when the tax payer enters into a similar transaction with unrelated parties, as is
done with a related party as well. This is considered a very good comparable, as the functions performed,
processes involved, risks undertaken and assets employed are all easily comparable – more so, on “an apple
to apple basis”.
The external CUP is available if a transaction between two independent enterprises takes place under
comparable conditions involving comparable goods or services. For example an independent enterprise buys
or sells a similar product, in similar quantities under similar term from / to another independent enterprise in
a similar market will be termed as external CUP.
46
Hrideja Shah
BA LLB 2012

Computation of Arm’s Length Price under CUP Method

Step 1: Determine the price charged or paid for the property transferred or services provided in a comparable
uncontrolled transaction
Step 2: Such Price is then adjusted to account for the Functional Differences between the International
Transaction & the Comparable Uncontrolled Transaction, which could materially affect the price in the open
market.
Step 3: Such Adjusted Price is the Arm’s Length Price

Applicability of the CUP Method

Comparable Uncontrolled Price method is treated as most reliable method of transfer pricing calculation but
it is not easy to find the controllable price method easily. The CUP is believed to be the most reliable / best
method, if one could identify and map it. CUP method can be applied without any difficulty in following
circumstances.
(1) Interest payment on a loan
(2) Royalty payment
(3) Software development where products are often licensed to a third party
(4) Price charged for homogeneous items like traded goods

Comparable uncontrolled price method is relevant in case of

● transaction of loans,
● royalties,
● services,
● transfer of tangibles.

(B) RESALE PRICE METHOD

This method is used where the vendor adds similarly little value to goods owned from associate enterprises.
Here, Arm’s Length Price is determined by reducing the relevant gross profit mark-up from the sale price
charged to free entity.

Rule 10B (1) (b) of Income Tax Rules, 1962 prescribes Resale Price method by which,
A. The price at which property purchased or services obtained by the enterprise from an associated
enterprise is resold or are provided to an unrelated enterprise is identified;
B. Such resale price is reduced by the amount of a normal gross profit margin accruing to the enterprise or to
an unrelated enterprise from the purchase and resale of the same or similar property or from obtaining and
providing the same or similar services, in a comparable uncontrolled transaction, or a number of such
transactions;
C. The price so arrived at is further reduced by the expenses incurred by the enterprise in connection with
the purchase of property or obtaining of services;
D. The price so arrived at is adjusted to take into account the functional and other differences, including
differences in accounting practices, if any, between the international transaction and the comparable
uncontrolled transactions, or between the enterprises entering into such transactions, which could
materially affect the amount of gross profit margin in the open market;
E. The adjusted price arrived at under sub-clause (iv) is taken to be an arms length price in respect of the
purchase of the property or obtaining of the services by the enterprise from the associated enterprise.

47
Hrideja Shah
BA LLB 2012

Example
1. A sold a machine to B (Associated enterprise) and in turn B sold the same machinery to C (an
independent party) at sale margin of 30% for `2,10,000 but without making any additional expenses
and change. Here Arm’s length price would be calculated as
Sales price to B = 2, 10,000
Gross Margin = 10,000 × 30% = 63,000
Transfer price = 1, 47,000
2. A sold a machine to B (Associated enterprise) and in turn B sold the same machinery to C (an
independent party) at sale margin of 30% for `4,00,000 but B has incurred 4000 in sending the machine
to C. Here Arm’s length price would be calculated as
Sales price to B = 4, 00,000
Gross Margin = 4,00,000 × 30%=1, 20,000
Balance = 2, 80,000
Less: Expenses incurred by B = 4,000
Arm’s length price= 2,76,000

Computation of Arm’s Length Price under Resale Price Method

Step 1: The Price at which the Property purchased or the Services obtained by the enterprise from an
associated enterprise are sold to an unrelated enterprise is first determined.
Step 2: Such Resale Price is reduced by the Normal Gross Profit Margin accruing to the Enterprise from the
purchase and resale of Similar Goods in a comparable uncontrolled transaction. If there is no comparable
uncontrolled transaction, then take the Gross Profit of an unrelated person from purchase and resale of
Similar Goods
Step 3: Then reduce the expenses incurred by the enterprise in connection with purchase of property.
Step 4: The price so arrived is adjusted to account for the functional differences in the International
Transaction & the Comparable uncontrolled Transaction which could materially affect the Gross Profit
Margin in the Open Market.
Step 5: The adjusted Price is the Arm’s Length Price

Resale price method is relevant in case of marketing operations of finished products more particularly in
case of distribution of products not involving significant value addition.
In this method the vendor adds comparatively small or no value to goods taken from associate enterprises.

(C) COST PLUS METHOD

In CP method first the cost incurred is determined.

● An appropriate cost plus mark up is then added to the cost to arrive at an appropriate profit.
● The resultant is the ALP

Rule 10B (1) (c) of Income tax Rules, 1962 prescribes Cost Plus Method, by which,
(i) The direct and indirect costs of production incurred by the enterprise in respect of property transferred
or services provided to an associated enterprise, are determined;
(ii) The amount of a normal gross profit mark-up to such costs (computed according to the same accounting
norms) arising from the transfer or provision of the same or similar property or services by the enterprise, or
by an unrelated enterprise, in a comparable uncontrolled transaction, or a number of such transactions, is
determined;
(iii) The normal gross profit mark-up so determined is adjusted to take into account the functional and other
differences, if any, between the international transaction and the comparable uncontrolled transactions, or
48
Hrideja Shah
BA LLB 2012

between the enterprises entering into such transactions, which could materially affect such profit mark-up in
the open market;
(iv)The costs referred to in sub-clause (i) are increased by the adjusted profit mark-up arrived at under
subclause (iii);
(v) The sum so arrived at is taken to be an arm’s length price in relation to the supply of the property or
provision of services by the enterprise.

Under the Cost Plus Method, an arm’s-length price equals the controlled party’s cost of producing the
tangible property plus an appropriate gross profit mark-up, defined as the ratio of gross profit to cost of
goods sold (excluding operating expenses) for a comparable uncontrolled transaction.

The formulas for the transfer price in intercompany transactions of products are as follows:
TP = COGS × (1 + mark-up), where:
• TP = Transfer Price of a product sold between a manufacturing company and a related company;
• COGS = Cost of goods sold of the manufacturing company
• Cost plus mark-up = gross profit mark-up defined as the ratio of gross profit to cost of goods sold
Gross profit is defined as sales minus cost of goods sold.
In this method, calculation of cost of goods sold and gross margin are the most important factor.
Computation of Arm’s Length Price under Cost Plus Method

Step 1: Determine the Direct and Indirect Costs of Production in respect of Property transferred or Services
provided to an associated enterprise
Step 2: Determine the normal gross profit mark up to such costs which will arise from transfer of similar
goods or services to an unrelated enterprise or in a comparable uncontrolled transaction
Step 3: The normal gross profit mark up should be adjusted to account for the functional differences if any
between the International Transaction and comparable uncontrolled transaction which could materially
affect such profit mark-up in the open market
Step 4: The cost referred in step 1 shall be increased by the adjusted profit mark up arrived
Step 5: The sum so arrived is the arm’s length price

Cost plus method is more relevant where raw materials or semi finished products are
sold.
Similarly, it can also be used where joint facility agreements or long term buy and supply arrangements or
provisions of services are involved.

(D) PROFIT SPLIT METHOD

PSM is used when transaction are inter related and is not possible to evaluate separately.
PSM first identifies the profit to be split for AE.
The profit so determined is split between the AE on the basis of the function performed

Rule 10B (1) (d) of Income tax Rules, 1962 prescribes Profit Split Method, which may be applicable mainly
in international transactions involving transfer of unique intangibles or in multiple international transactions
which are so interrelated that they cannot be evaluated separately for the purpose of determining the arm's
length price of any one transaction, by which:
(i) The combined net profit of the associated enterprises arising from the international transaction in which
they are engaged, is determined;
(ii) The relative contribution made by each of the associated enterprises to the earning of such combined
net profit, is then evaluated on the basis of the functions performed, assets employed or to be employed
and risks assumed by each enterprise and on the basis of reliable external market data which indicates
49
Hrideja Shah
BA LLB 2012

how such contribution would be evaluated by unrelated enterprises performing comparable functions in
similar circumstances;
(iii) The combined net profit is then split amongst the enterprises in proportion to their relative
contributions, as computed above;
(iv) The profit thus apportioned to the assessee is taken into account to arrive at an arm’s length price in
relation to the international transaction.

However, the combined net profit as determined in sub-clause (i) may, in the first instance, be partially
allocated to each enterprise so as to provide it with a basic return appropriate for the type of international
transaction in which it is engaged, with reference to market returns achieved for similar types of transactions
by independent enterprises, and thereafter, the residual net profit remaining after such allocation may be
split amongst the enterprises in proportion to their relative contribution in the manner specified under sub-
clauses (ii) and (iii), and in such a case the aggregate of the net profit allocated to the enterprise in the first
instance together with the residual net profit apportioned to that enterprise on the basis of its relative
contribution shall be taken to be the net profit arising to that enterprise from the international transaction.

Two step Approach of Profit Spilt Method

Step 1: Allocation of sufficient profit to each enterprise to provide a basic compensation for routine
contributions.

This basic compensation does not include a return for possible valuable intangible assets owned by the
associated enterprises. The basic compensation is determined based on the returns earned by comparable
independent enterprises for comparable transactions or, more frequently, functions.
Step 2: Allocation of residual profit (i.e. profit remaining after step 1) between the associated enterprises
based on the facts and circumstances. If the residual profit is attributable to intangible property, then the
allocation of this profit should be based on the relative value of each enterprise’s contributions of intangible
property.

Computation of Arm’s Length Price under Profit Split Method

This Method is applied in multiple International Transactions which are so inter-related that they cannot be
evaluated separately.
Step 1:- Compute the Net Profit of the Associated Enterprise arising from the International Transaction.
Step 2:- Compute the Relative Contribution made by each of the associated enterprise to the earning of the
combined Net Profit
Step 3:- Split the Combined Net Profit in proportion to their Contributions
Step 4:- The Sum so arrived at is the Arms Length Price

Profit split method is relevant where the transactions involved provision of integrated services by more than
one enterprise.
PSM method is used when associate enterprises are so combined that it turns into difficult to make transfer
pricing analysis on transactional methods basis.

Example on the Profit Split Method (Residual Analysis Approach)

Company A is an Indian Company and deals in telecommunication products. It has developed a
Microprocessor and it holds the patent for manufacturing of the microprocessor. Company B which is an
overseas subsidiary of Company A is engaged in manufacturing of Mobile equipment at Australia. Company
A supply the microprocessor to company B for using it in Mobile equipment and company B in turn after

50
Hrideja Shah
BA LLB 2012

manufacturing the mobile sends the mobile to company “A” in India. Company A sells all the mobile in
India.

Both companies contribute to the success of the mobile equipment through their design of the
microprocessor and the equipment. As the nature of the products is very advanced and unique, the group is
unable to locate any comparable with similar intangible assets. Therefore, neither the traditional methods i.e.
CUP Method, RSP Method nor the TNMM is appropriate in this case.

Nevertheless, the group is able to obtain reliable data on hand phone contract manufacturers and equipment
wholesalers without unique intangible property in the telecommunication industry. The manufacturers earn a
mark-up of 10% while the wholesalers derive a 25% margin on sales.
Company A’s and Company B’s respective share of profit is determined in 2 steps using the profit split
method (residual analysis approach).

(E) TRANSACTIONAL NET MARGIN METHOD (TNMM)

Compares the net profit margin of a taxpayer arising from a non-arm's length transaction with the net profit
margins realized by arm's length parties from similar transactions; and
Examines the net profit margin relative to an appropriate base such as costs, sales or assets.
Rule 10B (1) (e) of Income Tax Rules, 1962 prescribes, Transactional net margin method, by which,
(i) The net profit margin realized by the enterprise from an international transaction entered into with an
associated enterprise is computed in relation to costs incurred or sales effected or assets employed or
to be employed by the enterprise or having regard to any other relevant base;
(ii) The net profit margin realized by the enterprise or by an unrelated enterprise from a comparable
uncontrolled transaction or a number of such transactions is computed having regard to the same base;
(iii) The net profit margin referred to in (ii) arising in comparable uncontrolled transactions is adjusted to
take into account the differences, if any, between the international transaction and the comparable
uncontrolled transactions, or between the enterprises entering into such transactions, which could
materially affect the amount of net profit margin in the open market;
(iv) the net profit margin realized by the enterprise and referred to in (i) is established to be the same as
thenet profit margin referred to in (iii);
(v) The net profit margin thus established is then taken into account to arrive at an arms length price in
relation to the international transaction.

Computation of Arm’s Length Price under Transactional Net Margin Method

Step 1: Compute the Net Margin realised by the Enterprise from an International Transaction entered into
with an associated enterprise.
Step 2: Compute the Net Profit Margin realised by the enterprise or by an unrelated enterprise from a
comparable uncontrolled transaction.
Step 3: Adjust the Net Profit Margin computed in Step 2 to account for differences
Step 4: The Net Profit Margin computed in Step 1 is established to be the same as the net Profit Margin
referred to in Step 3
Step 5: The net profit margin thus established is then taken into account to arrive at an arm’s length price in
relation to the International Transaction

Transactional net marginal method is used in most of the cases including transfer of semi finished goods,
distribution of products where resale price method appears to be inappropriate and also in case involving
provision of services.
Case: Vodafone

51
Hrideja Shah
BA LLB 2012

TAX PLANNING, AVOIDANCE AND EVASION

TAX HAVENS AND OFFSHORE FINANCIAL CENTRES

Tax Evasion

All methods by which tax liability is illegally avoided are termed as tax evasion. An assesse guilty for tax
evasion may be punished under relevant laws. Tax evasion may involve stating an untrue statement
knowingly, submitting misleading documents, suppression of facts, omission of material facts on
assessment.
• Tax evasion – intention to avoid tax liability where there is actual knowledge of liability – involves
deliberate concealment of facts from the revenue authorities
• Tax evasion is looked upon as illegal conduct
• Examples: collecting revenue in cash with no record / bills, failure by a taxable person to notify the
tax authorities of his presence in the country if he is carrying on taxable activities in such country.
• Chapter XXII, Income Tax Act, 1961 has various penalty provisions

Tax Avoidance

Tax avoidance is reducing or negating tax liability in legally permissible ways and has legal sanction.
Essential features of Tax avoidance are as under:
a. Legitimate arrangement of affairs in such a way as to minimise tax liability
b. Avoidance of tax is not tax evasion and carries no public disgrace with it.
c. An act valid in law cannot be treated as fictitious merely on the basis of some underlying motive
supposedly resulting in lower payment of tax to authorities.
d. There is no element of malafide motive involved in tax avoidance.
• Unlike evasion, it indicates structuring one’s income with the aim of avoiding tax through legal
means - arranging affairs in such a way as to take advantage of weaknesses or ambiguities in the tax
law.
• Justice Reddy describes it as ‘the art of dodging tax without breaking the law’ (McDowell)
• Black’s Law Dictionary defines tax avoidance as ‘the minimization of one’s tax liability by taking
advantage of legally available tax planning opportunities. Tax avoidance may be contrasted with
evasion, which entails the reduction of tax liability by using illegal means’.
• Although the means are legal and not fraudulent, results are considered improper or abusive.

Some Examples of Tax Avoidance

• Compensating employees by structuring a significant part of income in the form of allowances and
perks.
• Investment by foreign institutional investors (FIIs) in shares of companies listed on stock exchanges
by routing investments through a firm floated in Mauritius. Capital gains in the hands of FIIs is
taxable in Mauritius where capital gains from shares are exempt. (Azadi Bachao Andolan v Union of
India (2004) 10 SCC 1)
• An example of a more complex tax avoidance strategy involving multiple jurisdictions is one known
famously as Double Irish with a Dutch Sandwich.

Double Irish Dutch Sandwich

52
Hrideja Shah
BA LLB 2012

Tax Planning/mitigation

Tax planning can be defined as an arrangement of one’s financial and economic affairs by taking complete
legitimate benefit of all deductions, exemptions, allowances and rebates so that tax liability reduces to
minimum. Essential features of tax planning are:
a. It comprises arrangements by which tax laws are fully complied
b. All legal obligations and transactions (both individually and as a whole) are met.
c. Transactions do not take the form of colorable devices (i.e. those devices where statute is followed in
strict words but actually spirit behind the statute is marred would be termed as colorable devices)
d. There is no intention to deceit the legal spirit behind the tax law.
• Tax avoidance may be further classified into acceptable and unacceptable conduct
• Conduct resulting in mitigation of tax exposure by the use of preferences given under the law
(example – utilizing the deductions and exemptions available under the law)
• An example from the Expert Committee on GAAR: setting up an industry in a SEZ so as to avail the
various tax sops under law
• Is it a person’s legitimate right to so arrange his affairs? (Westminster approach)
• In McDowell’s case (AIR 1986 SC 649), the Supreme Court held that tax planning may be legitimate
provided it is within the framework of law. However a colorable device was held to be outside the
scope of tax planning (tax evasion).

Is GAAR the solution?

 Codification of the substance over form approach in the domain of tax laws
 The idea behind GAAR (as presently drafted) is to tackle an impermissible avoidance arrangement
(IAA).
 An IAA means a transaction where the main purpose is to obtain a tax benefit and includes
transactions where there is an abuse / misuse of the law or where the transaction lacks commercial
substance.
 Latest announcement: GAAR will be implemented from April 2016 and would apply to business
arrangements where the tax benefit exceeds Rs. 3 crores.

Tax Havens

OECD has blacklisted over 25 nations for tax relaxations they offer for parking funds. These include
Mauritius, Cyprus, Switzerland and the Netherlands. Tax havens allow easy parking of money either
through investments or deposits. They may offer a range of incentives including a nominal capital gains tax
for companies to complete financial secrecy of accounts held by individuals and corporate.

• Lacks a precise definition – use has become increasingly pejorative

• Conventional picture: small island, recently independent and apart from financial services relies on
a handful of commodities and tourism for economic viability
• Examples: Andorra, the Bahamas, Belize, Bermuda, the British Virgin Islands, the Cayman Islands,
the Channel Islands, the Cook Islands, Hong Kong, the Isle of Man, Mauritius, Lichtenstein,
Monaco, Panama, Switzerland and St. Kitts and Nevis are all considered tax havens.
• Affiliations: Isle of Man, Gibraltar and Channel Islands with Great Britain; Moncao with France;
Andorra with France and Spain; Liechtenstein with Switzerland.
• 1987 Report of OECD – difficulty in defining a tax haven – good indicator: country or territory is
recognized as a tax haven
53
Hrideja Shah
BA LLB 2012

• OECD in its 1998 Report on Harmful Tax Competition describes a tax haven as a jurisdiction which
imposed no or nominal effective tax and provided opportunities to non residents to escape their home
taxes or to indulge in illegal activities
• A country that offers foreign individuals and businesses little or no tax liability in a politically and
economically stable environment.
• Tax havens also provide little or no financial information to foreign tax authorities.
• Individuals and businesses that do not reside a tax haven can take advantage of these countries' tax
regimes to avoid paying taxes in their home countries.
• Tax havens do not require that an individual reside in or a business operate out of that country in
order to benefit from its tax policies.
• However, pressure from foreign governments that want to collect all the tax revenue they believe
they are entitled to have caused some tax haven countries to sign tax information exchange
agreements (TIEAs) and mutual legal assistance treaties (MLAT) that provide foreign governments
with formerly secret information about investors' offshore accounts.

General Characteristics: Tax Havens

• Criteria identified by OECD :

 Tax rates: zero or low rate – starting point
 No effective exchange of information: information cannot (or not easily) be obtained from banks and
other financial institutions for official purposes such as tax collection (including other countries’
taxes)
 Lack of transparency: in the operation of the legislative, legal or administrative provisions
 Jurisdiction facilitates establishment of foreign owned entities without the need for a local
substantive presence or prohibits entities from having a commercial impact on the economy
(withdrawn in 2002)
• Combination of tax and non-tax factors (infrastructure, relaxed regulatory framework)
• Distinction between tax havens and preferential tax regimes (significant revenues from taxation,
subject to preferential features and adopting ring fencing)

Purposes served by a tax haven

• Three main purposes served by a tax haven:

 Location for holding passive investments
 Location where paper profits can be booked
 Affairs of taxpayers, particularly their bank accounts, are shielded from scrutiny by tax authorities of
other countries

Negative externalities

Tax havens or harmful preferential tax regimes that drive the effective tax rate levied on income from the
mobile activities significantly below rates in other countries have the potential to cause harm by:
 distorting financial and, indirectly, real investment flows;
 undermining the integrity and fairness of tax structures;
 discouraging compliance by all taxpayers;
 re-shaping the desired level and mix of taxes and public spending;
 causing undesired shifts of part of the tax burden to less mobile tax bases, such as labour, property
and consumption; and
 increasing the administrative costs and compliance burdens on tax authorities and taxpayers.

54
Hrideja Shah
BA LLB 2012

Offshore Financial Centres

Offshore financial centers (OFCs) are not easily defined, but they can be characterized as jurisdictions that
attract a high level of non-resident activity.
Traditionally, the term has implied some or all of the following (but not all OFCs operate this way):
• - Low or no taxes on business or investment income;
• - No withholding taxes;
• - Light and flexible incorporation and licensing regimes;
• - Light and flexible supervisory regimes;
• - Flexible use of trusts and other special corporate vehicles;
• - No need for financial institutions and/or corporate structures to have a
• physical presence;
• - An inappropriately high level of client confidentiality based on
• impenetrable secrecy laws;
• - Unavailability of similar incentives to residents.”

Described as countries or jurisdictions with financial institutions that deal primarily with non-residents on a
scale disproportionate to their size.
Usually possess one or more of the following characteristics: low or zero taxation, moderate or light
financial regulation and banking secrecy and anonymity.

Shell Companies

• A shell corporation is a company which serves as a vehicle for business transactions without itself
having any significant assets or operations. Some shell companies may have had operations, but
those may have shrunk due to unfavorable market conditions or company mismanagement.
• Shell corporations are not in themselves illegal, and they do have legitimate business purposes.
However, they are a main component of the underground economy, especially those based in tax
havens.
• They may also be known as international business company, personal investment companies, front
companies, or “mailbox" companies.
• Shell companies are also used for tax avoidance. A classic tax avoidance operation is based on the
buying and selling through tax haven shell companies to disguise true profits. The firm does its
international operations through this shell corporation, thus not having to report to its country the
sums involved, avoiding any taxes.

GLOBAL FORUM

In charge of promoting tax cooperation and information exchange among tax administration, the Global
Forum was restructured in September 2009 in Mexico in response to the G20 call to strengthen exchange of
information in the context of major progress made towards full transparency.
The Global Forum is the continuation of a forum which was created in the early 2000s in the context of
OECD work on tax havens. The restructured Global Forum now ensures that all its members are on an
equal footing and will fully implement the standard on exchange of information they have committed to
implement.

55
Hrideja Shah
BA LLB 2012

Who are the members of the Global Forum?

As of April 2013, there are 120 members . As agreed in Mexico the initial potential members are: all the
financial centres which participated in the previous Global Forum; all OECD countries and all G20
economies. The initial 91 potential members have confirmed their membership. In addition, in order to
maintain a level playing field, the Global Forum has identified countries of relevance to its work. This has
been the case of Botswana, the Federated States of Micronesia, Ghana, Jamaica, Former Yugoslav Republic
of Macedonia, Lebanon, Qatar and Trinidad & Tobago. Only Lebanon has so far refused to commit to the
standard and become a member of the Global Forum despite being identified as a jurisdiction relevant to the
Global Forum’s work. Finally, as requested by the G20, developing countries are invited to join the Global
Forum to benefit from the new environment of transparency; many developing countries have joined in 2012
and 2013.

How did the peer review process come about?

Tax evasion and the need for effective international co-operation in tax matters has been very high on the
political agenda in recent years, and has received a lot of attention from the G20. In 2009, unprecedented
progress was made by the international community in the fight against tax fraud and evasion, however there
was a need to ensure that the progress made results in full transparency and effective exchange of
information for tax purposes.
Reflecting this, the Global Forum on Transparency and Exchange of Information for Tax Purposes was
dramatically restructured at its Mexico meeting in September 2009 to make it a more effective and open
body and it was mandated to put in place a robust and in-depth peer review mechanism.
The aim is to safeguard the commitments jurisdictions made and to respond in particular to the G20 call for
rapid and effective implementation of the standards of transparency and exchange of information.
All members of the Global Forum as well as jurisdictions identified by the Global Forum as relevant to its
work, will undergo reviews of the implementation of their systems for the exchange of information in tax
matters. The peer review process is overseen by the 30 members of the Peer Review Group, which is chaired
by France, assisted by four vice-chairs from India, Japan, Singapore and Jersey.

How does the peer review process work?

The Peer Reviews happen in two Phases:

Phase 1 is a review of each jurisdiction’s legal and regulatory framework for transparency and the exchange
of information for tax purposes and
Phase 2 involves a survey of the practical implementation of the standards.

56
Hrideja Shah
BA LLB 2012

DOUBLE TAXATION AVOIDANCE AGREEMENTS

In the current era of cross -border transactions across the world, due to unique growth in international trade
and commerce and increasing interaction among the nations, residents of one country extend their sphere of
business operations to other countries where income is earned.
One of the most significant results of globalization is the noticeable impact of one country’s domestic tax
policies on the economy of another country.
This has led to the need for incessantly assessing the tax regimes of various countries and bringing about
indispensable reforms.
Therefore, the consequence of taxation is one of the important considerations for any trade and investment
decision in any other countries.

Where a taxpayer is resident in one country but has a source of income situated in another country, it gives
rise to possible double taxation.
This arises from two basic rules that enable the country of residence as well as the country where the source
of income exists to impose tax, namely,
Source rule
The source rule holds that income is to be taxed in the country in which it originates irrespective of
whether the income accrues to a resident or a nonresident
Residence rule
The residence rule stipulates that the power to tax should rest with the country in which the taxpayer
resides.

If both rules apply simultaneously to a business entity and it were to suffer tax at both ends, the cost of
operating in an international scale would become prohibitive and deter the process of globalization. It is
from this point of view that Double taxation avoidance Agreements (DTAA) become very significant.

In cases, where cross country economic activity is carried out, it is a tricky affair to identify and justify the
appropriate jurisdiction of tax authorities. In order to mitigate the hardships of multiple jurisdictions, the
Governments enter into bilateral arrangements, which are commonly denoted as “Double Taxation
Avoidance Agreements” (DTAA). DTAA refers to an accord between two countries, aiming at elimination
of double taxation. These are bilateral economic agreements wherein the countries concerned assess the
sacrifices and advantages which the treaty brings for each contracting nation. It would promote exchange of
goods, persons, services and investment of capital among such countries.

International double taxation has adverse effects on the trade and services and on movement of capital and
people. Taxation of the same income by two or more countries would constitute a prohibitive
burden on the tax-payer.

The domestic laws of most countries, including India, mitigate this difficulty by affording unilateral relief in
respect of such doubly taxed income (Section 91 of the Income Tax Act).
But as this is not a satisfactory solution in view of the divergence in the rules for determining sources of
income in various countries, the tax treaties try to remove tax obstacles that inhibit trade and services
and movement of capital and persons between the countries concerned. It helps in improving the general
investment climate.
The double tax treaties (also called Double Taxation Avoidance Agreements or “DTAA”) are
negotiated under public international law and governed by the principles laid down under the Vienna
Convention on the Law of Treaties.

57
Hrideja Shah
BA LLB 2012

The first international initiative regarding DTAA was taken by the Organization for Economic Co-operation
and Development. OECD presented the first draft of DTAA in ‘Model Tax Convention on Income and on
Capital’. DTAA was proposed as a tool of standardization and common solutions for cases of double
taxation to the taxpayers who are engaged in industrial, financial or other activities in other countries. The
double tax treaties are negotiated under international law and governed by the principles laid down under the
Vienna Convention on the Law of Treaties.

It is in the interest of all countries to ensure that undue tax burden is not cast on persons earning income by
taxing them twice, once in the country of residence and again in the country where the income is
derived. At the same time sufficient precautions are also needed to guard against tax evasion and to facilitate
tax recoveries.

Double taxation avoidance agreements may be classified into comprehensive agreements and limited
agreements based on the scope of such agreements. Comprehensive Double Taxation Avoidance
Agreements provide for taxes on income, capital gains and capital investments whereas Limited Double
Taxation Avoidance Agreements denote income from shipping and air transport or legacy and gifts.
Comprehensive agreements ensure that the taxpayers in both the countries would be treated on equitable
manner in respect of the issues relating to double taxation.

Double Taxation

The fiscal committee of OECD in Model Double Taxation Convention on Income and Capital,1977 defines
double taxation as:
‘The imposition of comparable taxes in two or more states on the same tax payer in respect of the
same subject matter and for identical periods’.
Double Taxation of the same income would cause severe consequences on the future of international trade.
Countries of the world therefore aim at eliminating the prevalence of double taxation. Such agreements are
known as "Double Tax Avoidance Agreements" (DTAA) also termed as "Tax Treaties”.
In India, the Central Government, acting under Section 90 of the Income Tax Act, has been authorized to
enter into double tax avoidance agreements with other countries.

Necessity of Double Taxation Avoidance Agreements

The need and purpose of tax treaties has been summarized by the OECD in the ‘Model Tax Convention on
Income and on Capital’ in the following words:
‘It is desirable to clarify, standardize, and confirm the fiscal situation of taxpayers who are engaged,
industrial, financial, or any other activities in other countries through the application by all countries of
common solutions to identical cases of double taxation’.

Objectives of Double Taxation Avoidance Agreements

Avoiding and alleviating the adverse burden of international taxation, by-

1. Laying down rules for division of revenue between two countries
2. Exempting certain incomes from tax in either country
3. Reducing the applicable rates of tax on certain incomes taxable in either countries.

Tax treaties help a taxpayer of one country to know with greater certainty the potential limits of his tax
liabilities in the other country.

58
Hrideja Shah
BA LLB 2012

Another benefit from the tax-payers point of view is that, to a substantial extent, a tax treaty provides against
non- discrimination of foreign tax payers or the permanent establishments in the source countries vis-à-vis
domestic tax payers.
DTAA treaties must help in avoiding and alleviating the burden of double taxation prevailing in the
international arena. The tax treaties must clarify the taxpayer to know with certainty of his potential tax
liability in the country, where he is carrying on economic activities. Tax Treaties must ensure that there is no
prejudice between foreign tax payers who has permanent enterprise in the source countries and domestic tax
payers of such countries. Treaties are made with the aim of allocation of taxes between treaty nations and
the prevention of tax avoidance. The treaties must also ensure that equal and fair treatment of tax payers
having different residential status, resolving differences in taxing the income and exchange of information
and other details among treaty partners.

Functions of DTAA

DTAAs ensure that countries adopt common definitions for factors that determine taxing rights and taxable
events. Crucial among these is the definition of a permanent establishment.
Most treaties also specify a Mutual Agreement Procedure (MAP) which is invoked when interpretation of
treaty provisions is disputed.
To prevent abuse of treaty concessions, treaties increasingly incorporate restrictions and rules, such as a
general anti- avoidance rule (GAAR), that allow tax authorities to determine if a transaction is only
undertaken for tax avoidance or not.
Benefit limitation tests and controlled foreign corporation (CFC) rules also place limits on claims of
residence in countries eligible for treaty concessions.
Exchange of tax information on either a routine basis or in response to a special request is provided for in
most treaties to assist countries counter tax evasion.

Salient Features of Double Taxation Avoidance Agreements (DTAAs) agreements between India and Other
Countries

As of now there exists 88 Double Taxation Avoidance Agreements (DTAAs) between India & other
countries.
These treaties are usually between countries with substantial trade or other economic relations. Most treaties
are between pairs of developed countries while, of the balance, most are between developed and developing
countries.
DTAA’s:
 Provide reciprocal concessions to mitigate double taxation,
 Assign taxation rights roughly in accordance with that “existing consensus” and
 Largely though not rigidly follow the OECD Model Tax Convention or, for developing countries, the
UN Tax Convention.

Recent treaties contain new clauses following the OECD Model Tax Conventions of 2005 to 2010 which
extend areas of cooperation to administrative and information issues.

A typical DTA Agreement between India and another country covers only residents of India and the other
contracting country who has entered into the agreement with India. A person who is not resident either of
India or of the other contracting country cannot claim any benefit under the said DTA Agreement.
Such agreement generally provides that the laws of the two contracting states will govern the taxation of
income in respective states except when express provision to the contrary is made in the agreement.

Relevant Provisions of Income-Tax Act, 1961 for DTAA’s

59
Hrideja Shah
BA LLB 2012

Section 90 - Agreement with foreign countries or specified territories –Bilateral Relief

 Since the tax treaties are meant to be beneficial and not intended to put tax payers of a contracting
state to a disadvantage, it is provided in Sec. 90 that a beneficial provision under the Indian Income
Tax Act will not be denied to residents of contracting state merely because the corresponding
provision in tax treaty is less beneficial.

Section 90A - Double taxation relief to be extended to agreements (between specified Associations) adopted
by the Central Government
Section 91 - Countries with which no agreement exists-Unilateral Agreements
Some Double Taxation Avoidance agreements provide that income by way of interest, royalty or fee for
technical services is charged to tax on net basis.

This may result in tax deducted at source from sums paid to Non-residents which may be more than the final
tax liability. The Assessing Officer has therefore been empowered under section 195 to determine the
appropriate proportion of the amount from which tax is to be deducted at source.

There are instances where as per the Income-tax Act, tax is required to be deducted at a rate prescribed in
tax treaty. However this may require foreign companies to apply for refund.

To prevent such difficulties Sec. 2(37A) provides that tax may be deducted at source at the rate applicable in
a particular case as per section 195 on the sums payable to non- residents or in accordance with the rates
specified in D.T.A. Agreements.

60
Hrideja Shah
BA LLB 2012

CAPITAL GAINS

When we buy any kind of property for a lower price and then subsequently sell it at a higher price, we make
a gain. The gain on sale of a capital asset is called capital gain. This gain is not a regular income like salary,
or house rent. It is a one-time gain; in other words the capital gain is not recurring, i.e., not occur again
and again periodically.
Opposite of gain is called loss; therefore, there can be a loss under the head capital gain. We do not use the
term capital loss, as it is incorrect. Capital Loss means the loss on account of destruction or damage of
capital asset. Thus, whenever there is a loss on sale of any capital asset it will be termed as loss under
the head capital gain.

The capital gain is chargeable to income tax if the following conditions are satisfied:

1. There is a capital asset.

2. Assessee should transfer the capital asset.
3. Transfer of capital assets should take place during the previous year.
4. There should be gain or loss on account of such transfer of capital asset.

Capital Asset
Capital asset, as per section 2(14) of the Act, means property of any kind except the following:
a) Stock-in-trade, consumable stores or raw-materials held for the purpose of business or profession.
b) Personal effects, i.e., movable property (including wearing apparel and furniture, held for personal use by
the assessee or any member of his family dependant on him; But excludes:-

Jewellery, which means,

i. 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;
ii. Precious or semi-precious stones, whether or not set in any furniture, utensil or other article or
worked or sewn into any wearing apparel.

 Archaeological Collections
 Drawings
 Paintings
 Sculptures or
 Any work of arts

c)Agricultural land in India other than the following lands specified here:
• In any area which is comprised within the jurisdiction of a municipality (by whatever name
known) or a cantonment board and which has a population of not less than 10,000 according
to the last preceding census; or
• Land situated in any area around the above referred bodies upto a distance of 8 kilometers
from the local limits of any municipality or cantonment board referred to in item (a) above, as
the Central Government may, having regard to the extent of, and scope for, urbanisation of
that area and other relevant considerations, specify in this behalf.
d)the following bonds issued by the Central Government,
• 6 ½ per cent Gold Bonds, 1977,
• 7 per cent Gold Bonds,1980,
• National Defence Gold Bonds, 1980, and
• Special Bearer Bonds, 1991,
61
Hrideja Shah
BA LLB 2012

e) Gold Deposit Bonds issued under the Gold Deposit Scheme, 1999 notified by the Central Government.
Will an agricultural land be treated as capital asset, in case it is located within 8 kilometers from the
local limits of a City Municipal Corporation, even though the same is not notified by the Central
Government under section 2(14)(iii)(b)?

CIT v. Madhukumar N. (HUF) (2012) 208 Taxman 394 (Kar.)

On this issue, the Karnataka High Court observed that, as per section 2(14), an agricultural land is not a
capital asset except in the following cases -
(a) when it is located within the jurisdiction of a municipality, etc, which has a population not less than
10,000 or
(b) when it is located within 8 kilometers from the local limit of a municipality, etc., mentioned in (a)
above, which is notified by the Central Government in this regard.
For an agricultural land to become a capital asset by virtue of (b) above, two conditions have to be satisfied
namely, the population of the municipality etc, should not be less than 10,000 and the same should be
notified by the Central Government.
Therefore, in case an agricultural land is situated within 8 kilometers from the local limit of a municipality,
etc. whose population is more than 10,000 but the same is not notified by the Central Government, the said
land would not be a capital asset and no capital gain tax would be attracted on its sale.

Would sale of a plot of land held as stock-in-trade by an assessee engaged in the business of real estate
and construction of plots, be treated as sale of capital assets, to attract the provisions of section 50C?

CIT v. Kan Construction and Colonizers (P) Ltd (2012) 208 Taxman 478 (All.)

On this issue, the Allahabad High Court observed that for applicability of section 50C, the essential
requirement is that the building and land transferred should be a capital asset.
Further, as per section 2(14), capital asset does not include stock-in-trade held for the purpose of an
assessee’s business or profession.
The Assessing Officer treated the sale of plot of land held by the assessee as sale of capital asset and
accordingly, applied the provisions of section 50C.
The High Court held that since the assessee is a builder and construction of buildings is its business,
investment in purchase and sale of plots by it is ancillary and incidental to its business activity. Therefore, it
was held that the assessee has held the land as stock-in-trade and not as a capital asset.
Hence, section 50C will not apply in this case and the profit on sale of land will be treated a business
income.

TYPES OF CAPITAL ASSET

There are two types of Capital Assets:

1. Short Term Capital Assets (STCA): An asset, which is held by an assesse for less than 36 months,
immediately before its transfer, is called Short Term Capital Assets. In other words, an asset, which
is transferred within 36 months of its acquisition by assessee, is called Short Term Capital Assets.

2. Long Term Capital Assets (LTCA): An asset, which is held by an assesse for 36 months or more,
immediately before its transfer, is called Long Term Capital Assets. In other words, an asset, which
is transferred on or after 36 months of its acquisition by assessee, is called Long Term Capital Assets

The period of 36 months is taken as 12 months under following cases:

62
Hrideja Shah
BA LLB 2012

• Equity or Preference shares,

• Securities like debentures, government securities, which are listed in recognised stock exchange,
• Units of UTI
• Units of Mutual Funds
• Zero Coupon Bonds

Long Term Capital Asset

A simple definition for Long-term capital asset in relation to Taxation of Capital Gains is "A capital asset,
which is not a Short-Term Capital Asset".

TYPES OF CAPITAL GAIN

The profit on transfer of STCA is treated as Short Term Capital Gains (STCG)while that on LTCA is known
as Long Term Capital Gains (LTCG).

While calculating tax the STCG is included in Total Income and taxed as per normal rates while LTCG is
taxable at a flat rate @ 20%.

TRANSFER

Capital gain arises on transfer of capital asset; so it becomes important to understand what is the meaning of
word transfer.
The word transfer occupies a very important place in capital gain, because if the transaction involving
movement of capital asset from one person to another person is not covered under the definition of transfer
there will be no capital gain chargeable to income tax. Even if there is a capital asset and there is a
capital gain.
The word transfer under income tax act is defined under section 2(47). As per section 2 (47) Transfer, in
relation to a capital asset, includes sale, exchange or relinquishment of the asset or extinguishments of any
right therein or the compulsory acquisition thereof under any law.

In simple words Transfer includes:

• Sale of asset
• Exchange of asset
• Relinquishment of asset (means surrender of asset)
• Extinguishments of any right on asset (means reducing any right on asset)
• Compulsory acquisition of asset
The definition of transfer includes only above said five ways. In other words, transfer can take place only in
these five ways. If there is any other way where an asset is given to other such as by way of gift, inheritance
etc. it will not be termed as transfer.

COMPUTATION OF CAPITAL GAINS

Computation of capital gain depends upon the nature of capital asset transferred. The tax incidence is
generally higher in the case of short term capital gain as compared to long term capital gains.
The capital gain can be computed by subtracting the cost of capital asset from its transfer price, i.e., the sale
price. The computation can be made by making a following simple statement:

63
Hrideja Shah
BA LLB 2012

Particulars Amount

Full Value of Consideration ----------

Less: Cost of Acquisition*(COA) -----------
Cost of Improvement*(COI) -----------
Expenditure on transfer -----------
Capital Gains -----------
Less: Exemption U/S 54 -----------
Taxable Capital Gains -----------
* To be indexed in case of LTCA -----------

FULL VALUE OF CONSIDERATION

Full value of consideration means & includes the whole/complete sale price or exchange value or
compensation including enhanced compensation received in respect of capital asset in transfer. The
following points are important to note in relation to full value of consideration.
• The consideration may be in cash or kind.
• The consideration received in kind is valued at its fair market value.
• It may be received or receivable.
• The consideration must be actual irrespective of its adequacy.

The full value of consideration does not mean market value of that asset which is transferred. It makes no
difference whether or not full value of consideration is received during the previous year. Even if the full
value of consideration is received in installments in different years, the entire value of consideration has to
be taken into consideration for computing the capital gains, which become chargeable in the year of transfer.

COST OF ACQUISITION

Cost of Acquisition (COA) means any capital expense at the time of acquiring capital asset under transfer,
i.e., to include the purchase price, expenses incurred up to acquiring date in the form of registration, storage
etc. expenses incurred on completing transfer.
In other words, cost of acquisition of an asset is the value for which it was acquired by the assessee.
Expenses of capital nature for completing or acquiring the title are included in the cost of acquisition.
The Cost Inflation Index(CII) has a major role to play in the calculation of COA.

Indexed Cost of Acquisition = COA X CII of Year of transfer

CII of Year of acquisition

If capital assets were acquired before 1.4.81, the assesses has the option to have either actual cost of
acquisition or fair market value as on 1.4.81 as the cost of acquisition. If assesses chooses the value as on
1.4.81 then the indexation will also be done as per the CII of 1981 and not as per the year of acquisition.

How does CII help in capital gains computation?

Capital gain arises when the net sale consideration of a capital asset is more than the cost. Since “cost of
acquisition” is historical, the concept of indexed cost allows the taxpayer to factor in the impact of inflation
on cost.
64
Hrideja Shah
BA LLB 2012

Consequently, a lower amount of capital gains gets to be taxed than if historical cost had been considered in
the computations.

EXPEDITURE ON TRANSFER

Expenditure incurred wholly and exclusively for transfer of capital asset is called expenditure on transfer. It
is fully deductible from the full value of consideration while calculating the capital gain.
Even if an expenditure has some nexus with the transfer, it does not qualify for deduction unless it is wholly
and exclusively in connection with the transfer.
Examples of expenditure on transfer are the commission or brokerage paid by seller, any fees like
registration fees, and cost of stamp papers etc., travelling expenses, and litigation expenses incurred for
transferring the capital assets are expenditure on transfer.
Note: Expenditure incurred by buyer at the time of buying the capital assets like
brokerage, commission, registration fees, cost of stamp paper etc. are to be added in the cost of acquisition
before indexation.

EXEMPTION FROM CAPITAL GAINS

Exemption means a reduction from the taxable amount of capital gain on which tax will not be levied and
paid. The exemptions are given under section 54, these exemptions are of various types but here we will
discuss only one of the exemptions relating to the house property.
Exemption u/s 54
• The exemption u/s 54 relates to the capital gain arising out of transfer of
residential house.
• The exemption is available to only Individual assesse.
• The exemption relates to the capital gains arising on the transfer of a residential house.

Conditions:
Exemption is available if: -
1. House Property transferred was used for residential purpose.
2. House Property was a long term capital asset.
3. Assesses has purchased another house property within a period of one year before or two years after the
date of transfer or has constructed another house property within three years of date of transfer i.e. the
construction of the new house property should be completed within three years. The date of starting of
construction is irrelevant

Asset: Means any property which can be realised into cash or some other valuable item, e.g., land, building,
car, jewellery, T.V., computer etc.
Debentures: Debentures are financial document of title, which states that the person whose name is written
on it has given a certain some of money to the company as loan and he is entitle to get interest on that
money till maturity.
Bearer Bonds: Against debentures, bearer bonds does not have any name on it, any person who will hold
these document will be eligible to get the money and interest. These bonds do not exist now days these have
already matured.
Equity Shares: Equity shares are also financial document of title, which states that the person whose name
is written on it (not in case of demat shares) has contributed to the capital fund of the company and will be
eligible for dividend.
Preference Shares: preference shares are also like equity shares with the difference that the dividend in
their case is fixed and it is paid first to preference shareholders, and later to equity shareholders.
Recurring: Means to recur to occur again and again, e.g., salary, rent etc. occurs again and again, while non
recurring means something which does not occur again and again which occur once in a while, although it

65
Hrideja Shah
BA LLB 2012

can occur again but there is no certainty of its occurrence again e.g., loss on account of road accident, gain
on sale of house etc.

Relevant Sections

Definitions: 2(14), 2(29A), 2(29 B), 2(42A), 2(42B), 2(47)

Exemption: 10(38)
Computation: 45 to 55A
Tax: 111A , 112

Sale
 The term ‘sale’ has not been defined in the Act.

 The Calcutta HC in Hall and Anderson Pvt. Ltd. v CIT (1963) 47 ITR 790 (Cal) observed that in
order to find out the legal implication of ‘sale’ one must resort to the Transfer of Property Act, 1882,
in the case of immovable property and to the Sale of Goods Act, 1956, in the case of movable
property.

 Section 54 of the Transfer of Property Act, 1882 defines ‘sale’ as a transfer of ownership in
exchange for a price paid or promised or part-paid or part-promised.

Exchange
• Under Sec. 118 of Transfer of Property Act, 1882, when two persons mutually transfer the
ownership of one thing for the ownership of another, neither of the things or both the things being
money only, the transaction is called an exchange.
• Accordingly, what appears to be a fundamental difference between sale and exchange is that in case
of sale, the consideration for transfer is money, whereas in case of exchange of, the consideration is
another asset.
• For example, Conversion of preference share into equity shares amounts to exchange, as held by the
Andhra Pradesh CIT v Trustees of HEH Nizam’s Second Supplementary Family Trust (1976) 102
ITR 248 (AP).

Example
Rai has inherited certain silver ornaments from her mother. For her marriage, she wishes to buy gold
jewellery. She likes the gold jewellery of her friend Sen. Sen too is keen to buy the ornaments of Rai. Both
the friends mutually decide to exchange their belongings.
The above example will fall within the ambit of ‘exchange’ under the provisions of the Act. Thus, the
transfer by way of silver ornaments and gold jewellery by Rai and Sen, respectively, will be chargeable to
tax in the hands of respective transferee.

However, Section 55(2)(b)(v)(e), inserted by the Finance Act, 1964, with effect from 1st April 1964,
provides that the cost of acquisition of shares converted from one kind to another will be computed with
reference to cost of acquisition of the original shares. The Government of India (Ministry of Finance,
Department of Revenue and Company Law) issued a Circular, dated 12th May, 1964, the relevant extracts of
which are as follows;
“…Section 14 of the Finance Act, 1964, introduces a new clause (v) in sub-section (2) of section 55 of the
Income Tax, laying down the method for determining the cost of acquisition of a new share into another

66
Hrideja Shah
BA LLB 2012

type of share. A question has been raised whether the transaction of conversion of one type of share into
another attracts the capital gains tax under Section 45(1)… The position in this regard is as follows;
• Where one type of share is converted into another type of share (including conversion of debentures
into equity shares) there is, in fact no ‘transfer’, of a capital asset within the meaning of section 2()47
of the Income Tax, 1961. Hence, any profits derived from such conversion are not liable to capital
gains under section 45(1) of the Income Tax. However, when such newly converted shares is
actually transferred at a later date, the cost of acquisition of such share for the purpose of computing
the capital gains shall be calculated with reference to the cost of acquisition of the original share of
that from which it is derived….”
• Thus, it may be possible to take a view that conversion of preference shares should be a tax neutral
transaction and only transfer of converted equity shares should result in a capital gain. This has been
further reiterated in CIT v Goel, Allahabad High Court’s order 9 November 1981 [(SLP rejected)
reference: 149 ITR (St) 90].

An interesting issue which arises is whether conversion of preference shares into equity shares could be
regarded as a transfer. While certain judicial precedents suggest that such a conversion of preference share
into equity shares results in ‘exchange’ and thus transfer, it will be useful to refer to an internal instruction
issued by the Department of Revenue and Company Law to all the Commissioners of Income Tax stating
that conversion of one kind of shares into another kind should not be regarded as a transfer within the
meaning of Sec. 2(47) of the Act.
Furthermore, Sec. 55(2)(b)(v)(e), as inserted by the Finance Act , 1964, with effect from 1st April 1964,
provides that the cost of acquisition of shares converted from one kind to another will be computed with
reference to the cost of acquisition of the original shares.

Relinquishment

Relinquishment means withdrawal from, abandoning or giving-up anything. In the case of relinquishment,
the owner of the property will cease to own the concerned asset through some act on the owner’s part. The
owner withdraws from the property and abandons his/her rights thereto. The property continues to exist and
will become the property of someone else.

Extinguishment of rights in an asset

• Extinguishment will connote total destruction, termination or extinction of a capital asset. The term
‘extinguishment of any right therein’ came up for consideration before Supreme Court in Vania Silk
Mills Ltd v CIT (1991) 191 ITR 647 (SC) and the court observed that existence of an asset is
essential for the transfer.
• The court held that money received under an insurance policy in the case of damage or destruction of
an asset cannot be treated as a consideration for transfer of a capital asset and hence no liability for
capital gains tax arises in such a situation. This decision of the Supreme Court has been nullified by
introducing Sec. 45(1A) in the Act, which provides that insurance money received from an insurer
on account of damage or destruction of a capital asset will rise to capital gains.
• The Supreme Court has distinguished the decision given in the Vania SilL Mills (Supra), in another
case CIT v Mrs Grace Collis (2001) 248 ITR 323 (SC), wherein the court held that destruction or
loss of an asset can be understood as transfer within the extended meaning of transfer, which
includes ‘extinguishment of any rights in a capital asset’.
• The Delhi High Court in the case of JK Kashyap v ACIT (2008) 302 ITR 255 (Del.) held that where
an assessee receives a sum for relinquishment rights it is immaterial whether the agreement is
completed or not or whether the vendee takes the possession of the property or not. The word
‘transfer’, under 2(47) of the Act, has a wider meaning and includes extinguishment of rights in a
property and from the facts it is clear that the assessee acquired interest in the said property which
67
Hrideja Shah
BA LLB 2012

was subsequently relinquished for consideration leading to transfer within the terms of Sec. 2(47) of
the Act, thus attracting the liability of the capital gains tax.

• The Delhi High Court, following Grace Collis (supra), in the case of CIT v Chand Ratan Bagri
(2010) 230 CTR (Del) 258 held that forfeiture of convertible warrants due to failure to make
payments results in extinguishment of rights of the assessee to obtain a share in the company and
results in loss under the head ‘capital gains’.
• The Special Bench of the Mumbai ITAT, in the case of Bennett Coleman & CO. Ltd. [2011] 12 ITR
(Trib) 97 (Mum) (SB), held that loss arising on account of reduction in share capital cannot be
subject to the provisions of Sec. 45 read with Sec. 48 and, accordingly, such loss was not allowable
as capital loss.
• The Tribunal held that it was a case of mere substitution of one kind of shares with another and there
was no effective change in the rights of the shareholder and hence, does not result in extinguishment
of rights.

Compulsory acquisition of asset

• Compulsory acquisition of an asset by government authorities is a transfer under Sec. 2(47) of the
Act. Acquisition of immovable properties under the Land Acquisition Act and acquisition of
industrial undertakings under Industries (Development and Regulations) Act, 1946 could be
examples of compulsory acquisition.

Important Case laws: Cost of acquisition

Date of acquisition is relevant - The cost of acquisition of the capital asset mentioned in section 48 implies
date of acquisition, and the date of acquisition of the asset is crucial for determining the capital gain
- Syndicate Bank Ltd. v. Addl. CIT [1985] 155 ITR 681 (Kar.)

Cost of property received on partition is cost on date of partition - Cost of an asset to a divided member
must necessarily be its cost to him at the time of partition - Kalooram Govindram v. CIT [1965] 57 ITR 335
(SC).

Cost must be as on the date of acquisition - Where the property was not a capital asset on the date of
acquisition but subsequently became a capital asset (like when it happens when agricultural land is
converted into non-agricultural use) prior to its sale, the cost of acquisition must be only with reference to its
date of acquisition, and not with reference to the date on which it became a capital asset - Ranchhodbhai
Bhaijibhai Patel v.CIT [1971] 81 ITR 446 (Guj.)/ CIT v. M. Ramaiah Reddy [1986] 158 ITR 611
(Kar.)/ CIT v. Smt. M. Subaida Beevi [1986] 160 ITR 557 (Ker.)

Where agricultural lands are converted into housing sites and sold, cost of acquisition of lands is their
original cost and not market value on date of conversion - Where the assessee converted agricultural
lands owned by him into housing sites and sold the sites, the cost of acquisition of the lands for purposes of
computation of capital gains will be their original cost, and not the market value on the date of their
conversion into housing sites. The principles laid down by the Supreme Court in Bai Shirinbai K.
Kooka [1962] 42 ITR 86 cannot be invoked, since those principles do not apply to provisions relating to
capital gains - M. Nachiappan v.CIT [1998] 230 ITR 98 (Mad.)

Events subsequent to date of acquisition are not relevant - While computing the capital gains, the
assessee is concerned with the cost of acquisition, that is, the price which was paid by the assessee for
acquiring the capital asset on the date it was acquired, subject to such adjustments as laid down under
68
Hrideja Shah
BA LLB 2012

section 55. The assessee has no concern with what would be the value of that asset on some subsequent
occasion; in other words, subsequent events need not be taken into consideration - CIT v. Steel Group
Ltd. [1981] 131 ITR 234 (Cal.)

Mortgage expenses are not excludible - Where the assessee purchased a property and on the very date of
purchase mortgaged the property in order to pay the vendor and for meeting the cost of stamp duty on the
sale deed, and later sold the property, the mortgage expenses incurred in connection with the acquisition of
the property as well as interest payable on the mortgaged amount would form part of the cost of acquisition
of the property for the purpose of computation of capital gains. The fact that the mortgage was executed
after the sale deed was obtained even though both the documents were signed and registered on the same
day does not render the mortgage and the borrowing made thereunder irrelevant to the task of determining
the cost of acquisition - CIT v. K. Raja Gopala Rao [2001] 252 ITR 459 (Mad.)

IMPORTANT POINTS:
a. If the capitals assets are distributed in kind by a company to its shareholders on its liquidation then
such a distribution is not treated as transfer.
b. Any distribution of capital asset in kind by a hindu undivided family on total or partial partition of
the family is not treated as a transfer.
c. If capital asset is transferred in kind by of the modes below then it is not transfer
i) Under gift
ii) Under will
iii) Under an irrevocable transfer

Cost of Improvement

Expenses must have actually been incurred - Only those expenses which have been actually incurred by the
assessee in making additions and improvements in the property ought to be taken into consideration as ‘cost
of improvement’ while computing capital gains under section 55(1)(b) of the Act - Shri Parmanand Bhai
Patel & Smt. Jyotsna Devi Patel v. CIT [1984] 149 ITR 80 (MP).

Asstt. CIT v. Narendra I. Bhuva (2004) 90 ITD 174(Mum.)

Ford Tourer 1931 model of car purchased by assessee in 1983 which remained parked at his residence and
was never used, could not be regarded as personal effect.

CIT v. Lingmallu Raghukumar (2001) 247 ITR 801 (SC).

The Supreme Court has held that when a partner retires from a firm and the amount of his share in the
partnership assets after deduction of liabilities and prior charges, is determined on taking accounts in the
manner prescribed by the partnership law, there is no element of transfer of interest in the partnership
assets by the retired partner to the continuing partners and the amount received by the retiring partner is not
capital gain.

T.V. Sundaram Iyengar & Sons Ltd. v. CIT (1959) 37 ITR 26 (Mad.)

Capital gains tax is payable in year in which assessee has acquired a right to receive profits, and its actual
receipt in that year is not necessary

B.B. Sarkar v. CIT (1981) 132 ITR 150 (Cal.)

69
Hrideja Shah
BA LLB 2012

Where assessee spent capital gains partly for purchase of another house and partly for further construction
on it, he would still be entitled to exemption under section 54.

70
Hrideja Shah
BA LLB 2012

EXEMPTIONS AND DEDUCTIONS

Exemptions under the Income Tax Act, 1961 – Sec.10

Are tax incentives good policy instruments?

• Tax incentives have been provided for in the law to promoted a multitude of objectives such as
regional development, stimulating investment, etc.
• What motivates an individual to invest in India?
 Tax factors
 Economic considerations
 Non-economic considerations
 Social policy considerations
• What are the instances in which tax incentives could have positive externalities?

The cost effectiveness of tax incentives

How important is the cost effectiveness of a tax incentive?

What are the costs of granting an incentive?
Distortions between investments enjoying incentives as opposed to others
Foregone revenue
Administrative costs
Social costs – corruption
Mardaani getting a tax exemption from entertainment tax because it discusses the issue of child trafficking

Agricultural Income

Agricultural income is exempt from tax if it comes within the definition of agricultural income as given in
Section 2(1A).
Exempt from List I so that States can tax under List II
• What is agricultural income? – Sec 2(1A)
 (a) any rent or revenue derived from land which is situated in India and is used for agricultural
purposes;
 (b) Income derived from such land by agricultural operations including processing of the agricultural
produce, raised or received as rent-in-kind so as to render it fit for the market, or sale of such
produce; and
 (c) Income attributable to a farm house, subject to some conditions.
 Income from saplings or seedlings grown in a nursery shall be deemed to be agricultural income.
 Agricultural income from a foreign country is treated as non-agricultural income in India.

Rent or revenue derived from land

• Recipient of the rent or revenue income need not be the owner of the land
• Are the following incomes derived from land?
 Dividend received by a shareholder from a company carrying on agricultural operations
 Surplus arising on transfer of agricultural land
 Commission earned by a broker for selling agricultural produce of an agriculturist
 Contract farming such as was in Namdhari Seeds

71
Hrideja Shah
BA LLB 2012

Agriculture or agricultural purpose

• No definition, we need to look at judicial interpretation

• CIT v Raja Benoy Kumar Sahas Roy [1957] 32 ITR 466
 Basic operations: human skill and labour being expended on the land itself – examples are tilling,
sowing of seeds, planting, etc.
 Subsequent operations: activities undertaken after the growth of the farm produce – examples are
weeding, digging, removal of undergrowth, tending, pruning, harvesting, rendering fit for market.
 Basic + subsequent operations form an integrated activity = agricultural purpose
• Agricultural products – range from food, grains to cash crops and to forest produce
• Mere connection with land is insufficient

Income from a farm building- Section 2(1A) (c )

 Building must be occupied by cultivator or receiver of rent in kind

 It is on or in the immediate vicinity of the land situated in India and used for agricultural purposes
 The cultivator or receiver of rent in kind, by reason of his connection with the agricultural land,
requires the building as a dwelling house or as a store house of other out-building
 Land is assessed to land revenue or local rate or alternatively the land is situated in a rural area.
• Income would be exempt only if land or building is used for agricultural purposes.

• Income from sale of forest trees, fruits and flowers growing naturally without the intervention of
human agency
• Income from contract farming – consider Namdhari Seeds

Receipts by a member of a HUF – Section 10(2)

• As per section 10(2), any sum received by an individual as a member of a HUF either
out of income of the family or out of income of estate belonging to the family is exempt
from tax. Such receipts are not chargeable to tax in the hands of an individual member even
if tax is not paid or payable by the family on its total income.

• Illustration - X, an individual, has personal income of Rs. 56,000 for the PY 2005-06. He is
also a member of a HUF, which has an income of Rs. 1,08,000 for the PY. Out of the income,
X gets Rs. 12,000, being his share of income. Rs. 12,000 will be exempt in the hands of X by
virtue of section 10(2). The position will remain the same whether (or not) the family is
chargeable to tax. X shall pay tax only on his income of Rs. 56,000.

Share of profit of partners in a partnership firm

As per Sec.10(2A), share of profit received by partners from a firm is not taxable in the hand of partners.

Leave Travel Concession

• The amount exempt under Sec.10(5) is the value of any travel concession or assistance received or
due to the assessee from his employer for himself and his family in connection with his proceeding
on leave to any place in India.
• The amount exempt can in no case exceed the expenditure actually incurred for the purposes of such
travel. Only two journeys in a block of four years is exempt. Exemption is available in respect of
travel fare only and also with respect to the shortest route.
72
Hrideja Shah
BA LLB 2012

Foreign allowance or Perquisite

• As per section 10(7), any allowance or perquisite paid or allowed outside India by the Government to
an Indian citizen for rendering service outside India is wholly exempt from tax.
 Context: Section 9(1)(iii) states that income chargeable under the head salaries is deemed to accrue
in India if it is payable by the government to an Indian citizen for rendering service outside India

Life Insurance Policies- Sums received

As per section 10(10D), any sum received on life insurance policy (including bonus) is not chargeable to
tax. Exemption is, however, not available in respect of the amount received on the following policies -
a. any sum received under section 80DD (3) or 80DDA (3);
b. any sum received under a Keyman insurance policy (look at explanation 1)
c. any sum received under an insurance policy issued
• on or after April 1, 2003 but before April 1, 2012 in respect of which the premium payable for any of
the years during the term of policy, exceeds 20 per cent of the actual sum assured;
• during 2012 – 2013 in respect of which premium payable exceeds 10% of actual sum assured;
• issued on or after April 1, 2013 in respect of which premium payable exceeds 10% or 15% of sum
assured
In respect of (c) (supra) the following points should be noted -
1. Any sum received under such policy on the death of a person shall continue to be exempt.
2. The value of any premiums agreed to be returned or of any benefit by way of bonus or otherwise, over
and above the sum actually assured, which is received under the policy by any person, shall not be taken into
account for the purpose of calculating the actual capital sum assured under this clause.

Educational Scholarships

• As per section 10(16), scholarship granted to meet the cost of education is exempt from tax. In order
to avail the exemption it is not necessary that the Government should finance scholarship.

INCOME OF A MINOR

• As per section 10(32), in case the income of an individual includes the income of his minor child in
terms of section 64(1A), such individual shall be entitled to exemption of Rs. 1,500 in respect of
each minor child if the income of such minor as includible under section 64(1A) exceeds that
amount. Where, however, the income of any minor so includible is less than Rs. 1,500, the aforesaid
exemption shall be restricted to the income so included in the total income of the individual.

Family Pension received by members of Armed Forces

 As per section 10(19), family pension received by the widow (or children or nominated heirs) of a
member of the armed forces (including para-military forces) of the Union is not chargeable to tax
from AY 2005-06, if death is occurred in such circumstances—
 acts of violence or kidnapping or attacks by terrorists or anti-social elements;
 action against extremists or anti-social elements;
 enemy action in the international war;
73
Hrideja Shah
BA LLB 2012

 action during deployment with a peace keeping mission abroad;

 border skirmishes;
 laying or clearance of mines including enemy mines as also mine sweeping operations;
 explosions of mines while laying operationally oriented mine-fields or lifting or negotiation mine-
fields laid by the enemy or own forces in operational areas near international borders or the line of
control;
 in the aid of civil power in dealing with natural calamities and rescue operations; and
 in the aid of civil power in quelling agitation or riots or revolts by demonstrators.

Dividend Income and Income from Mutual Funds

As per section 10(34)/ (35), the following income is not chargeable to tax—
a. any income by way of dividend referred to in section 115-O [i.e., dividend, not being covered by section
2(22) (e), from a domestic company];
b. any income in respect of units of mutual fund;
c. income from units received by a unit holder of UTI [i.e., from the administrator of the specified
undertaking as defined in Unit Trust of India (Transfer of Undertaking and Repeal) Act, 2002];
d. income in respect of units from the specified company.

DEDUCTIONS

The aggregate amount of deduction under section 80C to 80U cannot exceed gross total income. Where an
association of persons or body of individuals is entitled for deductions, a member there of cannot claim the
same deduction in his individual assessment in relation to his share in the total income of the association of
persons or body of individuals.
 encourage savings - saving based deductions are 80-C (certain investments towards LIC, PF),
80CCC (pension fund), 80CCD (Pension scheme of central Government).
 personal expenditure - 80D (Medical insurance), 80DD (Medical treatment of disabled dependent),
80E (Repayment of loan taken for higher education) and 80GG (rent paid)
 socially desirable activities - 80 G (donations to certain funds), charitable institutions
 disabled persons - Section 80U
• Where are they contained? - these 166 provisions are contained in Chapter VIA – Sec. 80C to 80U
• Effect of deductions: reduce the chargeable income and thus, the tax liability – serve as
inducements to act in the desired manner

Net income of the assessee is based on an aggregation of computation of income from each of the five heads
of income. The aggregate of income under the five heads is known as “gross total income”. Certain
deductions which are not deductible under any particular head of income are allowed out of gross total
income to arrive at the total income liable to tax.

Total income is accordingly computed as under:

1. Income from Salaries ___
2. Income from House property ___
3. Profits and Gains of Business and Profession ___
4. Income from Capital Gains ___
5. Income from other sources ___
Gross Total Income = ______________
Less deduction under Chapter VI-A(80C TO 80U)(-) _______
Net Income ______________

74
Hrideja Shah
BA LLB 2012

Basic rules of computation

 The aggregate amount of deductions under sections 80C to 80U cannot exceed gross total income
(gross total income after excluding long term capital gains, short term capital gain on equity shares
[Sec 111A], winnings from lottery, crossword puzzles and income earned under Sec.115A, 115AB,
115AC, 115ACA, 115AD, 115BBA and 115D)
 These deductions are to be allowed only if the assessee claims these and gives proof of such
investments/ expenditure/ income.
 Deduction is allowed when the saving is invested but normally any withdrawal is treated as income
in the year of withdrawal.
 There are some monetary thresholds on the allowable deductions under the different sections.
 Deductions are of two types, on account of certain : (a) payments and investments covered under
Section 80C to 80 GGC and (b) incomes which are already included under gross total income
covered under Section 80-IA to 80U.

Section 80C

 A new section 80C has been inserted from the AY 2006-07 onwards. Section 80C provides
deduction in respect of certain expenditure/ investments (which are specified in this section) paid or
deposited by the assessee in the previous year.
 Who can avail of this deduction?: Individual and HUF
 Monetary threshold: Whole of the amount paid or deposited in the previous year (gross qualifying
amount), as does not exceed Rs.1,50,000. Basically – gross qualifying amount or Rs.1,50,000,
whichever is lesser.
 Aggregate cap: The aggregate cap on investments under Section 80C, 80CCC and 80CCD is
Rs.1,50,000.

What all amounts are eligible for deduction under Section 80C?

1.Life Insurance premium paid on a policy taken on his own life, life of the spouse or any child (dependent/
independent). In the case of a HUF, policy may be taken on the life of any member of the family.

Any sum deducted from salary payable to a Government employee for the purpose of securing him a
deferred annuity (subject to a maximum of 20% of salary) – should be for benefit of individual, wife or
children.
3. Employee’s contribution towards Statutory Provident Fund, Recognized Provident Fund and approved
Superannuation Fund
4. Contribution towards Public Provident Fund (maximum of Rs 1,50,000 under the PPF scheme)
5. Subscription to National Savings Certificates, VIII Issue or IX Issue (no ceiling on investment)
6. Contribution for participating in the Unit-Linked Insurance Plan (ULIP) of Unit Trust of India or LIC
Mutual Fund (i.e. Dhanraksha plan).
7. Payment for notified annuity plan of LIC or any other insurer.
8. Subscription towards notified units of Mutual Fund or UTI
9. Contribution to notified pension fund set up by Mutual Fund or UTI
10. Any sum paid (including accrued interest) as subscription to Home Loan Account Scheme of the
National Housing Bank
13. Any sum paid as tuition fees to any university/college/educational institution in India for full time
education (does not include donation / development fees)

Contributions to certain pension funds – 80CCC

75
Hrideja Shah
BA LLB 2012

 Who can claim the deduction? - individual taxpayer

 Conditions for claiming deduction
• during the PY, the individual has paid/deposited a sum under an annuity plan of the LIC or any other
insurer for receiving pension.
• deduction should not have been claimed under Section 80C
 Amount of deduction - If the aforesaid conditions are satisfied, then the amount deposited or Rs.
1,00,000, whichever is lower, is deductible.
 Tax treatment of pension received - pension amount received by the assessee or his nominee as
pension will be taxable in the year of the receipt.
Pension Scheme or central government – section 80 CCD

 Who can avail of the deduction? – persons employed with the Central Government on or after 1st
Jan, 2004 or any other person who has invested in a pension scheme notified by the Central
Government
 What are the conditions to be satisfied?
• The taxpayer is an individual and
• who has in the previous year paid or deposited any amount in his account under a pension scheme notified
by the Central Government
 What is the amount of permissible deduction?
The amount deductible is :
a) The total of employee’s and employer’s contribution to the notified pension scheme during the year, or
b) 10% of salary (to include DA, if so provided) of the employee, whichever is less.
c) The maximum deduction under this section is capped at Rs.1,00,000 (from AY 2012-2013, employer’s
contribution towards NPS (to the extent of 10 % of employee’s salary shall not be considered for the ceiling)

Medical Insurance Premiums – Section 80D

 Conditions to be satisfied:
• taxpayer is an individual or a HUF
• Insurance premium is paid by the taxpayer in accordance with the scheme framed in this behalf by the
General Insurance Corporation of India and approved by the Central Government or any other insurer who
is approved by the Insurance Regulatory and Development Authority
• Mediclaim policy is taken on the health of the taxpayer, on the health of spouse, dependent parents or
dependent children of the taxpayer. In case of HUF on the health of any member of the family.
• Aforesaid premium should have been paid by cheque (for preventive health check-up, cash could have
been paid).

 Amount of Deduction:
• If all the aforesaid conditions are satisfied, then the
a) insurance premium paid or
b) deduction up to Rs. 20,000/- for senior citizens and up to Rs. 15,000/ in other cases for insurance of self,
spouse and dependent children
c) From AY 2013-14, within the existing limit a deduction of upto Rs. 5,000 for preventive health check-up
is available.
whichever is lower, is deductible.
• A person is a senior citizen if he is resident and at least of 60 years of age at any time during the
previous year. The limit is Rs.15,000/- in all other cases. From AY 2013-2014, age limit was reduced
from 65 to 60.
• Therefore, the maximum deduction available under this section is to the extent of Rs. 40,000/-.

Maintenance including medical treatment of a disabled dependent – 80DD

76
Hrideja Shah
BA LLB 2012

 Who can avail of the deduction? only individuals and HUF resident in India
 Disabilities – inter alia autism, cerebral palsy, mental retardation as specified in Persons With
Disabilities Act, 1995 (PWD Act).
 Conditions for availing the deduction are as follows:
• This deduction is given to the assesse if a person with disability is dependent upon him.
• The assesse has incurred expenditure by way of medical treatment (including nursing), training and
rehabilitation of a disabled dependent: or/and he has paid or deposited any amount under any scheme framed
by the LIC of India or any other insurer for the payment of an annuity or a lump sum amount for the benefit
of such dependent in the event of the death of the assesse.
• For claiming the deduction the assesse shall have to furnish a certificate by the prescribed medical
authority with the return of income.

Section 80DD

 Explanation: Dependent means

i) In case of an individual, the spouse children, parents, brothers, sisters of the individual or any of them.
ii) In case of HUF, a member of the HUF wholly or mainly dependent on such individual or HUF for
support and maintenance.
 Amount of Deduction
• If the above mentioned conditions are satisfied the amount of deduction is fixed at Rs. 50,000
irrespective of actual expenditure. In case of a person with severe disability (over 80 %) a higher
deduction of Rs. 1,00,000 shall be allowed irrespective of actual expenditure.
• A person with 'severe disability' means a person with 80% or more of one or more disabilities as
outlined in section 56(4) of the 'Persons with disabilities (Equal opportunities, protection of rights
and full participation)' Act, 1995.

Medical Treatment expenses- 80DDB

 Who can avail of the deduction? - individual or HUF resident in India

 Deduction is available if the following are satisfied :
• The assessee has actually paid for the medical treatment of specified disease or ailment, for himself
or any dependent* or in case of HUF any member of the family.
• The assessee furnishes a certificate, in the prescribed form from a specialized doctor, along with the
return of income.
 What is the amount that can be availed of as a deduction?
• The amount paid or Rs. 40,000, whichever is less
• Where the amount is paid in relation to a senior citizen the deduction will be allowed for amount
paid or Rs. 60,000, whichever is less.
• The deduction shall be reduced by the amount received, if any, under an insurance from an insurer
for the medical treatment of person mentioned in this section or reimbursed by the employer.
* The definition of ‘dependent’ is the same as in the above section.

Repayment of Loan for Higher Education – Section 80E

 When is the deduction available?

• Assessee is an individual who has taken a loan from any financial institution or an approved charitable
institution for himself or his relative (spouse and children)
• The loan must have been taken in relation to pursuit of higher education
• During the PY he has repaid some amount as interest on such loan
• Such amount is paid out of his income chargeable to tax.
77
Hrideja Shah
BA LLB 2012

 “Higher education” means any course of study pursued after passing the Senior Secondary
Examination or its equivalent from any school, board or university recognized by the Central
Government or State Government or local authority or by any other authority authorized by the
Central Government or State Government or local authority to do so
 Period of Deduction - deduction shall be allowed for the PY in which the assessee starts repaying
the loan or interest thereon and seven previous years immediately succeeding it or until the loan
together with interest thereon is paid by the assessee in full ,whichever is earlier.

Rent paid – Section 80GG

 Who can avail of this deduction? - an individual in respect of rent paid by him for an accommodation
used for his residential purposes provided the following conditions are fulfilled:
• Assessee is either a self-employed person or a salaried employee, not in receipt of HRA
• Actual rent paid is in excess of 10% of his total income
• He / his spouse / minor children / HUF, of which he is a member, does not own any residential
accommodation at the place where the assessee resides, performs the duties of his office or
employment or carries on his business or profession. Where, however, the assessee owns any
residential accommodation at any other place and claims the concessions of self-occupied house
property for the same, he will not be entitled to any deduction u/s 80GG even if he does not own any
residential accommodation at the place where he ordinarily resides, performs the duties of his office
or employment or carries on his business or profession.
• The assessee files a declaration in Form No. 10BA regarding the payment of rent.
 What is the deduction available under this Section? - The allowable deduction is the least of these
amounts:
• excess of actual rent paid over 10% of total income (GTI – LTCGs – STCGs under Sec 111A –
deductions under Secs.80 C- 80U – income under 115A);
• 25% of his total income; and
• Rs. 2,000 p.m.

Section 80 TTA: Deduction – Income by way of interest on savings account

 This deduction was inserted into the law w.e.f. 1st April 2012 (AY 2013-2014)
 Who can avail this deduction? - individual or HUF
 Deduction from gross total income up to a maximum of Rs.10,000, in respect of interest on deposits
in savings account (not time deposits) with a bank, co-operative society or post office

Deduction to a person with disability – Section 80U

 What are the conditions to avail of this deduction?

• The assessee is a resident individual
• He is a person with disability.
• He is certified by the medical authority to be a person with disability, at any time during the previous year.
• He furnishes a certificate issued by the medical authority in the prescribed form along the return of income
 What is the amount of deduction? It is a fixed deduction, per the following details:
• Rs. 50,000 in case of a person with disability
• Rs. 1,00,000 in case of a person with severe disability (having a disability over 80%)

Section 80RRB: Deduction in respect of any income by way of royalty of a patent

78
Hrideja Shah
BA LLB 2012

 Who can avail of the deduction? - Individual resident in India

 What are the conditions?
• The assessee must be an individual resident of India who is a patentee receiving royalty income in
respect of a patent registered on or after 1st April, 2003
• The assessee must furnish a certificate in the prescribed form duly signed by the prescribed authority
 What is the deduction? - up to Rs. 3,00,000 or the income received, whichever is less.

Deductions for socially desirable activities – Section 80 G

 There are various funds created by Governments to take care of natural calamities like earthquake,
floods, etc. Similarly certain funds have been created to promote social and economic welfare and
education.
 To incentivize contribution into these funds, deduction has been provided in Section 80G for
donations given by assessee to these funds.
 Who can avail of the deduction? All assessees
 What are the conditions for availing a deduction?
• Donation should be monetary – not in kind
• Donation should be made to the stipulated funds / institutions
 What should be the mode of payment? Donation can be given in cash, or cheque or draft. No
deduction shall be allowed under Section 80G in respect of donation made in cash of an amount
exceeding Rs 10,000 from AY 2013-2014.

For the sake of convenience, the donations have been divided into four categories depending on the quantum
of deduction.
A. Donations made to following are eligible for 100% deduction without any qualifying limit:
1. Prime Minister’s National Relief Fund
2. National Defence Fund
3. Prime Minister’s Armenia Earthquake Relief Fund
4. The Africa (Public Contribution - India) Fund
5. The National Foundation for Communal Harmony
6. Approved university or educational institution of national eminence
7. The Chief Minister’s Earthquake Relief Fund, Maharashtra
8. Donations made to Zila Saksharta Samitis.
9. The National Blood Transfusion Council or a State Blood Transfusion Council.
10. The Army Central Welfare Fund or the Indian Naval Benevolent Fund or The Air Force Central Welfare
Fund.

B) Donations made to the following are eligible for 50% deduction without any qualifying limit:
1. Jawaharlal Nehru Memorial Fund
2. Prime Minister’s Drought Relief Fund
3. National Children’s Fund
4. Indira Gandhi Memorial Trust
5. The Rajiv Gandhi Foundation.

C) Donations to the following are eligible for 100% deduction subject to qualifying limit (i.e. 10% of
adjusted gross total income):
79
Hrideja Shah
BA LLB 2012

1. Donations to the Government or a local authority for the purpose of promoting family planning.
2. Sums paid by a company to Indian Olympic Association
D) Donations to the following are eligible for 50% deduction subject to the qualifying limit (i.e. 10%
of adjusted gross total income).
1. Donation to the Government or any local authority to be utilized by them for any charitable purposes
other than the purpose of promoting family planning.

 The quantum of deduction is as follows :-

• Category A- 100 % of amount donated
• Category B - 50 % of the amount donated in the funds
• Category C – 100% of the amount donated in the funds subject to maximum limit of 10% of
Adjusted GTI.
• Category D – 50% of the amount donated in the funds subject to maximum limit of 10% of Adjusted
GTI.
 The total of these deductions under categories A,B,C, & D is the quantum of deduction under this
section without any maximum amount.
 Adjusted Gross Total income means Gross Total Income minus long-term capital gain, short term
capital gain taxable u/s 111A, and all deductions u/s 80C to 80U (except any deduction under Sec
80G) and income referred to under Section 115A to 115AD (income of NRIs and foreign companies
taxable at a special rate of tax).

80
Hrideja Shah
BA LLB 2012

ADVANCE RULING

Relevant Sections – Section 245 N-V

• It is in essence a binding statement from the Revenue Authorities, upon the voluntary request of a
private person, with respect to the treatment and consequences of one or a series of contemplated
future actions or transactions having exigible consequences.

Scope of Advance Ruling:

It is a mode of Alternate Dispute Resolution mechanism or better put, a dispute prevention mechanism.

Objectives

• To reduce litigation
• Lowering compliance costs to the Assessee.
• Introducing a level of certainty in taxation.
• To promote better Revenue-Taxpayer relations.
• To Provide a more congenial and investor friendly business environment to promote investment.

Advance Ruling in India

• Relevant law-
Chapter – XIXB , under sections 245N to 245V of the Income Tax Act, inserted via the Finance
Act, 1993, with effect from June 1st, 1993.
• Relevant Rules-
 Income Tax Rules 44E & 44F – Forms 34C, 34D and 34E
 Authority for Advance Rulings (Procedure) Rules 1996
 Authority for Advance Rulings (Salaries and Allowances, Terms and Conditions of
Service of Chairman and Members) Rules, 1994

Constitution of AAR

• It is provided for under section 245-O of the Act.

• It shall consist of:
 Chairman – A retired judge of the Supreme Court
 Member (Revenue) – An officer of IRS qualified, to be member of CBDT
 Member (Legal) – An officer of Indian Legal Service, qualified to be an Additional Secretary
of GOI
The office of the Authority shall be located in New Delhi.
It is permissible for an applicant under Section 245Q to approach the Advance Ruling Authority for
questions which pertain to the taxability of its employees serving in India.

Definition

The term Advance Ruling is defined under Section 245N of the IT Act, and includes:
 Primarily available to non-residents only, though the Finance Act of 2014 has stated extending AAR
to residents also
 Residents can apply but in relation to the determination of tax liability of the non-resident
 PSUs can apply as notified category of persons
81
Hrideja Shah
BA LLB 2012

 The intent was to permit Non-Residents to seek and obtain Advance Rulings on issues that could
arise in determining their Income Tax liability.

Questions on which ruling can be sought

• The advance ruling can be sought on any question of law or fact in relation to a transaction which
has been undertaken, or is proposed to be undertaken, by the non-resident applicant, in respect of
Income Tax liability of the non resident in India.
• The Authority does not have the jurisdiction to pronounce a ruling on matters relating to taxes levied
under other statutes.
• The Authority cannot give a ruling that is hypothetical in nature.

Who can apply

• The non resident whose tax liability is being determined

• A resident entering into or proposing to enter into a transaction with a non resident
• A resident falling in a class notified by the Central Govt. (PSUs) in respect of questions pending
before Income tax Authority or Appellate Tribunal, relating to computation of income.

While section 245N stipulates that a non resident can make an application under Chapter XIX-B, it does not
say in specific terms that he should be a non resident as on the date of the application. Residence or non
residence for the purposes of the act has to be determined with reference to previous year.

Meenu Sahi Mamik case

• The Applicant, a resident of Netherlands, wants to establish a manufacturing unit for formulation of
pharmaceuticals in partnership with her husband, in the State of Himachal Pradesh
• The applicant sought ruling of the Authority on the question of law under section 80-IC, with regard
to direct business procured by it, and processing charges
Ruling:
• The AAR ruled that since de facto control and management of the firm would be with the applicant’s
husband in India, the firm could not be said to be a non-resident entity
• The application was held to be not maintainable

Other pertinent pronouncements

• Indian company making payment to a foreign company seeking ruling on the question of TDS to be
made
• Dell International Services India Pvt. Ltd. 305ITR37
• Non-resident shareholder of an Indian company seeking ruling in respect of deductions available to
the company
• Umicore Finance: 318 ITR 78
• Indian company purchasing shares from foreign company can apply for ruling regarding tax liability
of the foreign company on capital gains on such transaction u/s. 245N(b)(ii).
• Mcleod Russel India Ltd 299ITR 79

82
Hrideja Shah
BA LLB 2012

Barred Applications

The first proviso to section 245R(2) prescribes that Advance Ruling cannot be sought if the matter in
question is already:

 pending before any income tax authority, the Appellate Tribunal or any court;
 involves determination of fair market value of any property; or

Meaning of “applicant” under
section 245N(b)
A non resident who makes an
application under 245Q(1)
 relates to a transaction which is designed prima facie for avoidance of income-tax.
Meaning of advance ruling as per The authority shall not allow the
section 245N(a) application when the question
raised in the application relates to
to the following
Determination by the authority in If i) its already pending before
relation to a transaction which any income tax authority or
has been undertaking by a non Appellate Tribunal or court, or ii)
resident applicant and such it involves determination of fair
determination shall include the market value of any property; or
determination of any question of iii) it relates to a transaction or
law or fact specified in the issue which is designed prima
application facie for the avoidance of income
tax

L.S. Cables Ltd. v. Director of Income tax

• The issue before the authority was the determination of the scope of proviso (i) of section 245R (2)
vis-à-vis pending applications.
• The Revenue argued that the application of the applicant is not maintainable since similar question
of law has been pending before the High Court in case involving the assessee and another third party,
not connected with the transaction before the AAR in this matter.
• Assessee contended that the transaction giving rise to the said dispute is different and the contract is
with a different party and hence the application is out side the purview of provisio (i), thus
maintainable.

• It was held that the first clause of the proviso to section 245R(2) ought not to be read in isolation
from other provisions other provisions of the Act.
• It was held that the term ‘Already pending’ would be restricted to applications only in respect of the
same transaction and applicants before the AAR.
• The mere possibility of conflicting decisions is not a good ground to truncate or restrict the scope of
the remedy provided under the Act.

Airport Authority of India case

• Applicant sought advance ruling in respect of its obligation to deduct tax under section 195 in
connection with contracts entered into by it with a US based company called Raytheon Company.
• However the question of Raytheon Company’s liability to pay income tax in India was already
pending before the income-tax appellate authority.

83
Hrideja Shah
BA LLB 2012

• The applicant argued that it was Raytheon Company’s liability under the provisions of the Act, read
with DTAA entered into between India and the US that was under consideration with the appellate
authority and not the question of tax deduction at source specifically.
Held
• While the issues were inter-related they were not identical. The application was maintainable

Additional cases

 It has been held that the filing of return of income after submission of an application before the AAR
does not preclude the AAR from dealing with the application.
[David Kenneth v. CIT, 231 ITR 464 (AAR)]

 An application under section 195(2) for determining the amount of TDS is not a pending proceeding
that may bar the jurisdiction of the AAR.
[Ericsson v. CIT, 224 ITR 203 (AAR)]

Procedure upon receipt of Application

 Section 245R of the Act prescribes the procedure to be followed by the AAR after receipt of an
application.
 Copy of the application is sent to the jurisdictional CIT.
-The CIT may resist/challenge the admission.
 The application is rejected only after giving the applicant an opportunity of being heard
 If no objection to admission, then the application is admitted without formal hearing and date is fixed
for hearing on merits.
 Applicant as well as the CIT are heard, either in person or through authorized representative
 The Proceedings before the Authority are not open to public. Accordingly, only the applicant or the
authorized representative can remain present during such proceedings.
 AAR may at its discretion permit the applicant to submit the additional information to enable it to
pronounce its ruling.
 The Applicant cannot urge or be heard in support of any additional question not set forth in the
application filed before the AAR, except without the leave of the AAR (Rule 12)
 The AAR shall pronounce its ruling within six months of the receipt of the application.

Applicability of the AAR Ruling as per section 245-S

The ruling pronounced is binding on:

 The Applicant who had sought it
 In respect of the transaction in respect of which the ruling is sought
 On the Commissioner and the revenue authorities subordinate to him, in respect of the Applicant and
the said transaction
It will also be binding on the commissioner and the income tax authorities to the commissioner. The ruling
will continue to remain in force unless there in a change in law or in fact on the basis of which the advance
ruling was pronounced.
Thus, the pronouncement of AAR is not a judgment in rem but a judgment in personam
For other transaction and other parties the ruling has a persuasive value
The ruling is binding as long as there is no change in law or facts on the basis of which the advance ruling
was rendered
Moreover, the Authority is not itself bound by its previous rulings.

84
Hrideja Shah
BA LLB 2012

Appeal against Advance Ruling

• No specific provision for appeal against the Ruling in the Act.

• However, the applicant/department can invoke the writ jurisdiction of the High Courts under Article
226 and 227 and extraordinary jurisdiction of the Supreme Court under Article 136 of the
constitution.

U.A.E Exchange centre LLC v. UOI and Anr.

• Issue before the Delhi High Court was whether a ruling by the AAR can be challenged by way of
writ, under Articles 226 and 227 of the Constitution.
• The Court observed that Section 245-S neither expressly nor implicitly exclude the Courts
jurisdiction under Article 226. it further added that there is no provision that gives finality to the
order/decision of the AAR.
• Court held that the AAR is a tribunal since it is invested with powers similar to a civil court under
the Civil Procedure Code, i.e., it has ‘Trappings of a Court’. Hence the AAR would qualify as a
tribunal within the scope of both Articles 226 and 227.

85