Month: February

In the following article, the authors have analysed the treatment of a provision for the purposes of MAT and brought out the various dimensions of the issue.

1. Introduction

The era of MAT began as an ‘alternative mode’ of tax. With the efflux of time, the MAT regime has actually left us with no ‘alternative’ but to ‘tax’. Its objective is well known; although the text and content is vexed which often keeps the tax doyens perplexed. This complex provision has thrown out innumerable issues from its Pandora box. In this article, we have attempted to address one such issue through a case study.

2. Case Study

X Limited is an Indian company which acquired 1,00,000 equity shares of Y Limited for a consideration of Rs. 60 crore. In Year 1, X Limited created a “Provision for investment loss” amounting to Rs. 16 crore [by debiting the profit and loss account]. Cost of investment in the balance sheet was reduced to the extent of the provision (ie, Rs. 16 crore). The net loss as per the profit and loss account was Rs. 17 crore.

While computing the book profit under the provisions of section 115JB of the Income-tax Act, 1961 (“the Act”), the Provision for investment loss (i.e. Rs 16 crore) was “added back” to net the loss as per the profit and loss account. The book loss (u/s. 115JB) for Year 1 was accordingly computed at Rs. 1 crore. The loss computed under the regular provisions of the Act was Rs. 50 lakh. The loss computed under regular provisions being lower than the book loss, the return of income for Year 1 was filed with the loss of Rs. 50 lakh.

Subsequently, in Year 2, X Limited sold the 100,000 equity shares in Y Limited for Rs. 68 crore. The sale resulted in a gain of Rs. 8 crore. X Limited recognised this gain as “Profit on sale of investment” in the Profit and loss account along with reversal of Provision for investment loss (pertaining to shares sold during the year) amounting to Rs. 16 crore. Cumulatively, profit on sale of investment recognised in financial statements added up to Rs. 24 crore [ie, 8 crore + 16 crore]. The company paid tax under the provisions of MAT (section 115JB) amounting to Rs. 2 crore [after reducing Rs. 16 crore from the net profit].

In this background, the write-up discusses the appropriateness of the MAT computation carried out by X Limited.

3. Case Analysis

MAT – General principles

Minimum Alternate Tax (“MAT”) computed u/s. 115JB is an alternative regime of taxation. The section provides for an alternate, nay an additional mechanism, of ‘computing the tax liability’ of an assessee apart from the normal computation. A comparison is made between tax payable under the normal provisions of the Act and the tax payable on “book profit”. The higher of the tax payable from out of the two computations would have to be discharged by the assessee company.

S/s. (1) to section 115JB requires a tax (at 18.5%) on book-profit to be compared with income-tax payable on the total income as computed under the Act. Section 115JB is an alternative tax mechanism. This is evident from the section heading which reads – “Special provision for payment of tax by certain companies”. It is thus a special provision for payment of tax. The intent of section 115JB is to maintain the minimum quantum of tax (at 18.5% on book profit) that an assessee-company should be liable to pay. If the tax u/s. 115JB is higher, the “book-profit” is deemed to constitute the total income of the Company.

‘Book Profit’ is defined in Explanation 1 to section 115JB. It is defined to mean the net profit as shown in the profit and loss account prepared as per s/s. (2) to section 115JB as reduced or increased by certain sums specified in the section. S/s. (2) requires the profit and loss account to be prepared in accordance with Parts II & III of Schedule VI of the Companies Act, 1956. In arriving at the net profit, therefore, the principles outlined in Parts II & III of schedule VI of the Companies Act, 1956, shall be followed [Apollo Tyres Ltd (2002) 255 ITR 273(SC) and CIT vs. HCL Comnet Systems & Services Ltd. (2008) 305 ITR 409 (SC)].

Explanation 1 outlines a process of additions and deletions of certain sums to the ‘net profit’ disclosed in the Profit and loss account. Judicial precedents indicate that these adjustments are exhaustive. No other adjustments apart from those outlined in the explanation can be made to the ‘net profit’ to arrive at the “book profit”.

Characteristics of book-profit

S/s. (1) to section 115JB envisages a comparison of taxes. If the tax on book profit is higher than the tax payable under the normal provisions of the Act, then, (i) such book-profit would be deemed to be the total income and (ii) the tax payable shall be the tax on book profit (at 18.5%). A two-fold deeming fiction is envisaged. The total income under the normal provisions is replaced with book profit and the tax payable under the normal provisions paves way for ‘tax on book-profit’. Thus, s/s. (1) visualises a 3 step-approach:

(i) The book profit should be an outcome of the computation envisaged in Explanation 1 wherein, net profit as per the profit and loss account is adjusted by the adjustments specified therein;

(ii) Tax on such book profit should exceed the tax on income under the normal provisions; and

(iii) On satisfaction of the twin characteristics above, the book profit is deemed as the total income and the tax on book profit shall be the tax payable by the assessee.

Step ‘(iii)’ is a natural consequence of steps ‘(i)’ & ‘(ii)’. S/s. (1) of section 115JB is operative only when steps (i) and (ii) result in step (iii). In other words, in the absence of book profit or if tax on income under the normal provisions exceeds or is equal to the tax on the book profit, the deeming fiction in step (iii) is not to be invoked. If step (i) and (ii) do not culminate in step (iii), the computation in step (i) [book profit computation] becomes relevant only for step (ii) [comparison] and not step (iii). This is because, the computation of total income under normal provisions is sustained and the occasion of its replacement by book profit does not occur/ arise.

In case the computation [of book profit] under step (i) results in a negative number (or book loss, step (ii) becomes inapplicable or irrelevant. The comparison envisaged in step (ii) is between ‘tax on total income’ and ‘18.5% on book profit’. A negative book profit will invariably result in tax on total income under the normal provisions not being lower than tax on book profits. This can be explained by looking at the twin possibilities below:

Case 1 – Positive total income and book loss

In the above case, tax on total income under the normal provisions (being a positive number) exceeds the “tax payable” on the negative book profit (or book loss) and consequently results in tax on total income under the normal provisions being higher than 18.5% of book profit. Accordingly, section 115JB(1) is not satisfied.

Case 2 – Nil total income and book loss

In the above case, tax on total income (being nil) exceeds the negative tax on the book profit (or book loss) and consequently results in tax on total income being higher than 18.5% of book profit. Accordingly, section 115JB(1) is not satisfied.
In both the situations, “tax” on total income un-der the normal provisions would exceed 18.5% on book loss (or negative book profit). It is a trite to state that ‘total income ’ could either be ‘positive’ or ‘nil’.There cannot be negative total income. Consequently, there cannot be a ‘tax in negative’. For section 115JB to operate, ‘18.5% of book profit’ should be higher than such tax. Even if ‘18.5% on book loss’ is taken to be ‘nil’ in both the aforesaid examples, tax on total income under the normal provisions would not be lower which is the primary condition for section 115JB to be invoked.

Creation of provision for investment loss

In the given case study, X Limited created ‘Provi-sion for investment loss’ which was added back (or adjusted) while computing the book profit u/s. 115JB. The company had filed its return of income in Year 1 with loss (computed under normal provisions of the Act) amounting to Rs. 50 lakh. This loss was lower than the book loss (u/s. 115JB) for Year 1 which was Rs. 1 crore.

Being a book loss, there was no occasion to compute ‘tax on book profit’. Comparison of taxes u/s/s. (1) was not possible. The total income and tax payable could not be deemed as ‘book profit’ and ‘tax on book profit’ respectively for Year 1. Accordingly, operation of section 115JB was not triggered. For Year 1, the ‘Provision for investment loss’ was added back (or adjusted) while computing the “book profit” u/s. 115JB. The net result of the computation was a loss.

The appropriateness of this treatment (i.e, adding back of the provision) can be examined by traversing through the various adjustments housed in Explanation 1. These adjustments can be bisected into ‘upward adjustments’ and ‘downward adjustments’ which increase and decrease the net profit respectively. The opening portion of the Explanation 1 reads – “For the purposes of this section, “book profit” means the net profit as shown in the profit and loss account for the relevant previous year prepared u/s/s. (2), as increased by…”.

The phrase used is ‘net profit’. The expression ‘net profit’ and ‘net loss’ are not synonymous and can-not be used interchangeably. One could argue that the Explanation 1 visualises only a ‘net profit’ and not a ‘net loss’. In other words, the adjustments contemplated under Explanation 1 are not operative where the net result of operation is a loss. This is because the threshold condition to ignite section 115JB, viz. ‘net profit’, is not satisfied.

Further, the opening portion of the Explanation 1 deals with ‘increase’ of ‘net profit’ by certain adjustments. The second portion which deals with downward adjustments deals with reduction of the net profit by certain adjustments. The phrase used therein is “reduced by”. Thus, the law envisages an ‘increase’ and ‘decrease’ of net profits. The legislature has not employed the phrase “adjusted by”. The phrases used in the Explanation 1 have specific connotations. They cannot be understood in any modified manner. This aspect is important because an adjustment which ‘increases’ a ‘net profit’ would arithmetically ‘decrease’ if the start point were to be a ‘net loss’. This opposite numerical consequence indicates that the adjustments in the first portion have to necessarily result in an increase in the base figure and the ones in the latter portion should cause a reduction. Accordingly, the law visualises only ‘net profit’ to be the start point or base figure [and not ‘net loss’].

In the present case study, the net loss as per Profit and loss account in the Year 1 was Rs. 17 crore. Existence of net loss thus excludes X Limited from the clutches of section 115JB. Accordingly, it could be argued that there was no need to carry out any computation u/s. 115JB.

Alternative view

If one were to adopt the aforesaid position [that MAT is operative only on ‘net profit’], then all loss making companies would be excluded from the gamut of MAT computation. Such interpretation, although may be literally correct, would defy the objective of MAT computation. This could encourage the practice of ‘skewing of profits’ or ‘window dressing’ of financial statements.

Having accepted that loss making companies are also subject to MAT provisions (like in the present case), one needs to understand whether the book profit computation carried out by X Limited for Year 1 is in accordance with Explanation 1.

Two adjustments which could be relevant in the present context are clause (c) and (i) of the first part of the Explanation 1. These clauses read as under:

(c)    the amount or amounts set aside to provisions made for meeting liabilities, other than ascertained liabilities

……

(i)    the amount or amounts set aside as provision for diminution in the value of any asset

As per clause (c) of Explanation 1, any provision for liability other than ‘ascertained liability’ is to be added to the net profit in order to arrive at the book profit for the purpose of section 115JB. A liability may be capable of being estimated with reasonable certainty though the actual quantification may not be possible. Even though estimation is involved, it would amount to a provision for ascertained liability. The intention of the legislature in inserting clause (c) is to possibly prohibit provision for contingent liability helping in reduction of the book profit. A provision for loss on investment should not be regarded as provision for meeting unascertained liability.

Prior to insertion of clause (i), there was no express provision which dealt with provision for diminution in the value of asset. It amply clarified by the Apex Court in the case of CIT vs. HCL Comnet Systems & Services Ltd. (2008) 305 ITR 409 (SC) that clause
(c)    does not deal with diminution in value of as-sets. The Court observed (although the decision was in the context of provision for doubtful debts) that a provision for doubtful debts is to cover up the probable diminution in value of asset (debtors) and is not provision for a liability. Thus, provision for diminution in value of assets cannot be equated with provision for liabilities. Consequently, clause (c) in Explanation 1 cannot be applied in cases where a diminution in value of investments is contemplated.

Subsequently, clause (i) in second part under Explanation 1 was inserted by the Finance (No. 2) Act, 2009, with retrospective effect from 01-04-2001. Acknowledging that clause (c) was not suitable to rope in provision for loss in the value of assets, clause (i) was inserted to achieve this objective. Clause (i) statutorily affirms the Apex Court decision that provision for diminution in value of assets is different from provision for liabilities.

Clause (i) employs the expression “provision for diminution in the value of any asset”. Both clause (c) and

(i)    use the term ‘provision’. This is possibly because a provision need not necessarily be for a liability and it could also be for diminution in the value of assets or for loss of an asset. This is discernible from the definitions/ description given in the ICAI literature and Company Law provisions. The word “provision” has not been defined in the Act. The Guidance Note on “Terms Used in Financial Statements” issued by the Institute of Chartered Accountants of India defines the term ‘provision’ as under:

“an amount written off or retained by way of providing for depreciation or diminution in value of assets or retained by way of providing for any known liability, the amount of which can-not be determined with substantial accuracy.”

Paragraph 7(1) of Part III of old Schedule VI to the Companies Act, 1956 defines the term ‘provision’ as under:

“the expression ‘provision’ shall, subject to sub-clause (2) of this clause, mean any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy.”

From the above, one can discern that a provision need not necessarily be for a liability. It can also be provision for depreciation or diminution in value of assets. The Mumbai Tribunal in the case of ITO vs. TCFC Finance Limited (ITA No.1299/Mum/2009) held that provision for diminution in the value of investment has to be added for computing book profit, regardless of the fact whether or not any balance value of the asset remains. The Tribunal also defined the meaning of the term “diminution” in the following manner:

“In common parlance the word “diminution” indicates the state of reduction. The Shorter Oxford Dictionary gives the meaning of the word “diminution” as “the action of making or becoming less; reduction “. Accordingly, any provision made for diminution in the value of any asset, is to be added for computing book profit under the provisions of section 115JB”

In the present case-study, the provision was created against loss due to decrease in the realisable value of investment (i.e, shares in Y Limited). It signifies preparedness for a dip in the value of the asset (Y Limited shares). The provision for investment loss after the amendment to the statute would be covered within the precincts of clause (i).

Reversal of provision for investment loss in Year 2

In the present case study, X Limited sold 100,000 equity shares in Y Limited in Year 2 for a gain of Rs. 8 crore. The company reversed the provision for investment loss amounting to Rs. 16 crore. Conse-quently, Rs. 16 crore was included in net profits while computing the MAT liability. After reducing Rs. 16 crore from the net profit, the company discharged its tax liability under MAT.

There is no dispute around inclusion of Rs. 8 crore in the book profit [being gain from the sale of shares]. The question is whether while computing book prof-its under MAT, reversal of “Provision for investment loss” was to be ‘retained’ or ‘reduced’ from the net profits in ascertaining tax on book profit.

As already detailed, Explanation 1 outlines the computation of book profit involving certain additions and deletions (or adjustments) to the ‘net profit’. The start point of such computation is ‘Net Profit as shown in the Profit & Loss Account’. The adjustments contemplated in the definition include ones which increase such net profit (‘Upward Adjustments’) and items which reduce the net profit (‘Downward Adjustments’). One such ‘Downward Adjustment’ is amount withdrawn from any Reserve or Provision, if any such amount is credited to the Profit & Loss Account and had been instrumental in increasing the book profit for any earlier year. Clause (i) of the second part of Explanation 1 which houses this adjustment, reads as under:

(i)    the amount withdrawn from any reserve or provision (excluding a reserve created before the 1st day of April, 1997 otherwise than by way of a debit to the profit and loss account), if any such amount is credited to the profit and loss account:

Provided that where this section is applicable to an assessee in any previous year, the amount withdrawn from reserves created or provisions made in a previous year relevant to the assessment year commencing on or after the 1st day of April, 1997 shall not be reduced from the book profit unless the book profit of such year has been increased by those reserves or provisions (out of which the said amount was withdrawn) under this Explanation or Explanation below the second proviso to section 115JA, as the case may be;

Clause (i) read with the proviso appended to it mandates reduction of net profits by the amount withdrawn from any reserves/provisions if – (a) it is credited to the profit and loss account and (b) the book profit u/s. 115JA / 115JB for year in which such provision was created had been increased by the amount of such provision. In other words, reduction as per Clause (i) is permissible only on satisfaction of twin conditions. Firstly, the amount withdrawn is credited to profit and loss account and secondly at the time of ‘creation’ of reserve, the ‘Book Profit’ had been increased by the amount of the said with-drawal. This was the mandate of the Apex Court in the case of Indo Rama Synthetics (I) Limited vs. CIT (2011) 330 ITR 363 (SC). The ruling advocates a strict reading of the downward adjustment for withdrawal from reserve. The Supreme Court held that if the reserves created are not referable to the profit and loss account and the amount had not gone to increase the book value at the time of creation of the reserve; the question of deducting the amount (transferred from such reserve) from the net profit does not arise at all. The Apex Court held that the objective of clauses (i) to (vii) is to find out the true and real working result of the assessee company.

In the present case, X Limited had credited the re-versal of provision for investment loss to its profit and loss account in Year 2. The reversal of the pro-vision to the profit and loss account satisfies the first condition referred to above. On this, there is no dispute. The doubt is regarding the compliance of the second condition. X Limited has excluded such reversal while computing the MAT liability. To enable such exclusion, the said reversal (of provi-sion) should have ‘decreased’ the book losses in the year of its creation (i.e, Year 1). A reduction of book loss has the same effect as increase in book profit. Accordingly, the second condition is satisfied. The question is whether the said treatment is tenable? Can increase in book profits (in the year of creation) to the extent of provision created by itself, satisfy the stipulated condition? Does such increase necessarily have to culminate in tax being payable under the MAT regime? Should an increase in book profit (on creation of provision) necessarily be accompanied with a tax liability u/s. 115JB?

The answer to this issue has both ‘for’ as well as ‘against’ view points. The analysis would not be complete, unless both the possible views are captured. The following paragraphs discuss these viewpoints:

View I – Increase in book profits should result in payment of tax under MAT

As per this view -point, the increase in book profit should result in tax liability under the MAT provisions. If such increase does not culminate in tax being payable u/s. 115JB, then the reversal of such provision should not be reduced while computing the book profit.

In this regard, it may be relevant to peruse circular no.550 issued by the Central Board of Direct Taxes explaining amendments to Income-tax Act vide Finance Act, 1989. The relevant portion of the same is as under:

“Amendment of the provisions relating to levy of minimum tax on ‘book profits’ of certain companies

24.4 Further, under the existing provisions certain adjustments are made to the net profit as shown in the profit and loss account. One such adjustment stipulates that the net profit is to be reduced by the amount withdrawn from reserves or provisions, if any, such amount is credited to the profit and loss account. Some companies have taken advantage of this provision by reducing their net profit by the amount withdrawn from the reserve created or provision made in the same year itself, though the reserve when created had not gone to increase the book profits. Such adjustments lead to unintended lowering of profits and consequently the quantum of tax payable gets reduced. By amending section 115J with a view to counteract such a tax avoidance device, it has been provided that the “book prof-its” will be allowed to be reduced by the amount withdrawn from reserves or provisions only in two situations, namely :—

(i)    if the reserves have been created or provisions have been made in a previous year relevant to the assessment year commencing before 1st April, 1988; or

(ii)    if the reserves have been created or provisions have been made in a previous year relevant to the assessment year commencing on or after 1st April, 1988 and have gone to increase the book profits in any year when the provisions of section 115J of the Income-tax Act were applicable.” (emphasis supplied)

The Circular clarifies that clause (i) is an anti-abuse provision. It was introduced to prohibit unintended lowering of profits and consequent reduction of tax payable. The intent was to induce parity in tax treatment in the year of creation and withdrawal of reserves. The objective is to plug-in tax leakage. The emphasis is on the payment of correct quantum of tax. The amendment seeks to impact the tax liability under MAT and not the mere arithmetic adjustment of book profit. In this background, it may be pertinent to observe the closing portion of the above quoted circular. It is clarified that the amount withdrawn from reserves or provisions is deductible in MAT computation only if (a) the reserves have been created or provisions have been made for the year on or after 1st April, 1988 and (b) have gone to increase the book profits in any year when the provisions of section 115J of the Income-tax Act were applicable. Twin conditions are visualised by the circular. The first relates to year of creation being on or after 01-04-1998 and the second mandates that the book profits should have been increased in the year in which section 115J is applicable. The latter condition thus requires not only enhancement of book profit but such increment has to occur in the year in which section 115J is applicable. MAT is “applicable” when the final discharge of tax happens under the regime of section 115J. The phrase “is applicable” has to be read in such context. Otherwise, it would have no meaning, as section 115J being a part of the statute would in any way be “applicable” to any company. The circular issued in the context of section 115J should also be applicable to section 115JB purposes, as in substance, the provisions are the same (More on ‘applicability’ of section 115JB later).

The latter condition of book profit enhancement accordingly has to occur in the year in which section 115JB is applicable. Section 115JB is an alternate tax regime. It is applicable only when the tax on book profits exceeds the tax on total income. If the tax on book profits does not ‘exceed’ tax on total income, section 115JB is not applicable.

To conclude, amount withdrawn from reserves or provisions is deductible in MAT computation only if (a) provisions have been made for the year on or after 01-04-1988; (b) such amount has gone to increase the book profit in the year in which taxes were payable under MAT regime (or section 115JB).

This view is supported by the Hyderabad tribunal in Vista Pharmaceuticals Ltd vs. DCIT (2012) 6 TaxCorp (A.T.) 27449 (Hyd). The issue before the tribunal was with regard to direction of the CIT to consider the interest waived to be included in the computation of book profit under section 115JB. The facts of the case were that the assessee computed its book profit u/s. 115JB at ‘nil’ after reducing the amount of interest waived by bank on the ground that it is the amount withdrawn from provision for interest to financial institutions debited to Profit and Loss account in earlier year now credited. The tribunal held as under:

“In the case of the present assessee, the amount withdrawn from reserve or provision i.e., waiver of interest cannot be considered as part of book profit since it was never allowed in the computation of book profit of the company in any of the earlier years since the company never had any book profit being sick industrial undertaking…….

It is also an admitted fact that in the earlier years there is no computation of book profit ex con-sequentia, there was no assessment with regard to computation of book profit u/s. 115JB of the Act. It was held in the case of Narayanan Chettiar Industries vs. ITO (277 ITR 426) that in respect of remission of liability no addition can be made un-less an allowance or deduction is allowed to the assessee in the previous year. Further in the case of Rayala Corporation Pvt. Ltd. vs. ACIT, 33 DTR 249, wherein it was held that returns for earlier years have been found defective by the Assessing Officer and declared to be nonest, as the assessee had failed to rectify the defect in spite of notice issued u/s. 139(9) of the Act, deduction of interest claimed in such returns cannot be deemed to have been allowed and, therefore, interest waived by bank cannot be charged u/s. 41(1) of the Act.

6.    Taking the clue from the above judgments, similarly, unless the provision created by the assessee towards interest liability is allowed as a deduction while computing the book profit u/s. 115JB, when the assessee writes back the same to the Profit and Loss A/c, then it should be considered for determining the book profit. It is nobody’s case that interest liability has been allowed as deduction in earlier years. In other words, an allowance or deduction has been made in earlier years in respect of interest liability while computing the book profit and writing back the same could be added to the book profit. A reading of clause (i) to Explanation 1 to section 115JB(2) gives the above meaning.” (emphasis supplied)

The Hyderabad Tribunal ruled that unless the provision increased the “book profit” in an earlier year, the write back of such provision should continue to be considered for determining the “book profit”. The Tribunal departed from the literal reading of clause (i) and the proviso therein. The clause (and the proviso) stipulates the increase in book profit in the year of creation of provision/reserve. The “increase” is not an exercise in vacuum but one which results in attraction and enhancement of book profit tax. The Tribunal opted to place reliance on the rationale in circular no.550.

In the present case, while computing book profit u/s. 115JB for Year 1, X Limited had decreased the net loss by the provision of Rs. 16 crore made for diminution in the value of investment. In Year 2, the company reversed Rs. 16 crore out of the above referred provision for investment loss.

The provision for investment loss was “added back” while computing book profit (in Year 1). However, there was no net profit as per Profit and loss account in that year. As already explained, in the absence of net profit, it could be argued that section 115JB is not applicable. Tax was also not discharged in that year u/s. 115JB. In effect, there is no addition of provision for diminution in value of investment allowance. Applying the principles of the circular and the Hyderabad Tribunal, X Limited has not suffered tax under MAT on creation of provision for investment loss. Consequently, reversal of such provision would continue to be included in book profits computation. Once section 115JB is not applicable in the year of creation of reserve, reversal of such provision cannot be excluded from book profit computation.

Further, the provision for diminution in value of investments did not result in any additional tax liability under the MAT computation. On the contrary, such provision has decreased/reduced income while computing the total income under the normal provisions of the Act. It is an ‘erosion of capital’ which resulted in a loss. Such loss was claimed as a charge against income chargeable to tax. Subsequently, these investments were sold at a price over and above the original cost of investments/ shares. To clarify:

Accordingly, one possible view is that reversal of provision for diminution in value of investment cannot be excluded under Clause (i) of the second part of Explanation 1 while computing book profits.

View II – Increase in book profits need not result in payment of tax under MAT

Literal interpretation
Clause (i) is permissible only on satisfaction of twin conditions – (i) amount withdrawn is credited to profit and loss account and (ii) at the time of ‘creation’ of reserve, the ‘Book Profit’ was increased by the amount of the said withdrawal. The mandate of the law is clear and unambiguous. Modern judicial approach to interpretation of statutes is often driven by literal rule. Laws and regulations are the intentions of legislators captured in words. Every statute must be read according to the natural construction of its words. The words of a statute are to be understood in their natural and ordinary grammatical sense. The aspect of allowance or deduction discussed by the Hyderabad Tribunal is deviation from the literal reading of the law. Nothing prevented the legislature to lay down law to this effect.  

View-I could result in absurd results Even otherwise, View I appears to revolve around whether the adjustment of provision for investment loss in the year of creation results in a positive book profits.  It could never be the intent of the law to discriminate between companies which have only a nominal value of book profits (post set-off of provision for investment loss) with those companies where the net loss is not completely wiped off by the provision for investment loss in the computation. This can be understood through the below explained illustration:

If the aforesaid provision was reversed in Year 2, Company B would not be able to claim reduction in that year (if View I were to be followed). On the contrary, Company A which has a nominal book profit of Rs. 100 may be allowed reduction of pro-vision reversal in Year 2 (although one could argue that only proportionate reduction will be allowed). Such interpretation would result in unintended consequence.

View I results in tax on capital

In the present case study, consideration received on sale of shares (by X Limited) was over and above the historical or original cost of such shares. The differential between such sale consideration and original cost is a gain and has to be necessarily offered to tax. There is no dispute on this aspect. One could argue that consideration to the extent of reversal of provision is ‘capital’ in nature. This is because, such consideration (i.e, to the extent of reversal of provision) refills the vacuum created by provision. Levying a tax on such consideration would amount to a ‘tax on capital’. In essence, it would culminate in higher effective rate of tax on capital gains. The philosophy of MAT taxation was to provide for an alternate tax regime and not double taxation. A denial of reduction from book profit would compel the taxpayer to pay taxes on income which he never earned.

Section 115JB – wider applicability

Circular no. 550 clarified that the amount withdrawn from reserves or provisions is deductible in MAT computation only if (a) the reserves have been created or provisions have been made for the year on or after 1st April, 1988 and (b) have gone to increase the book profits in any year when the provisions of section 115J of the Income-tax Act were applicable. The latter condition thus requires not only enhancement of book profits but such increment has to occur in the year in which section 115J is applicable.

S/s. (1) to section 115JB deals with the ‘applicability’ of the provision. It is applicable to every “company”. If 18.5% of book profit of such company exceeds tax on its total income then, such amount (i.e, 18.5%) would be the tax payable and book profit would be the total income. Thus, section 115JB is applicable to every company but the liability to pay tax is only in case of certain companies. The ‘certain companies’ are those which are liable to tax under MAT. This is supported by the section heading which reads – “Special provision for payment of tax by certain companies”. Section 115JB deals thus deals with payment of tax ‘by certain companies’. In other words, section 115JB is ap-plicable to all companies but renders only ‘certain companies’[whose tax under MAT exceeds normal tax computation] as liable to tax u/s. 115JB.

Applying this proposition in the present case, section 115JB was applicable to X Limited in Year 1 [although there was a book loss]. The provision for investment loss was “added back” while computing book profits for that year. The adjustment resulted in a reduction of loss. A “reduction of loss” is effectively the same as “increase in profits”. Accordingly, reversal of such provision in Year 2 should be excluded from while computing book profits for the year.

One may, in this connection, refer to the decision of the Kolkata Tribunal in the case of Stone India Limited vs. Department of Income-tax [ITA Nos. 1254/ Kol/2010]. The Tribunal in this case had an occasion to deal with treatment of “Provision for diminution in value of investment” for the purposes of book profits u/s. 115JB. In this case, the assessee debited its Profit and Loss A/c for the year ended 31.03.2001 with certain provision for diminution in the value of investment. In computation of book profit u/s. 115JB of the Act the said provision for diminution in the value of investment was not added back to the book profit. Subsequently, out of the said provision, the assessee wrote back certain amount in the accounts for the year ended 31-03-2006. The question was whether the reversal of provision for diminution in the value of investment was deductible in computation of book profit for AY 2006-07. The Court observed –

“It is also observed that clause (i) of Explanation to section 115JB of the Act says that the amount withdrawn from any reserves or provisions created on or after 01- 04-1997, which are credited to the profit and loss account, shall not be reduced from the book profits, unless the books profits were increased by the amount transferred to such reserves or provisions in the year of creation of such reserves (out of which the said amount was withdrawn). In this case, provision for diminution in the value of investment Rs. 7,05,73,000/ – was created in the financial year 2000-01 relevant to assessment year 2001-02 but book loss of the said year was not appreciated by the said amount in the computation filed u/s. 115JB along with the return. As there is a loss of Rs. 30,008/- prior to providing of prior year adjustment and diminution in the value of investment, no addition has been made u/s. 115JB by the assessee in the assessment year 2001-02 on account of diminution in the value of investment….. and the

exceptional item on account of diminution in the value of investment has not been adjusted while computing the book profit u/s. 115JB. Therefore, we are of the considered opinion that the observation of the Ld. CIT(A)was not justified in directing the assessee…” (emphasis supplied)

In the aforesaid case, provision for investment loss was not added back to the net loss while computing the book profits. The same had been reversed in subsequent year. In the year of provision, there was a net loss. The assessee did not carry out any adjustment. The Tribunal therefore ruled that reversal cannot be reduced from the book profits. The basis or rationale for such decision is that the book profits were not adjusted or appreciated by the provision created.

The Tribunal appears to have laid emphasis on the ‘adjustment or appreciation’ of book profits. The conclusion of the tribunal was driven by the non-adjustment of book profits in the initial year. Applying the ratio of the Tribunal ruling, it appears that if an adjustment of “book profit” had been made in the year of creation of the reserve, it would suffice to exclude the reversal of provisions while computing book profit for a subsequent year.

4.    To conclude

X Limited had a net loss as per Profit and loss ac-count for Year 1. A view could be taken that MAT computation is not applicable in the year of loss and no adjustment contemplated u/s. 115JB is required. A better view would be that MAT provisions are applicable even in the year of loss and accordingly, adjustment of adding back provision for diminution in the value of investment in the Year 1 was appropriate.

As regards, exclusion of reversal of provision from book profit computation in Year 2, there are two views possible. View II appears to be appropriate and therefore reversal of provision should be excluded while computing book profits for Year 2.

5.    Fall out of view-ii

In the present case, there was a provision created for diminution in investment amounting to Rs. 16 crore in Year 1. Such provision reduced the profits (or increased the losses) for the year. Subsequently, in Year 2, such provision was reversed and credited to Profit and loss account. Such credit ‘enhanced’ the profits for the year. While computing book profit for MAT purposes, X Limited reduced such reversal of provision. Thereby ‘enhancement of profit’ was nullified. By this, MAT liability was reduced.

Due to the provision entry in Year 1, the brought forward loss of Year 2 was increased. This enhanced loss translated into an ‘(increased) deduction’ from book profits while computing MAT liability for Year 2.

This is due to a ‘downward’ adjustment as per clause
(iii)    of Explanation 1 to section 115JB which reads –
“the amount of loss brought forward or unabsorbed depreciation, whichever is less as per books of ac-count.” In this adjustment, the amount of brought forward losses (or business loss) is compared with unabsorbed depreciation loss; lower of the two is reduced in the book profits computation. The brought forward losses are to be adopted from the books of account. Consequently, an expense/ charge in the earlier years enhances the brought forward losses of the current year.

To sum-up, if View-II were to be adopted, X Lim-ited would avail dual benefit by – (i) reducing the book profits by amount of reversal in provision for diminution in value of investment and (ii) availing accelerated losses (depreciation or business loss whichever is less).

• The phrase ‘copyrighted article’ is not used under the Income-tax Act, 1961 (‘the Act’) or in the Double Taxation Avoidance Agreements (‘DTAA’) or even under the Copyright Act, 1957; and

• As held by the Apex Court in the aforesaid decision, OECD Commentary is not a safe or acceptable guide or aid for interpretation of provisions of the Act or DTAAs between India and other countries.

The Tribunal concluded that royalty in respect of computer software has to be decided on the basis of provisions of the Act or relevant DTAA under consideration.

On the other hand, the Delhi High Court recently in the case of Asia Satellite Telecommunications Co. Ltd. v. DIT and vice versa, (332 ITR 340) upheld the reliance on OECD Commentary while interpreting the definition of ‘royalty’ in respect of leasing out transponder capacity on a satellite. The Court held that the technical terms used in DTAA are the same which appear in section 9(1)(vi) and for better understanding of the terms, OECD Commentary can always be relied upon. The Court relied on the decision of the Apex Court in the case of UOI and Anr v. Azadi Bachao Andolan & Anr., (263 ITR 706) and other catena of decisions1 to emphasise that the international accepted meaning and interpretation placed on identical or similar terms employed in various DTAAs should be followed by the Courts in India when it comes to construing similar terms occurring in the Act.

On a combined reading of the findings of the aforesaid decisions, one may reconcile that for better understanding of the terms used in the Act or DTAAs, one may refer to the OECD Commentary provided and subject to:

• The technical terms as sought for interpretation are ambiguous; and

• Technical terms as used in the Act or DTAAs are identical or similar to terms employed in OECD Commentary.

The true significance however, lies in the practical implementation of the aforesaid principle while interpreting the provisions of the Act and DTAAs, which may be subject to criticisms or limitations similar to reliance on English decisions and other international decisions and/or statutes. In addition, India not as a ‘Member’ of OECD but as ‘Observer’ has expressed its position/views on the Articles of OECD Model Convention and its commentary thereon, which has been published in the OECD Model Tax Convention on Income and on Capital 2010 (version dated 22 July 2010). The position is presented qua the Articles under the Tax Convention as regard to its disagreement with the Text of the Article or disagreement with an interpretation given in the commentary in relation to the Article. It would be further necessary to highlight that while nations like Indonesia and China, (non-OECD economies like India) have expressly clarified that in the course of negotiations with other countries, they will not be bound by their stated positions in the OECD Commentary; India has not expressly clarified as such. Therefore, one may suggest that India may be bound by its stated positions in respect of the OECD Commentary in its course of negotiation and interpretations of DTAAs with other countries.

In the backdrop of the aforesaid discussion, it may then be necessary to consider the legitimacy in relying on OECD Commentary for interpretation of provisions of the Act and DTAAs entered into by India with other countries.

Reliance on OECD Commentary in interpreting provisions of the Act

Reference to English and other International decisions for interpretation and construction of the provisions of the Act have been subject of concern and criticism, time and again by the Courts2 since the provisions of the Act are not in pari materia with the provisions of the other statues, as well as the fundamental concepts and the principles on which the provisions are incorporated under the Act are different vis-à-vis the other statues. The provisions of the Act though may at times appear to be similar to the provisions of OECD Tax Convention, on deeper scrutiny may reveal differences not only in the wording but also in the meaning of a particular expression which has been acquired in the context of the development of law in those countries. Reliance on OECD Commentary in interpreting the provisions of the Act may therefore be subject to similar criticisms and concerns.

OECD is a 31 Member country organisation where the respective governments work together to address the economic, social and environmental challenges of globalisation. The OECD Model Tax Convention on Income and on Capital was designed and developed by the member countries as a means to settle on a uniform basis the most common problems that arise in the field of International juridical double taxation. India while negotiating its tax treaties maintains a balance and follows either OECD Model or UN Model on Tax Convention or a mix of the two. So, the provisions and terms as used in the Act may not confirm to the same language, interpretation and meanings as used in the DTAAs by India with other countries. Observations have been made by various Courts in catena of decisions3 with respect to various provisions of the Act as being wider/narrower in scope to the analogous provisions of DTAAs.

One may therefore say that the provisions of the Act should be construed on their own terms without drawing any analogy of the OECD Commentary, subject to principles as drawn above.

Reliance on OECD Commentary in interpreting provisions of DTAAs

Though, India is not a signatory to Vienna Convention on the Law of Treaties (‘VCLT’), but the judicial forums4 in India have acknowledged its importance in interpreting the provisions of DTAAs and have observed as under:

“The DTAAs are international agreements entered into between States. The conclusion and interpretation of such convention is governed by public international law, and particularly, by the Vienna Convention on the Law of Treaties of 23 May 1969. The rules of interpretation contained in the Vienna Convention, being customary international law also apply to the interpretation of tax treaties. . . . .”

The principles governing the interpretation of tax treaties can be broadly summed up as follows:

(i) A tax treaty is an agreement and not a taxing statute, even though it is an agreement about how taxes are to be imposed.

(ii) The principles adopted in the interpretation of statutory legislation are not applicable in interpretation of treaties.

(iii) A tax treaty is to be interpreted in good faith in accordance with the ordinary meaning given to the treaty in the context and in the light of its objects and purpose.

(iv) A tax treaty is required to be interpreted as a whole, which essentially implies that the provisions of the treaty are required to be construed in harmony with each other.

(v) The words employed in the tax treaties not being those of a regular Parliamentary draughtsman, the words need not examined in precise grammatical sense or in literal sense. Even departure from plain meaning of the language is permissible whenever context so requires, to avoid the absurdities and to interpret the treaty ut res magis valeat quam pereat i.e., in such a manner as to make it workable rather than redundant.

(vii)    Words are to be understood with reference to the subject-matter, i.e., verba accopoenda sunt secundum subjectum materiam.

(viii)    When a tax treaty does not define a term employed in it, and if the context of the treaty so requires, the terms can be given a meaning different from its meaning in the domestic law. The meaning of the undefined terms in a tax treaty should be determined by reference to all of the relevant information and the context.

The rules of interpretation in VCLT can be found in Article 31 to 33 of the Convention. Article 32 of the Convention provides recourse to supplementary means of interpretation, which in turn should confirm to the broad principles of Article 31 as summarised above. According to Article 32 of VCLT, the ‘supplementary means of interpretation’ include the preparatory work of the treaty and the circumstances of its conclusion. The word ‘include’ indicates that the rule is not exhaustive and there may be other supplementary means of interpretation. One such means is provided by the commentaries appended to the OECD Model Tax Convention. To the extent, the provisions of DTAAs are similar to OECD Model Convention, the OECD commentaries may become relevant to interpretation of DTAAs.

The Kolkata Tribunal in the case of Graphite India Ltd. v. DCIT, (86 ITD 384) while deciding whether the services rendered by an American Consultant to an Indian Company are covered under the Article 15, being in the nature of professional services or under Article 12, being in the nature of Fees for Technical services, observed as under as regard to interpretation of OECD and UN Model Commentaries:

“17. The aforesaid interpretation is clearly in harmony with the OECD and UN Model Conventions’ official commentaries, ………….. Andhra Pradesh High Court has, in the case CIT v. Visakhapatnam Port Trust, (1984) 38 CTR (AP) 1: (1983) 144 ITR 146 (AP), referred to OECD commentaries on the technical expressions and the clauses in the model conventions, and referred to, with approval, Lord Radcliffe’s observations in Ostime v. Australian Mutual Provident Society, (1960) AC 459, 480: (1960) 39 ITR 210, 219 (HL), which have described the language employed in these documents as the ‘international tax language’. In view of the observations of Andhra Pradesh High Court, in Visakhapatnam Port Trust’s case (supra), these model conventions and commentaries thereon constitute international tax language and the meanings assigned by such literature to various technical terms should be given due weightage. In our considered view, the views expressed by these bodies, which have made immense contribution towards development of standardisation of tax treaties between various countries, constitute ‘contemporanea expositio’ inasmuch as the meanings indicated by various expressions in tax treaties can be inferred as the meanings normally understood in, to use the words employed by Lord Radcliffe, ‘international tax language’ developed by bodies like OECD and UN.”

As discussed earlier, India by giving its stance on the text of the Article of OECD Model Tax Convention and commentaries thereon has helped in confirming an interpretation, in resolving ambiguities and obscurities and in displacing interpretation which appears absurd or unreasonable from India’s point of view. India’s position qua the text of the Articles and commentaries thereon as stated in the OECD Model Tax Convention — July 2010 version under the chapter ‘Non -OECD Economies’ positions on the OECD Model Tax Convention’ is tabulated below:

However, a question that arises is whether the position by India with respect to provisions of OECD Model Tax Convention is binding on taxpayers, tax authorities and more so, on the judicial forums of India.

To begin with, it is necessary to find the statutory force or lack of it, under which India has provided its position to the OECD Model Tax Convention, since its nature will determine the legitimacy of reference to OECD Commentary for interpreting the provisions of DTAAs.

After considering the OECD Commentary — ‘Non-OECD Economies’ Positions on the OECD Model Tax Convention’ Chapter, one understands that these are official statements made by Government of India as regard its interpretation of the Tax Convention. The clarifications or comments provided to OECD are not issued as a rule u/s.295, Circular or order u/s.119 of the provisions of the Income-tax Act, 1961. A pos-sible conclusion which can then be drawn is that even though such clarification may not be binding on taxpayers, they shall have high persuasive value considering contemporary official statements made by the Government of India on the subject of interpretation.

One also needs to consider whether these official statements can be considered as an aid for construction of the DTAAs entered into by India and which are based on OECD Model Tax Convention.

The aforesaid explanations received from the Indian Government could be considered as an aid for construction, which is in accordance with the Latin Maxim Contemporanea expositio. The Indian Courts8 have time and again held that Contemporaneous Exposition by the administrators entrusted with the task of executing the statute is extremely significant in interpretation of the statutory instruments. The rule of contemporanea expositio provides that “administrative construction (i.e., contemporaneous construction placed by administrative or executive officers) generally should be clearly wrong before it is over-turned; such a construction commonly referred to as practical construction, although non-controlling, is nevertheless entitled to considerable weight, it is highly persuasive.” [Crawford on Statutory Construction, 1940 Ed, as in K. P. Varghese (supra)]. However, generally, such expositions from the administrators are subject to the following limitations:

•     The plain and unambiguous language of the statutory instruments shall hold

good against such expositions; and

•     Such expositions even though binding on the Income-tax Department, are not binding on the Tribunal and Courts.

Therefore, based on the aforesaid discussion and doctrine of Contemporanea exposition, one may hold that provisions of DTAAs could be construed based on the explanation as received from the Indian Government on the OECD Model Tax Convention, provided the said exposition adheres to the broad principles of Article 31 of the VCLT, even though the applicability of VCLT to India may be a question in itself.

So, besides, decisions delivered by the various Indian judicial forums interpreting the provisions of DTAAs, one can now rely on India’s position on the Articles of the OECD Model Tax Convention and commentary thereon.

Lastly, the relevant extracts of the decision of the Apex Court in the case of UOI v. Azadi Bachao Andolan and Anr. (supra) as regard to interpretation of DTAAs are reproduced below:

“………… Interpretation of Treaties

96.    The principles adopted in interpretation of treaties are not the same as those in interpretation of statutory legislation. While commenting on the interpretation of a treaty imported into a municipal law, Francis Bennion observes:

“With indirect enactment, instead of the substantive legislation taking the well-known form of an Act of Parliament, it has the form of a treaty. In other words the form and language found suitable for embodying an international Agreement become, at the stroke of a pen, also the form and language of a municipal legislative instrument. It is rather like saying that by Act of Parliament, a woman shall be a man. Inconveniences may ensue. One inconvenience is that the interpreter is likely to be required to cope with disorganised composition instead of precision drafting. The drafting of treaties is notoriously sloppy, usually for very good reason. To get Agreement, politic uncertainty is called for.

…… This echoes the optimistic dictum of Lord Widgery CJ that the words “are to be given their general meaning, general to lawyer and layman alike… the meaning of the diplomat rather than the lawyer.” [Francis Bennion, Statutory Interpretation, p. 461 (Butterworths) 1992 (2nd Ed.)]

An important principle which needs to be kept in mind in the interpretation of the provisions of an international treaty, including one for double taxation relief, is that treaties are negotiated and entered into at a political level and have several considerations as their bases. Commenting on this aspect of the matter, David R. Davis in Principles of International Double Taxation Relief, p. 4 (London Sweet & Maxwell, 1985), points out that the main function of a Double Taxation Avoidance Treaty should be seen in the context of aiding commercial relations between treaty partners and as being essentially a bargain between two treaty countries as to the division of tax revenues between them in respect of income falling to be taxed in both jurisdictions”

On a more practical front, one finds that since the publication of India’s position on OECD Model Tax Convention, the Courts have not acknowledged much, the said publication as an aid for construction in interpreting the provisions of DTAAs. The taxpayers could however look forward to taking re-course to the India’s position on OECD Commentary as an aid for construction, for the favourable interpretations with respect to provisions of DTAA.