RATE OF TAX APPLICABLE TO CAPITAL GAINS ON LOSS OF EXEMPTION BY A CHARITABLE OR RELIGIOUS TRUST

Issue for Consideration

A charitable or religious trust is entitled to exemption
under sections 11 and 12 of the Income-tax Act, 1961, provided that it is
registered u/s. 12AA and fulfils other requirements of sections 11 to 13. Under
sections 13(1)(c) and 13(1)(d), if a benefit is provided to a specified person
or the specified investment pattern is not adhered to, the benefit of the
exemption is lost and the income of the trust so losing the exemption is
taxable at the maximum marginal rate by virtue of the provisions of section
164(2).

Normally, for all assessees, long term capital gains is
chargeable to tax under the provisions of section 112 at the rate of 20%, while
certain types of short term capital gains arising on sale of equity shares on a
recognised stock exchange is chargeable to tax at the concessional rate of 15%
under the provisions of section 111A.

The issue has arisen before the tribunal as to what should be
the rate of taxation in respect of income in the nature of a long term capital
gains, in the case of a charitable or religious trust, losing exemption on
account of violation of section13. While the Mumbai bench of the tribunal has
taken the view that such gain is taxable at the rate of 20% u/s. 112, the
Chennai bench of the tribunal has taken a contrary view, holding that such gain
is taxable at the maximum marginal rate as per section 164(2) of the Act.

Jamsetji Tata Trust’s case

The issue first came up for consideration before the Mumbai
bench of the Tribunal in the case of Jamsetji Tata Trust vs. Jt.DIT(E), 148
ITD 388 (Mum).

In this case, the assessee trust sold certain shares of Tata
Consultancy Services Ltd, and acquired preference shares of Tata Sons Ltd. It
earned long-term capital gains on sale of the shares of TCS, which was exempt
u/s. 10(38), dividends, which were exempt u/s. 10(34), and other interest and short
term capital gains. It claimed exemption u/s. 11 in respect of the interest and
short term capital gains, besides the exemptions under sections 10(34) and
10(38) in respect of the dividends and the long term capital gains.

The assessing officer denied the benefit of the exemption
u/s. 11, by invoking the provisions of section 13(1)(d), on the ground, that by
holding equity shares of TCS and Tata Sons, the assessee had violated the
investment pattern specified in section 11(5). The assessing officer taxed the
entire income of the trust, including the dividends, the long-term capital
gains, the short term capital gains as well as the interest income at the
maximum marginal rate, by applying the provisions of section 164(2).
The Commissioner(Appeals) upheld the order of the assessing officer.

Before the Tribunal, on behalf of the assessee, it was argued
that the denial of exemption u/s. 11 was not justified, that the assessee was
entitled to the exemptions u/s. 10, and that only the income from the investments
attracting the provisions of section 13(1)(d) was taxable at the maximum
marginal rate. It was further argued that the rate of tax on the short term
capital gains arising from sale of shares should have been the rate prescribed
u/s. 111A, and not the maximum marginal rate.

On behalf of the revenue, it was argued that the denial of
exemption u/s. 11 was justified. As regards the rate of tax, it was argued that
since the provisions of section 164(2) were applicable, the maximum marginal
rate was to be applied to the entire taxable income of the assessee, and not
separate rates on income of separate nature.

The Tribunal, after considering the arguments of the assessee
and the revenue and after analysing the provisions of the Income-tax Act, held
that only the income arising from the prohibited investments was ineligible for
the benefit of the exemption u/s. 11, and attracted tax at the maximum marginal
rate, and not the entire income. The Tribunal further held that the income
which was exempt u/s. 10 (dividends and long term capital gains) could not be
brought to tax under sections 11 and 13, since those sections did not have
overriding effect over section 10. Once the conditions of section 10 were
satisfied, no other condition could be fastened for denying the claim u/s. 10.

Addressing the issue of whether the rate u/s. 111A of 15% or
the maximum marginal rate u/s. 164(2) was to be applied to the short term
capital gains, the Tribunal noted that section 164(2) did not prescribe the
rate of tax, but mandated the maximum marginal rate as prescribed under the
provisions of the Act. It observed that section 111A was a special provision
legislated for providing for rate of tax chargeable on short term capital gains
on sale of equity shares or units of an equity oriented fund, which was
subjected to securities transaction tax (STT) and as such  the maximum marginal rate for income from
specified short term gains should be the rate prescribed therein.

According to the Tribunal, when the short term capital gains
arising from the sale of shares subjected to STT was chargeable to tax at 15%,
then the maximum marginal rate, referred to in section 164(2), on such income
could not exceed the maximum rate of tax provided u/s. 111A of the Act. It
accordingly held that the short term capital gains on sale of shares already
subjected to STT was chargeable to tax at the maximum marginal rate, which
could not exceed the rate provided u/s. 111A of the Income-tax Act.

India Cements Educational Society’s case

The issue again came up before the Chennai bench of the
tribunal in the case of DDIT vs. India Cements Educational Society 157 ITD
1008.

In this case, the assessee was a Society registered u/s.
12AA. It sold a plot of land and advanced the sale proceeds of the land to a
company in which the president of the Society and his wife were directors. It
claimed exemption in respect of capital gains arising on such sale on the
ground that the sale proceeds were reinvested in a specified capital asset.

The assessing officer denied exemption u/s. 11 to the Society
on the ground that the amount advanced to the company was not an approved
investment u/s. 11(5). He therefore taxed the income of the Society and the
maximum marginal rate under the provisions of section 164(2).

The Commissioner (Appeals) allowed the assessee’s appeal,
holding that the assessing officer had not proved what benefit accrued to the
specified person from the advancement of the amount to the company, and that
mere making of an advance to third parties could not be treated as utilisation
for investment in capital asset within the meaning of section 11(5). He
therefore held that while the benefit of exemption u/s. 11 was available, the
making of the advance out of the sale proceeds was not an investment in a new
capital asset. In the context of the issue under consideration, the
Commissioner(Appeals) held that the capital gains to be assessed as per section
48, was to be taxed at the rate prescribed u/s. 112 of the Act, and not at the
‘maximum marginal rate’ adopted by the assessing officer.

Before the tribunal, on behalf of the assessee, it was argued
that the entire income of the Society, other than the capital gains, continued
to be exempt u/s. 11 of the Act and that the capital gains alone was to be
taxed in terms of section 164(2) on account of the alleged violation of the
conditions of section 13 of the Act by applying the maximum marginal rate
Reliance was placed on the decision of the Bombay High Court in the case of DIT(E)
vs. Sheth Mafatlal Gagalbhai Foundation Trust 249 ITR 533, and the decision of
the Karnataka High Court in the case of CIT vs. Fr Mullers Charitable
Institutions 363 ITR 230, for the proposition that whenever there was a
violation u/s. 11(5), then only income from such investment or deposit which
was made in violation of section 11(5) was liable to be taxed, and violation
u/s. 13(1)(d) did not result in denial of exemption u/s.11 for the entire total
income of the assessee. Reliance was also placed on the CBDT circular number
387 dated 6.4.1984 152 ITR 1 (St.), where it was stated in paragraph 28.6 that
where a trust contravened the provisions of section 13(1)(c) or 13(1)(d), the
maximum marginal rate of income tax would apply only to that part of the income
which had forfeited exemption under those provisions.

In the context of the issue under consideration, It was
further argued by the assessee that, in view of the decision of the Karnataka
High Court in the case of Fr Muller’s Charitable Institutions (supra),
the rate of tax applicable for taxing the capital gains was the rate prescribed
u/s. 112. Reliance was also placed on the decision of the Mumbai bench of the
tribunal in the case of Jamsetji Tata Trust (supra), which had held, in
the case of short term capital gains on sale of shares subject to STT, that the
maximum marginal rate on capital gains could not exceed the rate provided u/s.
111A. This decision had been followed by the Mumbai bench in the case of Mahindra
and Mahindra Employees Stock Option Trust vs. DCIT 155 ITD 1046, where the
tribunal had held that capital gain was to be assessed by applying the
provisions of section 112, even if the income was assessed as per section 164.

The tribunal examined the provisions of sections 11 and 13.
It noted that in the case before it, there was a violation of section 13(1)(c),
as the Society had invested funds in a limited company, where the trustee was
the managing director and his wife was a director. Following the decision of
the Supreme Court in the case of CIT vs. Rattan Trust 227 ITR 356 and the
decision of the Madras High Court in the case of CIT vs. Nagarathu Vaisiyargal
Sangam 246 ITR 164, the tribunal held that the assessing officer was
justified in applying the provisions of section 13(1)(c), and denying exemption
u/s. 11 to the Society.

Analysing the provisions of section 164(2), the Tribunal,
observed that the income of a charitable or religious trust, which was not
exempt u/s. 11 or 12 was charged to tax as if such exempt income was the income
of an AOP. The proviso to that section provided that where the non-exempt
portion of the relevant income arose as a consequence of the contravention of
the provisions of section 13(1)(c) or (d), such income would be subjected to
tax at the maximum marginal rate.

Considering both the decisions of the Mumbai bench of the
Tribunal, cited before it, the Chennai bench of the tribunal, in the context of
the issue under consideration, found that the Mumbai bench had not considered
the meaning of the term ‘maximum marginal rate’ as defined in section 2(29C),
whereunder the term was defined to mean the rate of income tax (including
surcharge on income tax, if any) applicable in relation to the highest slab of
income in the case of an individual, association of persons or, as the case may
be, body of individuals as specified in the Finance Act of the relevant year.
The Chennai bench of the tribunal observed that on account of section 2(29C),
the two decisions of the Mumbai bench could not be said to have laid down the
correct proposition of law.

The Chennai bench of the Tribunal therefore held that the
benefit of section 112 to assess the gain from the transfer of the capital
asset could not be given to the Society, and that the long-term capital gains
was chargeable at the maximum marginal rate u/s. 164(2) r.w.s. 2(29C) of the Act.

Observations

A similar question has arisen in the case of private trusts,
where the individual share of beneficiaries is unknown, known as discretionary
trusts. Under the provisions of section 164(1), the income of such trusts is
also taxable at the maximum marginal rate. The issue has been decided by Delhi
and Gujarat High Courts, in the cases of CIT vs. SAE Head Office Monthly
Paid Employees Welfare Trust (2004) 271 ITR 159 (Del) and Niti Trust vs.
CIT (1996) 221 ITR 435 (Guj), that the long term capital gains earned by a
discretionary trust is not taxable at the maximum marginal rate u/s. 164(1),
but at the concessional rate of tax u/s. 112. These decisions have not been
considered by the Chennai bench of the Tribunal. The language of both sections
164(1) and 164(2) being similar, the ratio of these decisions would apply
squarely to section 164(2) as well.

Section 2(29C) while defining the term ‘maximum marginal
rate’ provides for adoption of the highest slab rate prescribed for an
individual, etc.  This rate, in
certain cases, varies w.r.t . the nature of income and head of income and in
such cases the rate specially provided for becomes the maximum marginal rate
for taxing such income. In cases where the rate is specifically provided for in
a particular provision of the Act, it is that rate that should then be taken to
represent the maximum marginal rate. The decisions above referred to support
such a view.

Alternatively, it can be contested that both the provisions
are independent and operate accordingly. he language of neither section
111A/112 nor section 164(2) indicates that one has a specific overriding effect
over the other. None of these provisions could be said to be general. The
principle generalia specialibus non derogant providing that a specific
provision prevailing over a general provision also cannot be readily applied.
While section 111A/112 is a provision applicable to specific types of income of
all assessees, section 164(2) applies to all incomes of specific types of
assessees. In any case, if a view is to be taken then the better view is to
treat section 112 as a special provision.

It needs to be kept in mind that section 112 provides for a
rate of tax for long term capital gains, irrespective of the type of assessee
who earns the capital gains. This rate applies not only to individuals and
HUFs, but also to partnership firms, associations of persons, domestic
companies, as well as foreign companies. While an individual is liable to tax
at slab rates of tax, partnership firms and domestic companies are liable to a
flat rate of tax of 30%, and foreign companies are liable to tax at a flat rate
of 40%. Yet, for all these different types of entities liable to different
rates of tax, the rate of tax u/s. 111A or section 112 is the same, i.e. 15%
and 20% respectively. This indicates that the rate applicable to such types of
capital gains should not differ, irrespective of the rate of tax applicable to
the other income of the entity.

On the other hand, the provisions of section 164(2) are
intended to ensure that the trust losing exemption on account of the violation
of the provisions of sections 13(1)(c) or 13(1)(d) does not benefit by paying a
lower rate of tax by taxing such incomes at the maximum marginal rate. However,
till assessment year 2014-15, a trust would claim exemption under the
provisions of section 10 in respect of income such as dividends, long term
capital gains on sale of equity shares on which STT was paid, etc.,
irrespective of whether the remainder of its income was exempt u/s. 11 or not.
The question of payment of tax at the maximum marginal rate did not arise in
the case of such income which was exempt. That being the case, where certain
incomes, such as long term capital gains or short term capital gains is liable
to tax at lower rates of tax than normal income, the question of taxation at
the maximum marginal rate should equally not apply. The maximum marginal rate
should therefore apply to income which is otherwise not taxable at a
concessional rate of tax.

If one also examines the format of the income tax returns for
charitable and religious trusts in Form No 7, as well as the forms applicable
to discretionary trusts in Form No 5, there is a specific reference in schedule
SI – Income Chargeable to tax at special rates, to specific rates of 15% under
section 111A for specified types of short term capital gains and of 20% u/s.
112 for long term capital gains. This clearly indicates that such gains are not
intended to be taxed at the maximum marginal rates.

The view that is beneficial to the assessee should be adopted
in a case where two views are possible. Besides, whenever there is a difference
of opinion between two benches of the Tribunal, such a difference is required
to be referred to a Special Bench of the Tribunal for consideration. The
Chennai bench of the tribunal chose to not to follow the decisions of the Mumbai
bench of the Tribunal, though cited before it, on the ground that the Mumbai
bench had overlooked a certain provision of the Act, rather than referring the
issue to a Special Bench.