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WOULD BUYBACK RESULT IN AN OPEN OFER? — SAT says no and changes existing interpretation

Recently, on 21st November 2011 (Appeal No. 134 of 2011, Raghu Hari Dalmia & Others v. SEBI) the Securities Appellate Tribunal (SAT) held that the increase in percentage holding of a person because of buyback of shares does not amount to acquisition and thus cannot result in an open offer. This is, in my view, a correct legal interpretation of the law (as also argued by me earlier in this column of the Journal for the April 2010 and September 2008 issues). But SEBI had, in practice, taken a view that such increase does amount to acquisition. On this basis, it granted exemptions, selectively and subject to certain conditions, from applicability of relevant provisions including open offer. Further, where such ‘acquisitions’ triggered the open offer requirements and the ‘acquirers’ did not make such offers, SEBI passed adverse orders (here and also here which case was now reversed by the SAT). It even inserted a proviso in the Regulations exempting increase in certain cases such ‘acquisitions’, thereby implicitly assuming that such increases were ‘acquisitions’.

My preceding articles referred earlier discuss this issue in more detail where I also expressed my views why such increase should not amount to ‘acquisition’. The regulations define ‘Acquirer’ as a person who ‘acquires or agrees to acquire’ shares, voting rights, etc. Hence, if an acquirer acquires:

5% or more shares, he has to make certain disclosures.

15% or more (under the 1997 Regulations), he has to make an open offer.

In additions there are other compliance requirements.

In case of buyback of shares, if a person does not participate in it — that is — does not offer his shares in buyback, there is an involuntary or passive increase of percentage holding. For example, a person holding, say, 60% shares and does not participate in a 20% buyback of shares then, post-buyback, his percentage holding would be 75%. Thus, his percentage holding would increase by 15 percentage points without his having acquired a single additional share. In my view, this passive increase does not make the shareholder an acquirer. One may argue that the intention of the law may be that such increases should also result in an open offer. One may also say a person holding, as in the above example, 60% shares, may initiate a buyback, and then not participate in it, thereby ensuring that his percentage holding increases. However, intentions or potential misuses cannot be allowed to stretch the interpretation of the law. Nevertheless, instead of simply making an amendment to the law, though several opportunities were available when other amendments were made, SEBI initiated and persisted in adopting a practice of taking a stand that such increases amounted to acquisitions.

The SAT rejected this attempt in fairly clear and emphatic words. In the case under consideration, consequent to a buyback, the holding of the Promoters increased from 62.56% to 75%. While there are other aspects and issues in the case, the essential question before the SAT was whether this increase should result in an open offer.

The SAT relied on the definition of an ‘acquirer’ under the Regulations as well as in a legal dictionary. It held that a passive increase in percentage holding pursuant to a buyback cannot amount to acquisition. It observed (emphasis supplied in all extracts):

“In this context the word ‘acquire’ implies acquisition of voting rights through a positive act of the acquirer with a view to gain control over the voting rights. In the case before us, it is the admitted position of the parties that the appellants (promoters of the company) did not participate in the buyback and that there was no change in their shareholding. The percentage increase in their voting rights was not by reason of any act of theirs, but was incidental to the buyback of shares of other shareholders by the company. Such a passive increase in the proportion of the voting rights of the promoters of the company will not attract Regulation 11(1) of the takeover code. The argument of the learned counsel for the Board that merely because there is increase in the voting rights of the appellants, Regulation 11(1) gets triggered cannot be accepted.”

Does such an increase amount to an ‘indirect’ acquisition? This argument too was rejected by observing:

“He also referred to the definition of ‘acquirer’ in Regulation 2(b) of the takeover code and strenuously contended that a passive acquisition of the kind we are dealing with is indirect acquisition and, therefore, the provisions of Regulation 11(1) are attracted. We have no hesitation in rejecting this argument outright. The words ‘directly’ and ‘indirectly’ in the definition of ‘acquirer’ go with the person who has to acquire voting rights by his positive act and if such acquisition comes within the limits prescribed by Regulation 11(1), it would only then get attracted. Passive acquisition as in the present case cannot be regarded as indirect acquisition as was sought to be contended on behalf of the Board.

The SAT also rightly highlighted another absurdity involved. If the view that passive increase may also amount to acquisition, then even a non-controlling shareholder holding, say, 14% may find the requirements of open offer getting triggered off if he does not participate in a buyback and finds his holding increased to, say, 16%. The SAT observed:

“Again, a non-promoter shareholder may increase his percentage of shareholding without participating in the buyback over which he has no control. In such an event he would be burdened with an onerous liability to make a public announcement. It is a well-settled principle of law that a provision ought not to be interpreted in a manner which may impose upon a person an obligation which may be highly onerous or require him to do something which is impossible for no action of his.”

Other difficulties in adopting such an interpretation were also highlighted. At the end, the SAT, in quite emphatic words, held that “we are of the firm opinion that passive acquisition does not attract the provisions of Regulation 11(1) of the takeover code.”

Once such an interpretation is accepted, the following situations, arising out of buyback and under the 1997 Regulations, need to be considered: 1. If a person’s holding increases to 5% or more, will disclosure be required?

2. If a person holding 5% or more finds his holding increased by 2% or more, will disclosure be required?

3. If a person holds less than 15% finds his holding increased to 15% or more, will an open offer be required?

4. If a person holding 15% or more finds his holding increased, will such increase be counted as part of creeping acquisition or will he be entitled to acquire a further 5% in a financial year ignoring such increase?

5. If a person holding 55% or less finds his holding increased beyond 55%, will he be deemed to have violated the Regulations? — And so on.

Applying the decision of the SAT, the answer to each of the aforesaid questions appear to be in the negative.

However, while this was the position under the 1997 Regulations, the question is whether will it also hold good under the 2011 Regulations. The curious thing is that while the corresponding wording in the definition of ‘acquirer’ under the 2011 Regulations remains exactly the same, the Regulations have made further provisions on the assumption that such a passive increase amounts to acquisition. It has exempted two types of such increases (from below 25% to 25% or more, and more than the creeping acquisition if holding is already more than 25%) if certain conditions are satisfied. It is submitted that considering that even the 1997 Regulations did contain such a provision, the ratio of the decision of the SAT should hold good.

One will have to wait and see whether SEBI appeals to the Supreme Court and, if yes, what view the Supreme Court takes. It is also possible that SEBI may amend the Regulations.

In conclusion, one cannot help expressing disapproval of adopting a practice — approach of SEBI — which results in the law becoming opaque and/ or arbitrary depending on the internal — administrative — preference or practice of SEBI.

Nirav Shah

PART A : ORDERS of CIC & the Supreme Court

Section 8(1)(a) & (e) of RTI Act

CIC, Shailesh Gandhi has made an order of great interest.

The following information was sought: 1. Total amount of money deposited by Indian citizens in nationalised Indian banks during the period 2006 to 2010. Provide information for each year separately;

2. (a) Information till date regarding total amount of loan taken but not repaid by industrialists from Indian nationalised banks and total amount of interest accumulating on such unpaid loans; and

(b) Details of default in loans taken from public sector banks by industrialists. Out of the above list of defaulters, top 100 defaulters, name of the businessman, address, firm name, principal amount, interest amount, date of default and date of availing loan.

(c) Steps being taken for putting information sought in query 2(a) and list of defaulters on the website of the respondent — Public authority.

By letter dated 14-10-2010, the CPIO informed the appellant that query 1 was transferred to DEAP, queries 2(b) and (c) were transferred to DBOD/DBS.

By letter dated 22-10-2010, the CPIO denied information on query 2(b) on the basis that it was held in fiduciary capacity and was exempt from disclosure u/s.8(1)(a) and (e) of the RTI Act.

In the first appeal, the FAA stated inter alia that the CPIO, DEAP had provided certain information vide letter dated 12-10-2010. Further he stated: ‘As regards the contention of the appellant with respect to his query at point 2(b) (which relates to the default in loans taken by industrialists from public sector banks and matters associated with them), I find that the CPIO, DBS has specified that the information received from banks, in this regard is held by the Reserve Bank in fiduciary capacity and as such it cannot be disclosed in terms of clauses (a) and (e) of section 8(1) of the Act. There can be no doubt that the information on defaulters received from banks is held by the Reserve Bank in a fiduciary capacity and confidential in nature. Therefore, the exemption claimed u/s.8(1)(e) is, without doubt, proper in the eyes of law. Whether the exemption provided by clause (a) of section 8(1) would be attracted in given case would depend upon the factual position. In this matter, since section 8(1)(e) is clearly attracted, I do not propose to consider the other exemption which the CPIO, DBS has made use of for withholding the information.’

The order of CIC is very powerful and I consider it as gem, for information analysis of section 8. Hence, instead of my summarising it, I reproduce the Completer Decision announced on 15th November, 2011:

“Based on perusal of papers and submission of parties, it appears that no information has been provided in relation to query 2(c), despite the order of the FAA. As regards query 2(b), the respondent has contended that the information sought was exempt u/s.8(1)(a) & (e) of the RTI Act. The Commission will first consider the claim of exemption u/s.8(1)(a) of the RTI Act made by the PIO. The PIO has claimed exemption u/s.8(1)(a) but not explained how this would apply. The first Appellate Authority has not given any comment on this. No justification was offered at the time of hearing as well. Section 8(1)(a) exempts, ‘information, disclosure of which would prejudicially affect the sovereignty and integrity of India, the security, strategic, scientific or economic interests of the State, relation with foreign State or lead to incitement of an offence;’. It appears that the PIO is claiming that the economic interests of the State would be prejudicially affected. It is impossible to imagine that any of the other interests mentioned in the provision could be affected. This Bench rejects the contention of the PIO that the economic interests of India would be affected by disclosing the names and details of defaulters from public sector banks. If it means that such borrowers would not bank with public sector banks for fear of exposure, it would in fact be in the economic interest of the nation. This Commission does not accept the claim of exemption u/s.8(1)(a) by the PIO. It is also unlikely that the economic well-being of the nation could get affected adversely by disclosing the names and details of defaulters. The Indian economy is dependent on far stronger footings.

The Commission will now examine the claim for exemption u/s.8(1)(e) of the RTI Act.

Section 8(1)(e) of the RTI Act exempts from disclosure “information available to a person in his fiduciary relationship, unless the competent authority is satisfied that the larger public interest warrants the disclosure of such information”.

This Bench, in a number of decisions, has held that the traditional definition of a fiduciary is a person who occupies a position of trust in relation to someone else, therefore requiring him to act for the latter’s benefit within the scope of that relationship. In business or law, we generally mean someone who has specific duties, such as those that attend a particular profession or role, e.g., doctor, lawyer, financial analyst or trustee. Another important characteristic of such a relationship is that the information must be given by the holder of information who must have a choice — as when a litigant goes to a particular lawyer, a customer chooses a particular bank, or a patient goes to a particular doctor. An equally important characteristic for the relationship to qualify as a fiduciary relationship is that the provider of information gives the information for using it for the benefit of the one who is providing the information. All relationships usually have an element of trust, but all of them cannot be classified as fiduciary. Information provided in discharge of a statutory requirement, or to obtain a job, or to get a licence, cannot be considered to have been given in a fiduciary relationship.

Information provided by banks to RBI is done in furtherance of statutory compliances. In fact, where RBI requires certain information to be furnished to it by banks and such banks have no choice but to furnish this information, it would appear that such requirement of RBI is directory in nature. Moreover, no specific benefit appears to be flowing to the banks from RBI on disclosure of the information sought by the appellant. Consequently, no fiduciary relationship is created between RBI and the banks.

The respondent has also argued that information about customers is held by banks in a fiduciary capacity and hence disclosure of the same would violate the fiduciary — trust placed by borrowers of the banks. The Commission finds some merit in this argument. Information of customers is held by banks in a fiduciary capacity. If this information is disclosed to the RBI and subsequently furnished to the citizens under the RTI Act — it may violate the fiduciary relationship existing between the customers and the banks. Therefore, the information sought in query 2(b) is exempt from disclosure u/s.8(1)(e) of the RTI Act. However, if a customer defaults in repayment, should the information about the default also be considered as information held in a fiduciary capacity, is a moot question. The lender is likely to take all measures including filing suits to recover the money due, and these actions would mean publicly disclosing the default amounts. In such circumstances the bank would make these details public, and not feel fettered by the fiduciary nature of the relations.

However, I am not going into delving into this trend of thought and accept that the information about the default by a borrower may be considered to be information held by a bank in a fiduciary capacity. When the Commission comes to the conclusion that the exemptions of section 8(1) of the RTI Act apply, it needs to consider the provision of section 8(2) of the RTI Act which stipulates as follows

:
“Notwithstanding anything in the Official Secrets Act, 1923 (19 of 1923) nor any of the exemptions permissible in accordance with s.s (1), a public authority may allow access to information, if public interest in disclosure outweighs the harm to the protected interests.”

Section 8(2) of the RTI Act mandates that even where disclosure of information is protected by the exemptions u/s.8(1) of the RTI Act, if public interest in disclosure outweighs the harm to such protected interests, the information must be disclosed under the RTI Act. There is no requirement for the existence of any public interest to be established when seeking or giving informa-tion. However, if an exemption applies, then it must be considered whether the public interest in disclosure outweighs the harm to the protected interests.

According to P. Ramanatha Aiyar’s, The Law Lexicon (2nd edition; Reprint 2007) at page 1557, ‘public interest’ ‘means those interests which concern the public at large’. Banks and financial institutions in India heavily finance various industries on a routinely basis. However, it is a fact that large sums of such amounts are sometimes not recovered. In some cases, loans availed of are not repaid despite the fact that the industrialist(s) may actually be in a financial position to pay. Where financial assistance is given to industries by banks, in the absence of financial liquidity, it would result in a blockade of large funds creating circumstances that would retard socio-economic growth of the nation.

At this stage the Commission would like to quote Thomas J. of the High Court of New Zealand 1995, ‘The primary foundation for insisting upon open-ness in government rests upon the sovereignty of the people. Under a democracy, parliament is ‘supreme’, in the sense that term is used in the phrase ‘parliamentary supremacy’, but the people remain sovereign. They enjoy the ultimate power which their sovereignty confers. But the people cannot undertake the machinery of government. That task is delegated to their elected representatives……the government can be perceived as the agent or fiduciary of the people, performing the task and exercising the powers of government which have been devolved to it in trust for the people.

I wish the Government and its instrumentalities would remember that all information held by them is owned by citizens, who are sovereign. Further, it is often seen that banks and financial institutions continue to provide loans to industrialists despite their default in repayment of an earlier loan. The Supreme Court of India in U.P. Financial Corporation v. Gem Cap India Pvt. Ltd., AIR 1993 SC 1435 has noted that “Promoting industrialisation at the cost of public funds does not serve the public interest; it merely amounts to transferring public money to private account”. Such practices have led citizens to believe that defaulters can get away and play fraud on public funds. There is no doubt that information regarding top industrialists who have defaulted in repayment of loans must be brought to the citizens’ knowledge; there is certainly a larger public interest that would be served on disclosure of the same. In fact, information about industrialists who are loan defaulters of the country may put pressure on such persons to pay their dues. This would have the impact of alerting citizens about those who are defaulting in payments and could also have some impact in shaming them. RBI had by its Circular DBOD No. BC/CIS/47/20.16.002/94, dated 23rd April 1994 directed all banks to send a report on their defaulters, which it would share with all banks and financial institutions, with the following objectives:

1. To alert banks and financial institutions (FIs) and to put them on guard against borrowers who have defaulted in their dues to lending institutions.

2. To make public the names of the borrowers who have defaulted and against whom suits have been filed by banks/FIs.

Many Revenue Departments publish lists of de-faulters and All India Bank Employees Association has also published list of bank defaulters. It would be relevant to rely on the observations of the Supreme Court of India in its landmark decision in Mardia Chemicals Ltd. v. Union of India, (decided on 8-4-2004). The Supreme Court of India was considering the validity of the SARFAESI Act and recovery of ‘non-performing assets’ by banks and financial institutions in India. While discussing whether a private contract between the borrower and the financing institution/bank can be interfered with, the Court observed:

“…. it may be observed that though the transaction may have a character of a private contract yet the question of great importance behind such transactions as a whole having far-reaching effect on the economy of the country cannot be ignored, purely restricting it to individual transactions more particularly when financing is through banks and financial institutions utilising the money of the people in general, namely, the depositors in the banks and public money at the disposal of the financial institutions. Therefore, wherever public interest to such a large extent is involved and it may become necessary to achieve an object which serves the public purposes, individual rights may have to give way. Public interest has always been considered to be above the private interest. Interest of an individual may, to some extent, be affected but it cannot have the potential of taking over the public interest having an impact in the socio-economic drive of the country.” (Emphasis added)

There are times when experts make mistakes, other times when corruption influences decisions. It is dangerous to put complete faith in the judgment of a few wise people to alert everyone. Democracy requires reducing inequality of opportunity. Asymmetry of information deprives the citizens of an opportunity to take proper decisions. The Commission is aware that information on defaulters is being shared by Reserve Bank with an organisation called CIBIL. In such a situation, it is difficult to understand the reluctance to share this information with citizens using RTI. RBI’s Circular of 1994, — mentioned above, — infact appears to promise to share this information suo moto with the public.

In view of the arguments given above, the Commission is of the considered view that the details of defaulters of public sector banks should be revealed since it would be in larger public interest. Revealing these would serve the object of reining in such defaulters, warning citizens about those who they should stay away from in terms of investments and perhaps shaming such persons/entities. This could lead to safeguarding the economic and moral interests of the nation. The Commission is convinced that the benefits accruing to the economic and moral fibre of the country, far outweigh any damage to the fiduciary relationship of bankers and their customers if the details of the top defaulters are disclosed.

Hence, in view of section 8(2) of the RTI Act, the Commission rules that information on query 2(b) must be provided to the appellant, since there is a larger public interest in disclosure.

The appeal is allowed.
“The PIO shall provide the complete information as per records on queries 2(b) and 2(c) to the appellant before 10th December 2011.

The Commission also directs the Governor, RBI to display this information on its website, in fulfil-ment of its obligations u/s.4(1)(b)(xvii) of the RTI Act.

This direction is being given under the Commission’s powers u/s.19(8)(a)(iii). This should be done before 31st December, 2011 and updated each year”.

[Mr. P. P. Kapoor v. PIO & Chief General Manager, Reserve Bank of India, Mumbai, [Decision No. CIC/SM/A/2011/001376/SG/15684, Appeal No. CIC/ SM/A/2011/001376/SG]

[Note: Full decision is posted on website of BCAS & PCGT]

As reported in The Times of India on 10-12 -2011, this judgment has been stayed by the Delhi High Court.

The Delhi High Court on 9-12-2011 stayed the direction of the Central Information Commission (CIC) asking the Reserve Bank of India to provide details of industrialists who have defaulted in re-payment of loan taken from nationalised banks.

A Bench of Justice Vipin Sanghi, in its interim ex parte order, asked the information seeker to respond to petition filed by RBI challenging the CIC order.

The Court listed the next hearing on 27th February, 2012, on RBI’s petition which said the CIC’s directives were in violation of the Right to Information Act.

Counsel T. R. Andhiyaarjuna, appearing for the RBI, contended that the CIC’s order would have a far-reaching impact as this kind of information is confidential and the Information Commissioner has dealt with the matter in a wrong way, without considering all the relevant provisions under the RBI Act.

He also said the order of the CIC was beyond its jurisdiction under the transparency law, as RBI is exempted from providing such info u/s.8(1)(a).

Sections 18 and 19 of the RTI Act:

On 12th December, 2011, the Supreme Court of India has delivered judgment, very powerful and detailed, running into 30 pages dealing with the provisions of sections 18 and 19 of the RTI Act.

As decision reported is of many pages, the same is posted on BCAS and PCGT websites. Those interested may view it there. Only one para of it is reproduced hereunder:

“We are of the view that sections 18 and 19 of the Act serve two different purposes and lay down two different procedures and they provide two different remedies. One cannot be a substitute for the other.”

[Chief Information Comm. and Another v. State of Manipur and Another under civil Appeal Nos. 10787-10788 of 2011 (arising out of S.L.P. (c) Nos. 32768-32769/2010)]

Note: Please see part B for DNA’s report on above decision.

Nirav Shah

Maintenance — Dependents unmarried daughter — Hindu Adoptions and Maintenance Act, 1956 sections 20(3) and 21.

[ Vijay Kumar Jagdishrai Chawla v. Reeta Vijay Kumar Chawla, 2011 Vol. 113(5) Bom. L.R. 3098]

The appellant — husband and respondent — wife got married as per Hindu Vedic rites. Out of the said wedlock daughter Shraddha and son Siddhesh were born. The parties, however, started staying separately due to their differences. The appellant, therefore, filed petition u/s.9 of the Hindu Marriage Act for decree of restitution of conjugal rights. The respondent on the other hand filed petition seeking maintenance for herself and her daughter and other consequential reliefs. The Family Court had found as of fact that daughter Shraddha who was staying with the respondent was pursuing Pilot Training Programme. For that, she had obtained loan of substantial amount to pay fees. The respondent-wife was not in a position to take the burden of the said education expenditure of Shraddha, nor was she in a position to pay the loan instalments. The respondent was being helped by her mother and brother financially. The Family Court found that on the other hand the appellant-husband was well placed in life. His income was substantial. He was engaged in business of restaurant/dhaba. The Family Court held that the husband shall pay maintenance to the wife at the rate of Rs.40,000 per month including accommodation charges payable from the date of this order and shall repay the loan amount of the daughter. The appellant had challenged the direction issued by the Family Court.

The moot question arose whether the wife can seek relief of maintenance for and on behalf of her major daughter/son. The Court observed that the petition was filed by the respondent-wife before the Family Court was one u/s.18 r.w.s. 20 of The Hindu Adoptions and Maintenance Act, 1956. Section 18 governs the scheme for providing maintenance to the wife. Section 20, on the other hand, deals with the regime of providing maintenance of children and aged parents.

In the present case, it is not in dispute that daughter Shraddha is residing with her mother. She is admittedly unmarried. Her mother does not own income or other property except the income by way of meager salary earned by her. She is thus not in a position to take the burden of education expenditure of her daughter Shraddha, which is quite substantial for undergoing the professional course. The Court observed that under Clause (v) of section 21 of the Act the term ‘Dependants’ encompasses unmarried daughter as Dependant. Therefore, there can be no doubt that the unmarried daughter was entitled to receive maintenance amount from her father or mother, as the case may be, so long as she is unable to maintain herself out of her own earnings or other property. Admittedly, Shraddha has no earning of her own and is pursuing her further education, as the income of the respondent-wife from her salary is very meager. For that reason, Shraddha would be entitled to maintenance amount and her education expenses from her father (appellant). Rather the father would be obliged to pay the amount towards maintenance of her daughter and for education expenditure, in law the mother is competent to pursue relief of maintenance for the daughters even if they have become major, if the said daughters were staying with her and she was taking responsibility of their maintenance and education.

The appellant would, therefore, be liable to repay the loan amount obtained by daughter Shraddha for pursuing her Pilot Training Programme forthwith.

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Nirav Shah

Doctrine of Spes Successionis — Muslim Law — Relinquishment of future share in property — Transfer of Property Act, 1882, section 6.

[ Shehammal v. Hasan Khani Rawther & Ors., AIR 2011 SC 3609]

One Mr. Meeralava Rawther died in 1986, leaving behind him surviving three sons and three daughters, as his legal heirs. At the time of his death he possessed 1.70 acres of land which he had acquired on the basis of a partition effected in the family. Meeralava Rawther and his family members, being Mohammedans, they are entitled to succeed to the estate of the deceased in specific shares as tenants in common. Since Meeralava Rawther had three sons and three daughters, the sons were entitled to a 2/9th share in the estate of the deceased, while the daughters were each entitled to a 1/9th share thereof.

It is the specific case of the parties that Meeralava Rawther helped all his children to settle down in life. The youngest son, Hassan Khani Rawther, the respondent No. 1, was staying with him even after his marriage, while all the other children moved out from the family house. The case made out by the respondent No. 1 is that when each of his children left the family house, Meeralava Rawther used to get them to execute Deeds of Relinquishment, whereby, on the receipt of some consideration, each of them relinquished their respective claim to the properties belonging to Meeralava Rawther, except the respondent No. 1, Hassan Khani Rawther. The respondent No. 1, Hassan Khani Rawther filed a suit for seeking declaration of title, possession and injunction in respect of the said 1.70 acres of land, basing his claim on an oral gift alleged to have been made in his favour by Meeralava Rawther in 1982.

The issue arose as to can a Mohammedan by means of a family settlement relinquish his right of spes successionis when he had still not acquired a right in the property?

The Court observed that Chapter VI of Mulla’s ‘Principles of Mahomedan Law’ deals with the general rules of inheritance under Mohammedan Law. The Mohammedan Law enjoins in clear and unequivocal terms that a chance of a Mohammedan heir-apparent succeeding to an estate cannot be the subject of a valid transfer or release. Section 6(a) of the Transfer of Property Act was enacted in deference to the customary law and law of inheritance prevailing among Mohammedans.

As opposed to the above are the general principles of estoppel as contained in section 115 of the Evidence Act and the doctrine of relinquishment in respect of a future share in property. Both the said principles contemplated a situation where an expectant heir conducts himself and/ or performs certain acts which makes the two aforesaid principles applicable in spite of the clear concept of relinquishment as far as Mohammedan Law is concerned.

The Court further observed that there cannot be a transfer of spes successionis, but the exceptions are pointed out by this Court in Gulam Abbas v. Haji Kayyum Ali & Ors., AIR 1973 SC 554, the same can be avoided either by the execution of a family settlement or by accepting consideration for a future share. It could then operate as estoppel against the expectant heir to claim any share in the estate of the deceased on account of the doctrine of spes successionis. While dealing with the various decisions on the subject, reference was made to the decision of the Allahabad High Court in the case of Latafat Hussain v. Hidayat Hussain, (AIR 1936 All 573), where the question of arrangement between the husband and wife in the nature of a family settlement, which was binding on the parties, was held to be correct in view of the fact that a presumption would have to be drawn that if such family arrangement had not been made, the husband could not have executed a deed of Wakf if the wife had not relinquished her claim to inheritance. Thus, the general principle that a Mohammedan cannot by Will dispose of more than a third of his estate after payment of funeral expenses and debts is capable of being avoided by the consent of all the heirs.

Having accepted the consideration for having relinquished a future claim or share in the estate of the deceased, it would be against public policy if such a claimant is allowed the benefit of the doctrine of spes successionis. The five deeds of relinquishment executed by the five sons and daughters of Meeralava Rawther constitute individual agreements entered into between Meeralava Rawther and the expectant heirs. However, the doctrine of estoppel is attracted so as to prevent a person from receiving an advantage for giving up of his/her rights and yet claiming the same right subsequently. Being opposed to public policy, the heir expectant would be estopped under the general law from claiming a share in the property of the deceased.

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Nirav Shah

Using the Internet for mass collaboration

About this article:

This article is based on a video of Luis von Ahn aired recently on a popular site i.e., www.ted.com. The video itself was recorded sometime around April 2011.

Every once in a while you come across something, an idea or a vision, that knocks you down completely. The thing that strikes you the most, is the simplicity. This article is about one such idea and how few individuals have used their minds to harness energies of millions and millions of people to help make a difference.

The Internet, as a resource, is viewed differently by different individuals. For some it is a source of information and knowledge, for others it is a means of earning a livelihood, and then there are those who are able to use their limitless imagination and ingenuity to effortlessly harness the power and labour of millions and millions of individuals, to achieve the unbelievable or the next to impossible.

One honest confession I need to make is that, while I had heard about mass collaboration and had seen its practical application (one of which is Wikipedia), but, when I first saw this video, I was completely awestruck and blown away.

Here are a few statistics to tell you why:

Currently, more than 350,000 websites are using these ideas ?

Time spent per day is equivalent to 500,000 man-hours ?

The number of words digitised by these sites exceeds 100 million a day — that’s the equivalent of effort required to digitising (approx) 2.5 million books a year ?

The effort put in, is all done one word at a time/10 seconds per person by approximately 500 million people.

Mind you ! ! ! this is just a sample of what limitless imagination and ingenuity can achieve.

So what is this mind boggling, out of the box idea, that I am raving about? Well . . . . . . . all I can say are three words CAPTCHA, RECAPTCHA & DUOLINGO.

CAPTCHA:

Captcha = Completely Automated Public Turing test to tell Computers and Humans Apart

Whats that . . . . . you said ? ? ? Is a very common response, so let me translate that into non-geek language.

Let say you are trying to register or log into sites like Google, Facebook, Twitter (and several others) and you see some oddly distorted letters/words (see picture below).

These seemingly innocuous letters (or text pieces) are a common site today. While most recognise these as a security feature, lesser number of web surfers know that these are tools for identifying whether the person accessing the site is a human being or a computer (bot) and hence the name – Completely Automated Public Turing test to tell Computers and Humans Apart.

For those of you who are unaware, unlike humans, a ‘bot’ cannot read distorted words. When you type the (correct) words in the box, it proves that you are human and the website allows you to register/access content/purchase goods/make reservations, etc.

Over a period of time Captcha has become (almost) a standard security feature. In the video von Ahn revealed that (by April 2011) there were more than 350,000 websites using Captcha and some approximately 500 million users every day were spending 10 seconds each while accessing various e-commerce sites.

The first reaction to the above is ‘WOW’ — 350,000 websites, 500 million users. von Ahn too felt a sense of pride that his invention was being used by so many people, but then he also thought that each of these 500 million users were spending 10 seconds each during the verification process, this translated to 500,000 man-hours (approx). Then came the thought, “Is there something I can do to utilise this effort to do something — something huge but simple — something that machines cannot do (as yet) as efficiently as humans can?” Needless to say that stopping the use of Captcha, given its benefits, was not an option. This thought was the seed to another research, resulting in what is commonly known as RECAPTCHA.

RECAPTCHA: von Ahn and his associate/intern came up with this idea on the basis of the findings of their research. The idea was to use the efforts of the 500,000 man-hours to digitise books. There are several projects doing this already, including one being pursued by Google. It is common knowledge amongst most people who are involved in the endeavour to digitise books, that computers and more specifically, optical character recognition (OCR) technology is applied for digitising books. And that typically, this involves one person using a scanner device to scan one page at a time and then wait for the OCR software to convert the scanned image in to a document. What is not very commonly known (at least with the public at large) is that the technology is not 100% accurate. Machines and for that matter computers/ software, at times, are not able to ‘recognise’ many of the characters that are scanned by them. This is more so when the book being scanned is older than 10 years. The difficulty arises due to a variety of factors such as the typeface used, yellowing of the pages, creases in the pages, wear and tear/ condition of the book. In all such cases, human effort is required (computers cannot do it as easily as humans). Thus, RECAPTCHA was born. Once again the idea was a simple one, the visitor was presented with two words (instead of one in Captcha) one which was known to the software and the other which was required to be ‘recognised’. When both words were recognised, the visitor was granted access to the site he was visiting. All the time, in the background, RECAPTCHA was comparing this result with the response provided by another 10 users (who were given the same combination). If the result matched, then another word was digitised.

Once again the idea was a runaway success — The number of words digitised by these sites exceeds 100 million a day — that’s the equivalent of effort required to digitising (approx) 2.5 million books a year. Given the success, RECAPTCHA was acquired by Google.

von Ahn and team revisited their question and embarked on a yet another journey. This time they decided that all the parties involved in the process should have something to gain — in captcha human effort was used to verify their status as humans. While this helped the website owners, it resulted in wastage of human effort. Recaptcha used this human effort to convert books — once again website owners and book readers gained- nothing for the visitors who were assisting in the digitising process were not being compensated. This thought gave birth to DUOLINGO.

DUOLINGO:

Just like digitising books, translating content is another ‘skill’ which the machines/software do not posses (as yet). It’s one thing to merely translate words and a different thing to translate the words with context. It is the context in which the words are spoken, which makes the text readable and by that measure more comprehensible. If you don’t believe try using the translators available for converting a poem in Hindi to English and vice versa (no offence but its like watching a Chinese movie — dubbed in Tamil — the tone/pitch of the dialogue or a fight scene versus the body language — I have always found it hilarious — try it sometime). Coming back to the topic . . . von Ahn and team came up with the idea of DUOLINGO.

What von Ahn and team realised was that there was content on the web which needed to be translated. The video has cited the example of translating content on the English version of Wikipedia to Spanish version — currently the Spanish version is only 30% of the English version and the cost of converting the same — as the video suggest — from the lowest cost vendor, based on the effort of exploited labourers in a third-world country- was $ 50 million. Cost apart the other quandary was where do you find enough people who know more than one language and were willing to participate in the translation process. The solution was that there are hundreds and thousands of people who want to learn another language, they have to pay money to learn, here was an opportunity to learn and apply at the same time — without spending anything from their pockets. Now there is a win-win for almost all !

Content can be translated

With context, translation is easier, fun, improves the learning/experience

The accuracy is far higher than that offered by software currently available and almost comparable to the accuracy of a professional translator

Both parties don’t pay money but put in their ‘efforts’

Both parties gain

And on the hindsight lesser exploitation of labour

The result: based on current stats the translation can be done in a matter of weeks.

Now that’s what I call innovation.

Like I said earlier, I was completely blown away when I saw the video, I am sure after reading this write-up (and maybe watching the video) you will be too.

Wish you Merry Christmas and a Happy New Year.

Disclaimer:

The purpose of this article is not to promote any particular site or person or software. The sole intention is to create awareness and to bring in to limelight some thought-provoking content.

Nirav Shah

Related parties under Ind AS: Enhanced scope and disclosure requirements

Related party relationships and transactions with such parties are an integral part of day-to-day business for many groups. Users of financial statements are likely to be interested in the existence of these relationships and in transactions, along with their potential impact, between such parties when they assess the operations, financial performance and financial position of an entity.

The accounting definition of a related party under AS-18, which is a part of the present Indian GAAP, is not as far reaching in its scope as the international practice.

As part of convergence to IFRS, the Ind AS attempts to address the above and introduces certain additional disclosure requirements to enhance the quality of financial information to the users of financial statements.

In this article we shall consider some of the key differences in the identification of related parties for financial reporting purposes between Indian GAAP and Ind AS.

Definition of related party

AS-18 defines a related party as follows — ‘Parties are considered to be related if at any time during the reporting period one party has the ability to control the other party or exercise significant influence over the other party in making financial and/ or operating decisions’. It clarifies that AS-18 applies only to related party relationships described in the standard, which are as under:

(a) enterprises that directly, or indirectly through one or more intermediaries, control, or are controlled by, or are under common control with, the reporting enterprise (this includes holding companies, subsidiaries and fellow subsidiaries);

(b) associates and joint ventures of the reporting enterprise and the investing party or venturer in respect of which the reporting enterprise is an associate or a joint venture;

(c) individuals owning, directly or indirectly, an interest in the voting power of the reporting enterprise that gives them control or significant influence over the enterprise, and relatives of any such individual;

(d) key management personnel and relatives of such personnel; and

(e) enterprises over which any person described in (c) or (d) is able to exercise significant influence. This includes enterprises owned by directors or major shareholders of the reporting enterprise and enterprises that have a member of key management in common with the reporting enterprise.

Ind AS 24 states that a related party is a person or entity that is related to the entity that is preparing its financial statements referred to as the ‘reporting entity’.

(a) A person or a close member of that person’s family is related to a reporting entity if that person:

(i) has control or joint control over the reporting entity;

(ii) has significant influence over the reporting entity; or

(iii) is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.

(b) An entity would be a related party if any of the following conditions apply:

(i) The entity and the reporting entity are members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others).

(ii) One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member).

(iii) Both entities are joint ventures of the same third party.

(iv) One entity is a joint venture of a third entity and the other entity is an associate of the third entity.

(v) The entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity.

(vi) The entity is controlled or jointly controlled by a person identified in (a). (vii) A person identified in (a) (i) has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity).

Related party relationships included and excluded

For the purpose of this section, we shall analyse these relationships from the perspective of Reporting Entity (RE), and reference to Parent, Associates and Joint Ventures of the reporting enterprise shall be denoted as P, A and J, respectively. Further, to highlight indirect relations within a group structure, for instance, Parent company’s investment in its Joint venture is referred to as P-J, where the ‘P’ denotes RE’s Parent Company and the ‘J’ that follows ‘P’ denotes to another Joint venture of the Parent Company.

Parent’s investment in Joint Venture (i.e., P-J) and associates (i.e., P-A)

Under the present Indian GAAP, parent’s investment in another subsidiary (i.e., P-S) is a related party, as that subsidiary is reporting entity’s fellow subsidiary. However, from the drafting of the relationships stated above, the parent’s investment in its joint venture (i.e., P-J) is not considered as related party under current Indian GAAP. Similarly, the parent’s investment in its associate (i.e., P-A) is also not considered as a related party to RE.

Under Ind AS, two entities are related if one entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member). Since the group is defined to include the parent company and each of entities under its direct and indirect control, the parent’s investment in its joint venture (i.e., P-J) is a related party to RE. Similarly, the parent’s investment in its associates (i.e., P-A) is also considered to be related party to RE.

Subsidiaries of joint ventures (i.e., J-S) and associates (i.e., A-S)

The present Indian GAAP does not specifically clarify whether a reference to the associates and joint ventures in AS-18 should be interpreted as those stand-alone entities or their entire group. As such, it is a common practice of not considering the subsidiaries of associates and joint ventures as related parties.

Under Ind AS, it is specifically stated that an associate includes subsidiaries of the associate and a joint venture includes subsidiaries of the joint venture. As such, for instance, an associate’s subsidiary (i.e., A-S) and the investor (i.e., RE) that has significant influence over the associate (A) are related to each other. Similarly, J-S is also considered to be a related party under Ind AS.

Key managerial personnel (KMP)

Under present Indian GAAP, a non-executive director of a company is not considered as a KMP by virtue of merely his being a director unless he has the authority and responsibility for planning, directing and controlling the activities of the reporting enterprise.

Under Ind AS, KMP are those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity.

Classification of investees as subsidiaries, joint ventures and associates

It may be noted that the reference to the terms subsidiaries, joint ventures and associates as stated above are required from the perspective of the Ind AS principles in assessing control, joint control and significant influence, considering the rights to participate in the financial and operating policies of the investee. As such, unlike present Indian GAAP, the percentage ownership of the investee’s capital may not be the determinative factor in assessing the relationship with the investee.

As such, the related party relationships may undergo a change not only on account of changes to the identified related party relationships in the standard, but also on account of change in classification of the investees based on the degree to which the company can influence the operations of the investee.

State-controlled enterprise/Government-related entities

The present Indian GAAP defines a state-controlled enterprise as an enterprise which is under the control of the Central Government and/or any State Government(s). Under the definition of state-controlled enterprises, those enterprises that are under joint control or under significant influence of the Central and/or State Government(s) are not considered as state-controlled enterprises. As such, the disclosure exemptions provided under AS-18 do not extend to such enterprises under joint control/ significant influence of the government.

Under Ind AS, a government-related entity is an entity that is controlled, jointly controlled or significantly influenced by a government. As such, disclosure exemptions provided under Ind AS 24 extend to enterprises under joint control/significant influence of the same government. Further, it follows that the differences stated above (such as subsidiaries of associates i.e., A-S) may additionally be considered for this purpose.

Disclosure requirements
Duties of confidentiality

Like the present Indian GAAP, the Ind AS states that the related party disclosure requirements as laid down under Ind AS 24 do not apply in circumstances where providing such disclosures would conflict with the reporting entity’s duties of confidentiality as specifically required in terms of a statute or by any regulator or similar competent authority.

However, this is a departure from the IFRS as issued by IASB (commonly referred to as a carve-out). As such, IFRS does not prescribe any such exemption from disclosure requirements prescribed under IAS 24 on account of duties of confidentiality as specifically required in terms of a statute or by any regulator or similar competent authority.

Compensation to KMP

Under the present Indian GAAP, the employee compensation provided to KMP is required to be disclosed. However, there is no specific requirement to disclose the breakup of such compensation.

Under Ind AS, the employee compensation to KMP is required to be disclosed, along with its breakup into short-term employee benefits, post-employment benefits, other long-term benefits, termination benefits and share-based payments.

Disclosure of terms and conditions of transaction

The present Indian GAAP requires disclosure of, amongst other things, name of related party, description of related party relationship and the description of the transaction.

Ind AS additionally requires disclosure of terms and conditions of the related party transactions, including whether they are secured, and the nature of the consideration to be provided in settlement; and details of any guarantees given or received.

Disclosure exemptions for government-related entities

As per AS-18, no disclosure is required in the financial statements of state-controlled enterprises as regards related party relationships with other state-controlled enterprises and transactions with such enterprises.

As per Ind AS 24, the reporting entity is exempt from the disclosure requirements in relation to related party transactions and outstanding balances, including commitments, with:

a) a government that has control, joint control or significant influence over the reporting entity; and
b) another entity that is a related party because the same government has control, joint control or significant influence over both the reporting entity and the other entity.

If a reporting entity applies the exemption as stated above, it shall disclose the following about the transactions and related outstanding balances:

a) the name of the government and the nature of its relationship with the reporting entity (i.e., control, joint control or significant influence);

b) the following information in sufficient detail to enable users of the entity’s financial statements to understand the effect of related party transactions on its financial statements:

i) the nature and amount of each individually significant transaction; and
ii) for other transactions that are collectively, but not individually, significant, a qualitative or quantitative indication of their extent.

Summary
One of the key GAAP differences between present Indian GAAP and Ind AS is that of indirect relationships, whereby Ind AS considers the all group entities of an entity (instead of that separate legal entity) to be related if that entity is related to the reporting entity. Accordingly, for instance, if an entity is related to a reporting entity in the capacity of an associate or joint venture, all entities controlled by such associates and joint ventures are considered as related parties under Ind AS. Similar is the case with the associates and joint ventures of the reporting entity’s parent company.

Overall, the implementation of Ind AS will require identifying the additional related party relationships covered within the scope of the standard. Further, the related party relationships need to be identified after appropriately classifying all the entities concerned as subsidiaries, associates and joint ventures, in accordance with Ind AS (that could be different from its classification under present Indian GAAP) from the perspective of the investor i.e., the reporting entity or its investee within its group or its associates/joint ventures as the case may be. It may particularly be difficult at times to assess the appropriate classification of the investees of an associate into subsidiary/ associates/joint venture, on account of associate company not reporting under Ind AS and limited access to the financial information of the associate.

While the Ind AS is not mandatory as yet, it is expected that preparers will want to evaluate their involvement with related parties under the new standard soon, as the changes in the group structure from an accounting perspective under Ind AS will have additional implications.

Nirav Shah

Revision for dividend declaration

NHPC Ltd. (31-3-2011)

From Notes to Accounts

33. Subsequent to the approval of accounts for the year ended 31st March, 2011 by the Board of directors on 27th May, 2011, the members of the Board has recommended dividend @ Rs.0.60 per share [subject to rounding off to nearest Rupee in terms of Rule 23 of Companies (Central Government’s) General Rules & Forms, 1956] on the paid-up equity capital of the Company (as per Balance Sheet as at 31st March 2011) for the year ended as at 31st March 2011 in the meeting held on 30-6-2011. Accordingly the Company has reopened and revised its earlier finalised audited account for the year ended 31st March 2011 and a provision for dividend amounting to Rs.738.04 crore (subject to rounding off) @ 6% on the paid up equity capital amounting to Rs.12300.74 crore (divided into 1230,07,42,773 equity shares of Rs.10 each fully paid-up) and dividend distribution tax thereon, has been made.

From Auditors Report

1. We have audited the attached revised Balance Sheet of M/s. NHPC Limited as at March 31, 2011 and the revised Profit & Loss account, revised Statement of expenditure during construction and revised Cash Flow Statement of the Company for the year ended on that date annexed thereto. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

2. Reference is invited to Auditors’ Report dated 27-5-2011 given by us on the Financial Statements of NHPC Limited for the financial year ended as at 31-3-2011.

3. The Company has amended its aforesaid financial statements covered by the abovereferred Auditor’s Report so as to incorporate the provision for dividend and dividend distribution tax thereon in the books, which has been recommended by the Board of NHPC Limited. Accordingly, the Balance Sheet as at 31-3-2011 and Profit & Loss Account for the period ended on even date, audited by us (covered by our above-referred Auditors Report) has been amended by the Company (refer Note No. 33 of Schedule 24).

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Nirav Shah

Revision pursuant to merger

Tata Communications Ltd. (31-3-2011)

From Notes to Accounts

The Board of Directors of the Company at its meeting held on 31st January 2011 had approved the merger of the Company’s wholly owned subsidiary, Tata Communications Internet Services Limited (TCISL) with the Company with effect from 1st April 2010. The Company had obtained the consent of the shareholders for the merger at Extra Ordinary General Meeting held on 27th April 2011.

In accordance to the final order dated 20th August 2011 as pronounced by the Bombay High Court the financials have been revised to reflect the merger of TCISL with the Company effective 1st April 2010.

In accordance to the said Scheme, the Company has accounted for this amalgamation in the nature of merger under the pooling-of-interest method. Consequently:

(i) All the assets, debts, liabilities and obligations of TCISL have been vested in the Company with effect from 1st April 2010 and have been recorded at their respective book values.

(ii) The net asset value of TCISL as on the date of amalgamation was Rs.15.28crore as against the investment of the Company of Rs.384.47 crore. The excess of the cost of investment of Rs.369.19 crore is adjusted against the general reserve to the extent of Rs.78.24 crore, Rs.0.56 crore against capital reserve and Rs.291.51 crore against the opening profit and loss account.

(iii) Consequent to the merger there has been a reduction in the current tax expense of Rs.37.97 crore and increase in deferred tax benefit of Rs.39.65 crore.

From Auditors’ Report

(3) The financial statements for the year ended 31st March, 2011 were audited by us and our report dated 29th May, 2011 expressed an unqualified opinion on those financial statements. Consequent to order dated 20th August, 2011 of the High Court of Bombay sanctioning the merger of Tata Communications Internet Services Limited with the Company, the audited financial statements for year ended 31st March, 2011 were revised by the Company to give effect to the said merger, effective from 1st April, 2010. We have accordingly carried out audit procedures and amended the date of our audit report in respect of this subsequent event. (Refer Note B9 of Schedule 19 to the financial statements.)

(1) As required by the Companies (Auditor’s Report) Order, 2003 (CARO) issued by the Central Government in terms of section 227(4A) of the Companies Act, 1956, we enclose in the Annexure a statement on the matters specified in paragraphs 4 and 5 of the said Order.

(2) Further to our comments in paragraph 3 . . .

For ………………… & Co. Partner (M. No. . . . . . . .)

__________________________

Chartered Accountants

Mumbai 29th May 2011 (30th August 2011 as to give effect the amendment discussed in paragraph 3 above).

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Nirav Shah

GAPs IN GAAP — Amortisation of Leasehold Improvements

Over what period does a lessee depreciate leasehold improvements that it makes to a property under an operating lease that contains an option for the lessee to extend the lease?

Fact pattern
A lessee enters into an operating lease for an office property. The lease has a term of 5 years, and contains an option for the lessee to extend the lease for a further 5 years. The rentals for the period under the extension option (i.e., years 6-10) are at market rates. Upon commencement of the lease term, the lessee incurs CU100,000 constructing immoveable leasehold improvements specific to the property. The economic life of the leasehold improvements is 7 years. At commencement of the lease, the lessee expects to exercise the extension option, but is not reasonably certain it will do so.

Conclusion View 1: The useful life of the leasehold improvements is the shorter of the lease term or the assets’ economic life.

The lessee depreciates the leasehold improvements over the lease term of 5 years.

Reasons for View 1

AS-19.3 states:
“The lease term is the non-cancellable period for which the lessee has agreed to take on lease the asset together with any further periods for which the lessee has the option to continue the lease of the asset, with or without further payment, which at the inception of the lease it is reasonably certain that the lessee will exercise.”

In this fact pattern, at the inception of the lease, the lessee is not ‘reasonably certain’ that it will exercise the lease option, although renewal may be expected. For the purpose of AS-19, the lease term is thus 5 years. AS-6.20 requires “the depreciable amount of a depreciable asset shall be allocated on a systematic basis to each accounting period during the useful life of the asset”.

AS-6.3.3 defines ‘useful life’ as either: “
(a) The period over which a depreciable asset is expected to be used by the enterprise; or
(b) The number of production or similar units expected to be obtained from the use of the asset by the enterprise.”

In addition, AS-6.7 states that:

“The useful life of a depreciable asset is shorter than its physical life and is:

(i) Predetermined by legal or contractual limits, such as the expiry dates of related leases.
(ii) ……………. ” In the fact pattern, one of the factors in determining the useful life of the leasehold improvements is the expiry date of the related lease. The expected utility of the leasehold improvements should be consistent with the reasonably certain lease term as defined in AS-19. Therefore, the useful life of the leasehold improvements is 5 years.

View 2: The expected economic life of the leasehold improvements is used as the useful life.

In the fact pattern, the lessee depreciates the leasehold improvements over 7 years, since it expects to extend the lease to 10 years and utilise the leasehold improvements for 7 years.

Reasons for view 2

AS-6.20 requires “the depreciable amount of an asset shall be allocated on a systematic basis over its useful life”.

AS-6.3.3 defines ‘useful life’ as either:

(a) The period over which a depreciable asset is expected to be used by the enterprise; or

In addition, AS-6.7 states that:

“The useful life of a depreciable asset is shorter than its physical life and is:

(i) Predetermined by legal or contractual limits, such as the expiry dates of related leases.”

The useful life of the leasehold improvements is based on the ‘expected utility’ (AS-6.3.3). To determine the expected utility, the lessee would consider ‘all the factors’ in AS-6.7. While 6.7 should be considered, the factor regarding ‘expected usage of the asset’ in AS-6.3.3 is equally relevant in determining the useful life. The condition contained in AS-6.7 reflects the necessity to consider the existence of legal or other externally imposed limitations on an asset’s useful life. However, in the fact pattern, the ability to extend the lease term is within the control of the lessee and is at market rates so there are no significant costs or impediments to renewal.

The lease term as defined in AS-19 does not include the extension period because the lessee is not ‘reasonably certain’ of extending the lease. However, a different threshold is used in AS-6 for the determination of the useful life, which is the period over which the lessee expects to use the leasehold improvements. The term ‘expected usage of the asset’ for the determination of useful life of an asset indicates a lower threshold than the ‘reasonably certain’ of extending the lease threshold for including the extension period in the lease term for accounting purposes. As a result, although the accounting lease term is 5 years, the leasehold improvements is depreciated over the period over which the lessee expects to use the assets (as it expects to extend the lease to 10 years), which is 7 years.

In accordance with AS-6.23, if the assessment of useful life changes as a result of the lessee not expecting to exercise the lease renewal option, the unamortised depreciable amount should be charged over the revised remaining useful life.

The author believes that view 1 is conservative and fits into the concept of prudence enshrined in Indian GAAP framework. On the other hand view 2 is also justified on the basis of AS-6.

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Nirav Shah

FINDING FRAUDS IN FINANCIAL STATEMENTS — 10 COMANDMENTS FOR AUDITORS

Introduction

“Auditor is a Watch Dog But Not a Blood Hound” is the famous quote well known amongst the entire professional community; but the expectations of society from the auditors may not be exactly on these lines and it expects the auditors to play a role bigger than mere accountants confirming the numbers recorded in the financial statements. The gap in the expectation and the reality gets widened primarily because of the interpretations of the responsibility of the auditors in finding frauds through their audit of the financial statements. Though the fact remains that the auditor is not an investigator or a fraud specialist, he does have certain responsibilities in responding to the fraud risks in the financial statements subjected to the audit process. This article summarises the 10 important commandments for the auditors in responding to such fraud risks while discharging his professional responsibility.

Auditors responsibility towards frauds

The auditor should conduct the engagement with a mindset that recognises the possibility that a material misstatement due to fraud could be present, regardless of any past experiences with the entity and regardless of the auditor’s belief about management’s honesty and integrity. In India there is an Auditing Standard (SA-240) which deals with the responsibilities of auditors to consider fraud and error in the audit of the financial statements. This auditing standard is generally consistent in all material respects with those set out in the International Standard on Auditing (ISA) 240 on The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements.

According to this standard, the primary responsibility for the prevention and detection of fraud and error rests with both those charged with governance and the management of an entity. It also explains that the objective of an audit of financial statements, prepared within a framework of recognised accounting policies and practices and relevant statutory requirements, if any, is to enable an auditor to express an opinion on such financial statements. An audit conducted in accordance with the auditing standards generally accepted in India is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatements, whether caused by fraud or error. The fact that an audit is carried out may act as a deterrent, but the auditor is not and cannot be held responsible for the prevention of fraud and error. An auditor cannot obtain absolute assurance that material misstatements in the financial statements will be detected. Owing to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements of the financial statements will not be detected, even though the audit is properly planned and performed in accordance with the auditing standards generally accepted in India.

The critical principle arising out of this auditing standard is that an audit does not guarantee that all material misstatements will be detected because of factors such as the use of judgment, the use of testing, the inherent limitations of internal control and the fact that much of the evidence available to the auditor is persuasive rather than conclusive in nature. For these reasons, the auditor is able to obtain only a reasonable assurance that material misstatements in the financial statements will be detected.

Challenges and audit techniques

It is not always easy to find out a well-structured fraud if perpetuated by the management of the entity. The fact remains that irrespective of the audit procedures performed, the integrity and the honesty of those charged with governance and those running the operations of the entity and their corporate culture is very important and is the corner-stone for determining the content, quality and the transparency of the financial statements. Hence, due care needs to be taken while accepting a client. The auditor who has a tremendous responsibility of forming an opinion about these financial statements needs to perform his professional duty duly considering the fraud risks.

Dr. Steven Albrecht, the famous Professor in Accountancy who has done extensive studies and research on business frauds and ethics, wrote that fraud is seldom witnessed firsthand. Instead, only fraud symptoms (or ‘red flags’) exist to alert management or the auditors about the possible existence of fraud. He has identified six categories of fraud symptoms:

Accounting or document symptoms: Anything that is wrong with the accounting records or documents of the entity — either electronic or paper (e.g., a copy where there should be an original, a journal entry or G/L that does not balance, a missing invoice, etc.).

Analytical symptoms: Things that are too big, too small, unusual, wrong person, wrong time, out of the ordinary, unexpected, etc. (e.g., balances or ratios changing too quickly, new vendors with unusually high transactions/balance amounts, etc.).

Lifestyle symptoms: This symptom is better for misappropriation of assets than for financial statement fraud, but when people embezzle money, they rarely save what they steal. Rather, they spend the ill-gotten gains to meet whatever financial pressures they had and then they start to increase their lifestyles. Sudden increases in lifestyles are fraud symptoms.

Behavioural symptoms: When people commit fraud, they feel stress. Because they have to cope with this stress, they usually change their behaviour. Sudden changes in behaviours are fraud symptoms.

Internal control overrides: It takes the combination of pressure, opportunity and rationalisation for someone to commit fraud, especially first-time offenders. Overriding internal controls provides fraud opportunities and often completes the fraud triangle. Such overrides are excellent fraud symptoms.

Tips and complaints: While tips and complaints are often great fraud risk factors, it is often difficult to know what motivates them. Like the other five types of symptoms, they should be seriously considered, but their presence does not mean that fraud is definitely occurring.

Auditors have to identify these symptoms and then carry out the required procedures to form an opinion about the financial statements.

Commandment No. 1: Identification of fraud risk factors

While carrying out the audits, the auditors have to keep in mind that “If you were management, how could you manipulate an account balance AND conceal it from the auditors”. If they approach the audit with this mindset, there is every possibility of identifying the fraud risks affecting the financial statements.

In considering the risk of material misstatement resulting from fraud, the auditor should consider whether fraud risk factors are present that indicate the possibility of either fraudulent financial reporting or misappropriation of assets while identifying and responding to the fraud risks. The fact that fraud is usually concealed can make it very difficult to detect. However, using the auditor’s knowledge of the business, the auditor may identify events or conditions that provide an opportunity, a motive or a means to commit fraud, or indicate that fraud may already have occurred.

The presence of fraud risk factors may indicate that the auditor will be unable to assess control risk at less than high for certain financial statement assertions. On the other hand, the auditor may be able to identify internal controls designed to mitigate those fraud risk factors that the auditor can test to support a control risk assessment below high.

Commandment No. 2: Inquiries on fraud

Many times when you ask questions formally there is a tremendous pressure on the individual to tell you the truth. Hence, as part of the audit process, auditors should have formal inquiries on fraud not with the management but also with those in charge of governance. These formal inquiries should be adequately documented and minuted as part of the audit files. While structuring such inquiries, due care needs to be taken in choosing the number of persons to be inquired, their level in the hierarchy, representation across various divisions/departments, role/responsibilities etc. Further, such inquiries could focus on the following:

obtaining an understanding of:

i) Management’s assessment of the risk that the financial statements may be materially misstated as a result of fraud; and

ii) The accounting and internal control systems management has put in place to address such risk;

to obtain knowledge of management’s understanding regarding the accounting and internal control systems in place to prevent and detect error;

to determine whether management is aware of any known fraud that has affected the entity or suspected fraud that the entity is investigating; and

to determine whether management has discovered any material errors.

The auditor should also have formal discussions with those in charge of governance to have an understanding of their concerns, if any, affecting the financial environment, the adequacy of accounting and internal control systems in place to prevent and detect fraud and error, the risk of fraud and error, and the competence and integrity of management.

In addition to the formal inquiries, the auditor should also have informal discussions with the entity personnel. He should always keep his eyes and ears open. Many times, such informal discussions with the entity personnel may provide valuable information to the auditor, which can be evaluated for determining the extent/nature of further inquiries. At times, discussion discloses more information than documents. As the term auditor emanates from the word ‘audire’, which means ‘to hear’, he should keep listening to people and should have more and more discussions with people. He will get to know more about the entity he is auditing when he talks to people rather than by only going through the documents.

Commandment No. 3: Brainstorming amongst the audit team members

According to SAS 99, Consideration of Fraud (US Auditing Standard), brainstorming is a required procedure and should be applied with the same degree of due care as any other audit procedure, such as inventory observation or confirmation of accounts receivable. Brainstorming amongst the audit team members facilitates the following objectives:

Reinforce importance of professional skepticism;

Discuss external and internal fraud risk factors;

Consideration of frauds on or by the entity which occurred in the past;

Exchange ideas about how fraud could occur, including through management override;

Consider how management could conceal financial reporting fraud and how assets could be misappropriated; and

Consider audit procedures to address fraud risks — the nature, timing and extent of audit procedures.

The importance attached to such brainstorming sessions facilitates greater awareness about the responsibility on the part of the audit team and helps in gaining a better understanding of the potential for material misstatements in the financial statements resulting from fraud or error in the specific areas of the audit assigned to them, and how the results of the audit procedures that they perform may affect other aspects of the audit.

Commandment No. 4: Journal entry testing/ review of year-end entries

As part of the audit process, the auditors could perform Journal Entry Testing to address key fraud considerations. There is also a need to examine journal entries and other adjustments for evidence of possible material misstatement due to fraud, to mitigate the risk of management override of controls. The auditors are required to include procedures in their audits to test for management override of controls and to test manual journal entries.

Material misstatements of financial statements due to fraud often involve the manipulation of the financial reporting process by (a) recording inappropriate or unauthorised journal entries throughout the year or at period end, or (b) making adjustments to amounts reported in the financial statements that are not reflected in formal journal entries, such as through consolidating adjustments, report combinations, and reclassifications. Accordingly, the auditor should design procedures to test the appropriateness of journal entries recorded in the general ledger and other adjustments (for example, entries posted directly to financial statement drafts) made in the preparation of the financial statements. More specifically, the auditor should

obtain an understanding of the entity’s financial reporting process and the controls over journal entries and other adjustments;

identify and select journal entries and other adjustments for testing;

determine the timing of the testing; and

inquire of individuals involved in the financial reporting process about inappropriate or unusual activity relating to the processing of journal entries and other adjustments.

To identify and select journal entries and other adjustments for testing, the auditor should use professional judgment in determining the nature, timing, and extent of the testing of journal entries and other adjustments. For purposes of identifying and selecting specific entries and other adjustments for testing, and determining the appropriate method of examining the underlying support for the items selected, the auditor should consider

the auditor’s assessment of the risk of material misstatement due to fraud;

the effectiveness of controls that have been implemented over journal entries and other adjustments;

the entity’s financial reporting process and the nature of the evidence that can be examined;

the characteristics of fraudulent entries or adjustments;

the nature and complexity of the accounts; and

journal entries or other adjustments processed outside the normal course of business.

Inappropriate journal entries and other adjustments often have certain unique identifying characteristics. Such characteristics may include entries (a) made to unrelated, unusual, or seldom-used accounts, (b) made by individuals who typically do not make journal entries, (c) recorded at the end of the period or as post-closing entries that have little or no explanation or description, (d) made either before or during the preparation of the financial statements and do not have account numbers, or (e) containing round numbers or a consistent ending number.

Further, a detailed/specific review of the entries recorded at the end of the reporting period could also give critical inputs required for the auditors in drawing overall conclusions.

Commandment No. 5: Surprise elements in the audit

The auditor should incorporate an element of unpredictability with respect to the nature, timing, and extent of audit procedures. He should never allow the auditee to predict the exact procedures he is going to perform. Surprise verification of cash and inventory is a classic example of such surprise audit procedures. He could insist on obtaining certain new types of confirmations every year in addition to the past types of confirmations. Further, by way of introducing new audit procedures, every year, the auditor not only brings in robustness in the audit process, but also addresses the important fraud risk criteria through this process.

Many times, by following the approach of ‘Same As Last Year’ (SALY), there is a possibility of overlooking the fraud risks inherent in the control environment. The auditor should not only challenge the past practice, but also evaluate its applicability/relevance every time so as to make sure that the audit procedures do not become redundant/a formality, but always challenge the status quo and gives the required comfort to the auditor in discharging his duties.

Commandment No. 6: Audit is for the entity and not for the finance team

Invariably, the audit process is considered as an event that occurs once in a year and this has something to do with the finance department. This mindset and the approach needs to change totally and there should be awareness both on the part of the auditor and the auditee that the audit process is for the entity as a whole. This would imply that the auditor has to necessarily interact with business heads/other non-finance teams as well to have an understanding of the entity as a whole. Many times, such interactions with non-finance personnel will provide valuable insights and also throw light on the various red flags which need to be investigated further.

Further, the auditor while interacting with various personnel from the entity needs to observe closely, their behavioural pattern, their thought process, culture, etc.

Needless to insist that in all such interactions, the auditor needs to evaluate the responses by applying common sense. If he is not satisfied/clear about the explanations, he should challenge the same rather than accepting them without understanding the explanations totally. Many times, well -managed frauds are covered by way of providing confusing explanations/diverting from the core issues with some incidental/trivial matters, etc.

At times, dominating characters would like to push through some vague explanations/rosy presentations and the auditor should be watchful in dealing with such situations.

The client management and interaction skills are extremely important in the audit process and the auditor should sharpen his skills in those areas to effectively manage the audit engagements.

Commandment No. 7: Make your presence felt!

In the real sense, the process of audit is more to put a moral fear in the minds of the people to make sure that there is an oversight and if there are any issues, the same will be checked by someone else. By way of having an independent examination, the auditor brings in credibility to the financial statements and also is playing the role of providing important checks and balances to the financial reporting system.

Considering this in mind, the auditor has to make sure that his presence is felt by the system. This could be done by way of meeting up with various people, discussing with them, identifying and raising issues at the right forum, performing surprise audit procedures, etc. Interactions with the junior-most persons in the organisation could help him in getting a better understanding of ground level issues since the basic recording of transactions is done by them. Further, the auditor should talk about the importance of the audit process, consequences of false/ incorrect reporting, its repercussions, and statutory requirements, etc. so as to create awareness in the minds of the people. The moral fear created across the system will help in creating an atmosphere for preventing people from engaging in fraudulent activities.

Further, such an environment could also set the tone for having smooth/purposeful interactions and transparent discussions with the auditee.

Commandment No. 8: Sanctity to the audit processes

The auditor should never dilute the importance attached to any audit process. The audit procedures carried out in any form, such as physical verification of inventory, sending confirmation requests, investigating the differences arising on any reconciliation exercise, performing walkthroughs for the various business cycles, disposal of the issues raised by the audit team members, etc. should be given utmost sanctity and importance. The extent of importance provided by the auditor drives and dictates the importance attached to those processes/importance gained from the auditee. Further, the auditor should escalate the key issues arising out of the audit on a timely basis to the management and those in charge of governance.

Commandment No. 9: Corroboration of the information from more than one source

The information obtained as part of the audit process should always be corroborated with other information/other sources. This would help in ensuring appropriate checks and balances and provide a platform for validating/cross checking the information. Such an exercise would also help in mitigating the fraud risks.

Commandment No. 10: Trust but verify!

The auditor should be alert and should be looking out for circumstances/situations requiring detailed scrutiny. He should never take any information at face value and should follow the golden principle of ‘Trust but Verify’ which requires eloquent application of ‘professional skepticism’. There is a need for fine balancing of challenging everything vis-à-vis accepting the same at face value.

Conclusion

Professional skepticism is the backbone of the audit process and the auditor has to apply this diligently and carefully. While designing his audit procedures, he should always keep in mind that he should not miss the woods for trees. Considering the expectations of society and the professional responsibility, the auditor should pay more attention to identifying and responding to the fraud risks affecting the financial statements. The Ten Commandments explained above is a combination of procedures he should perform and the precautions he needs to take while discharging his duties. Further, based on the major accounting failures and the fraud stories all across the globe, the auditor should continuously learn and fine tune the audit process. As quoted by Russel Means, If you learn from an experience, that’s good — so nothing bad happened to you!

Nirav Shah

Nimbus Sport International Pte. Ltd. v. DDIT (2011) TII 178 ITAT-Del.-Intl. Articles 5, 7 & 12 of India-Singapore DTAA A.Ys.: 2002-03, 2003-04, 2004-05 Dated: 30-9-2011 Before K. D. Ranjan (AM) and R. P. Tolani (JM) Counsel for assessee/revenue: S. R. Wadhwa/A. K. Mahajan, A. D. Mehrotra

(i) On facts, the taxpayer had no fixed place PE or service PE in India.

(ii) Receipts of the taxpayer were in the nature of FTS and not business income.

(iii) FTS received by the taxpayer were taxable @10% in terms of Article 12(2) of India-Singapore DTAA.

(iv) As the taxpayer did not have PE in India, the advertisement revenue received in respect of matches played outside India which were telecast outside India was not taxable in India. The force of attraction also cannot apply merely because some viewers may be in India or advertisement may have some incremental value in India.

Facts:
The taxpayer was Singapore company (‘SingCo’) engaged in the business of sports coverage, production, distribution, event management, sponsorship, etc. SingCo was formed as a joint venture between two independent and unrelated companies, one was a Mauritius company and another was a BVI company. SingCo was a tax resident of Singapore and was wholly managed and controlled from Singapore. It had claimed that it did not have a fixed place PE, a service PE, an agency PE or any other type of PE in India. Pursuant to an International Bidding, SingCo entered into agreement with Prasar Bharti (‘PB’), a broadcaster owned by the Government of India for production of TV signals of international cricket events from February 2002 to October 2004 for which it received remuneration from PB. SingCo also received advertisement revenue outside India from certain advertisers in India.

The AO held: (i) that SingCo had a PE in India; (ii) its income was in the nature of FTS; and (iii) accordingly, in terms of section 44D read with section 115A, its gross receipts were taxable @20%. The AO further held that the advertisement revenue of SingCo was changeable to tax in India.

The issues before the Tribunal were as follows:

(i) Whether SingCo had a PE in India?

(ii) Whether receipts of SingCo from PB were business income of a taxpayer having no PE in India?

(iii) Whether gross receipts of SingCo from PB should be treated as FTS and taxed @10% as claimed by SingCo or @20% as held by AO?

(iv) Whether advertisement revenue received by SingCo in Singapore from Indian companies was taxable in India?

Held:
The Tribunal observed and held as follows.

(i) PE in India:

Contract was signed in Singapore and all activities relating to it were carried out from Singapore.

There was no evidence that the management and control of SingCo were not situated in India. Holding of mere one board meeting in India cannot lead to the conclusion that the control and management of SingCo was situated only in India.

On facts, affairs and management of SingCo were not carried out in India and SingCo was rightly held to be non-resident.

Further, SingCo had provided sufficient evidence to establish that while furnishing the services, the stay of its personnel in India was less than 90 days. Consequently, SingCo did not have a fixed place PE or service PE in India during the relevant years.

(ii) Nature of receipts:

The receipts of SingCo from PB were FTS as service of production and generation of live television signal rendered by SingCo was in the nature of technical service and SingCo had made available services which were based on technical knowledge, skill and know-how.

(iii) Applicable rate of tax:
In terms of Article 12(2) of the DTAA, taxability of FTS would be chargeable to tax @10% of the gross receipts.

(iv) Taxability of advertisement revenue:

The key fact is that SingCo did not have a PE in India, the advertisement revenue was in respect of the matches that were not played in India and the telecast of those matches was also not in India.

Hence, force of attraction cannot apply merely because some viewers may be in India and advertisement may have some incremental value in India.

As the dominant object of the Indian advertisers was advertising outside India, advertisement revenue cannot be attributed to India and in absence of PE, it was not taxable in India.

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Nirav Shah

Time to axe old laws that only harass the honest

The word ‘difficult’ often crops up in conversations, ranging from “it is difficult to do business in India” to “it is difficult to express oneself in India”.

The Jain Commission, in its ‘Report of the Commission on Review of Administrative Laws’ (September 1998), commented: “There is a perception among many people that despite a fairly extensive state intervention and a regulatory regime in our country, there is no real deterrence and effective enforcement for the benefit of society in general and the average citizen in particular.”

Under the Factories Act, 1948 — which with its statespecific rules reeks of the license raj — business entities have to ‘suffer’ inspections from various different government departments, and notices for even minor lapses are sent directly to directors. No wonder the World Bank’s ‘Ease of Doing Business’ ranking leaves India at 132nd place out of 183 countries.

The Jain Commission admitted that multiplicity and complexity of laws and rules, as well as lack of information about them leads to misuse (read facilitates corruption) and hampers growth. It sought repeal of over 1,300 central laws (including 11 British statutes). The Commission admitted that there isn’t even a rough estimate of similar state laws, which could run into several thousands. Since the Acts and the rules neither recognise current realities, nor do they facilitate compliance, there is a tendency to evolve mechanisms which are not in the interest of employees, employer or even the state. Harassment and circumvention emerge as the key conduct.

The National Law Commission down the years has also been giving its recommendations for repeal or revision of laws. Yet, apart from a one-stroke repeal of 315 Amendment Acts in March 2002, progress is pathetically slow. Owing to our legislative framework, a law or Act never dies unless specifically repealed.

As no one wants to take responsibility for repeal of old laws, the Jain Commission suggested adoption of the US or UK model. The UK, then, had in place a Deregulation and Contracting Out Act, 1994, which permitted the authorised minister to amend the provision of a legislation or repeal it through administrative orders (after inviting objections) so long as this reduced the burden imposed by that legislation. However, an outcry over dilution of the sanctity of the UK Parliament led to the repeal of this Act. Today in the UK, under The Legislative and Regulatory Reform Act, 2006, legislations can be repealed by a Parliament resolution (a full-fledged time-consuming debate is not required).

The Jain Commission also suggested the US model with its sunset clauses. “There is no general or comprehensive requirement at the US federal level that all laws, or even specific categories of laws, must be reviewed, renewed, modified or set to expire. At the state level, however, sunset requirements are more common.

“While giving unprecedented rights to a minister for repeal of an Act may prove dangerous and even unconstitutional, perhaps the sunset clause mechanism could be explored,” says M. L. Bhakta, senior partner of law firm Kanga & Co. (Source: The Times of India dated 29-11-2012)

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Nirav Shah

Stem The Rot – IOA and IABF suspensions must trigger a reclamation of sport from self-serving politicians

The decision of the International Boxing Association to provisionally suspend the Indian Amateur Boxing Federation (IABF) for irregularities in the latter’s recent elections exposes the rot within sports administration in the country. That the IABF suspension follows that of the Indian Olympic Association (IOA) is not surprising either, the common link between the two being new IOA president Abhey Singh Chautala. The Haryana politician had contested the IOA elections as a representative of the IABF. In September, Chautala was nominated to the newly created post of IABF chairman to circumvent the government’s sports code that stipulates tenure and age limits for sports officials. Meanwhile, the Archery Association of India, whose president V K Malhotra has served in that position for 40 years, was also derecognised by the sports ministry for violating the sports code.

All of this exemplifies the vice-like grip of politicians over Indian sports. Elections to the various sports bodies are straightforward political contests with little thought given to electing the right man for the right job. In several cases the same political personality is seen to be holding critical administrative positions in multiple sports federations for years together. Ironically, politicians who rarely see eye to eye on public policy matters have no qualms about collaborating on sports. Hence, tainted Congress leader Suresh Kalmadi is seen supporting INLD’s Chautala’s candidature in the IOA. This incestuous politicians’ clique is eating away at the innards of Indian sport.

Noxious politicisation is the primary reason why a country of 1.2 billion people produces so few champions. Funding for sports bodies is a waste, as politicians and their appointees use it to disburse patronage. The existing system needs to be dismantled and a new one put in its place. Politicians have no business governing sports and must give way to former sportspersons or other professionals associated with sport. With their knowledge of and feel for sport they can mentor young athletes and raise sporting standards many times over.

(Source: The Times of India dated 10-12-2012)

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Nirav Shah

Correlation between Economic Growth & Corruption

Which countries in the world are the least corrupt, according to Transparency International’s (TI) latest Corruption Perceptions Index? Denmark, Finland, New Zealand, Sweden, Singapore and Switzerland. Their average per capita income: INR3,403,668. And which are the most corrupt (the word is applied only to the public sector — so, essentially, government corruption)? Somalia, North Korea, Afghanistan, Sudan and Myanmar. Their average per capita income? Less than INR61,885. The richest countries are also the cleanest, while the poorest are perceived as the most corrupt. The question begs itself: do corruption levels mirror per capita income levels, just as the United Nations’ human development index does? So it would seem, from a closer look at TI’s latest list of 174 countries, ranked using information from 13 different international data sources.

Take India. TI ranks it 94th out of 174 countries. But of the 93 countries that have a better corruption ranking, as many as 86 also do better on per capita income. Only seven countries that are poorer than India manage to do better on corruption. Six of them, interestingly, are in Africa (Rwanda, Lesotho, Liberia, Zambia, Malawi and Burkina Faso), so parts of that continent are doing some things better than us in India. Look then at the South Asia corruption scores, and the picture is generally consistent: corruption perceptions usually improve as incomes rise. Bhutan has the second highest per capita income (INR127,050) and also the best corruption rank (33). That is followed by Sri Lanka (INR178,228 and rank of 79), and then India (INR93,508 and corruption rank of 94). The poorer neighbours (Pakistan, Bangladesh, Nepal) also do worse on corruption, ranking between 139 and 144. The moral in the numbers seems to be clear: get rich and your country is also likely to become clean (or at least cleaner).

(Source: “Weekend Ruminations” by T.N. Ninan in Business Standard dated 08-12-2012)

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Nirav Shah

Scams, retro tax hurt India’s image: Ratan Tata

Ratan Tata, outgoing chairman of the Tata group, is “rattled” by India’s current image emerging from scams and retrospective taxation, and wants the government to give an “irreversible commitment” that the law of the land has sanctity.

“Never before has India had that kind of image,” Tata said in an interview. India has been “hurt” by scams, court process and some of the retrospective taxation acts which had given “a sense of uncertainty to investors in terms of the credibility of the government”, he said.

“You get FIPB approval to invest in India and to own a company, you get a licence to operate and then, three years later, the same government… tells you that your licences are illegal and that you have lost everything. This leads to a great deal of uncertainty. Never before has India had that kind of image. So that really rattled me because then anything can happen,” the Tata patriarch said.

India must give an “irreversible commitment” that law of the land has sanctity and the government approval cannot be taken lightly, he emphasised, adding “otherwise India would be taken lightly”. (Source : The Times of India dated 10-12-2012)

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Nirav Shah

European Union wants member states to adopt common general anti-avoidance rules

Indian tax authorities have got support for the much criticised anti-tax avoidance rules from European Commission, giving it the necessary backing to take a decision on the stalled proposal.

The executive body of the 27-member European Union has drawn up an action plan to combat tax evasion and avoidance and wants member states 530 (2013) 44-B BCAJ to adopt a common general anti-avoidance rules, or GAAR.

India has deferred the implementation of GAAR by a year after domestic and foreign investors voiced concerns, and it could be pushed to 2016-17 if the country accepts recommendations of the review committee.

The recommendations are with Manmohan Singh, but a decision has been difficult because of opposition from tax authorities that are not in favour of any further delay in the rules that they feel is necessary to curb tax evasion.

Shome committee had suggested a three-year deferral, arguing that the administrative machinery was not ready. GAAR rules seek to deny tax benefit to any arrangement that is entered into with the sole objective of avoiding taxes. Though primarily targeted at foreign investors coming into India through the tax havens and Mauritius, the rule could well apply to domestic structures as well, which has worried the domestic industry. Worried foreign investors had pressed sales in stock markets fearing the law would apply to their investments routed through Mauritius. India Incs biggest fear was that the rules would leave too much discretionary powers in the hands of income tax officials leading to their harassment.

(Source: The Economic Times dated 10-12-2012)

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Nirav Shah

The ‘Ugly Indian’?

Most people in India have assumed that the Maldives is guilty of breach of contract in the case of the Malé airport, and GMR the victim. But is there another side to the story? The contract was a revenue-sharing arrangement (one per cent till 2014, 10 per cent after that; also 15 per cent and 27 per cent revenue share on fuel). The contract allowed GMR to charge an airport development fee (users of Delhi airport, also run by GMR, will be familiar with this issue). The issue went to court in Malé, which in late 2011 struck down the fee as illegal. The Maldives then allowed GMR to set off its revenue share against the fee that might have been collected. The consequences became clear in the first quarter of 2012, when a revenue share for the Maldives of INR538 million was reduced to INR31 million after setting off the airport fee. By the second quarter, the Maldives instead of receiving revenue share was asked to pay INR93 million; the bill climbed further in the third quarter, totalling INR217 million. The new Maldives government feared that, far from receiving an expected INR62 billion, it might end up paying massive sums to GMR over the 25-year period of the contract, extendable by 10 years. Abrogation of the agreement followed. Readers will see parallels with the Enron/Dabhol case, where Maharashtra was in the position of the Maldives government: stuck with a contract that would ruin the state, but faced with severe penalties if it walked away. India eventually paid a price for throwing out Enron, and that may well be the fate awaiting the Maldives. Where should our sympathies lie?

Cut to another case. Back in 2011, Pankaj Oswal was riding high; his company in Western Australia was supremely profitable, and he and his wife set up an extravagant home outside Perth that got a lot of press attention. Soon, however, the headlines became negative; there were allegations of money being siphoned out of Burrup Fertiliser to privately held firms in Singapore, and Burrup went into receivership. Mr Oswal and his wife left Australia and their fancy home outside Perth, and are said to be in Dubai or Singapore.

The question to be asked, as more and more Indian businessmen invest overseas, is whether we are risking the birth of the “ Ugly Indian”. Lakshmi Mittal’s problems in France, where the French government has threatened to nationalise a unit of Arcelor Mittal, would seem to have more to do with the vagaries of French politics. But there is also the case of Jindal Steel and Power (JSP), which had to exit Bolivia in May. JSP had made headlines in 2007 by bagging the world’s largest untapped iron ore mine, and agreeing to set up a steel plant in Bolivia. Amid a welter of charges and counter-charges, a new Bolivian government said the company had not fulfilled its investment targets, while it said the government had not provided it with the required natural gas for fuel. End of project, no steel plant and no iron ore.

In both Bolivia and the Maldives, there was a change of government before contracts were cancelled. France too has seen a change of tune after the François Hollande government assumed office. India has its own history of throwing out companies after a change of government — Coca- Cola and IBM after the Janata came to power in 1977; Enron after the Shiv Sena government took charge in Maharashtra in 1995. Now the boot is on the other foot, and poses tricky challenges for Indian diplomacy (should the government automatically back Indian companies?), as well as for India’s entrepreneurs. Companies get into all manner of scrapes in the crony-capitalist business environment at home (Jindal in the coalgate affair, GMR over the Delhi airport), but continue doing business; thet consequences in another country are quite different, and also on a wider plane.
(Source: “Weekend Ruminations” by T.N. Ninan in Business Standard dated 01-12-2012)

Nirav Shah

Chains of gold – Reduce Gold imports, but don’t punish those holding gold

The import of two items contributes disproportionately to India’s record trade gap and current account deficit. One of these, namely energy imports, is unavoidable. The strong demand for the other item – gold – is driven by several factors and may perhaps be reduced. India imports up to a quarter of annual global production, and gold imports equal 75 per cent of the current account deficit. Gold has always been a traditional repository of savings, and households contribute 80 per cent of demand. An estimated 25,000 tonnes of bullion is held by Indian households. While that is an impressive stock of wealth, it is unproductive and earns no interest. It has, however, been an excellent hedge against inflation. In the last three years, high inflation and slow GDP growth have made alternative assets like equity and debt unattractive. At the same time, gold has gained against hard currencies, as debt-to-GDP ratios have hit worrying levels across the euro zone and the US.

The asset mis-allocation arising from a focus on gold is unlikely to change until there’s an economic rebound. The policy priority now should be to reduce imports, without depriving investors of possible upsides from holding the metal. The gems and jewellery industry has suggested ways in which domestic institutions could release some holdings for exports via, say, “working capital” loans of gold. A scheme where individual Indians can sell gold for hard currency may help reverse the one-way flow, but this is probably too radical for the mandarins to consider. Creative financial engineering could perhaps find other ways to unlock that store of 25,000 tonnes. RBI Deputy Governor Subir Gokarn recently suggested offering gold-backed bonds or reverse mortgage schemes on household holdings of the metal. Previous experiments with such schemes have not been successful. This was partly due to rigidity in income-tax treatment and also because jewellery had to be melted down. Any new scheme would have to be structured to circumvent such known issues — but, given the trend, the sooner such ideas are implemented, the better.

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Nirav Shah

Representation to CBDT on Tas

Comments on Final Report of Accounting Standards Committee

The Committee constituted for formulating accounting standards for notification under section 145(2) of the Income Tax Act, 1961 has submitted its final report. We give below our comments and suggestions on the recommendations of the committee. General

1. It is submitted that there is absolutely no need for notifying a different set of Tax Accounting Standards (TAS) for the purpose of computing income under the provisions of the Income-tax Act.

Though phased introduction of Ind-AS would mean that some taxpayers would be following Ind-AS while others would be following AS notified under the Company Rules, even today the position is that corporates are following Accounting Standards notified under the Company Rules, while non-corporates are following Accounting Standards issued by ICAI. Each set of taxpayers may be permitted to compute their taxable income as per the relevant accounting standards applicable to each of them.

2. One of the stated purposes of TAS is to harmonise the accounting standards issued by ICAI with the direct tax laws in India. It is submitted that the accounting standards are already in harmony with the provisions of the direct tax laws in India, since the commencement of computation of business profits, is from the profit as per the profit and loss account. The deviations from the accounting standards are in relation to specific allowances and disallowances provided for under the Income Tax Act. If the desire is really to harmonise the two, then it is the Income Tax Act which really needs to be amended to remove such artificial allowances and disallowances from the profits declared in the accounts prepared in accordance with accounting standards, and not have TAS which increases the number of differences between the profits as per accounts and the taxable income.

3. TAS are now meant to be the basis of computation of taxable income by a mere notification. This will open the door to amendments in the law without requiring amendments in the Act, and thereby the executive will be encroaching on the powers of the legislature. This would also amount to excessive delegation of authority.

4. It needs to be kept in mind that accounting standards have to follow commercial reality. Having accounting standards which are completely at variance with the commercial reality, such as TAS, will cause untold hardship to businesses.

5. From the recommendations of the Committee, it appears that the provisions of TAS are being utilised to overcome the ratio of various judgments, which were in favour of taxpayers, without having to take recourse to make amendments in the law, rather than for any harmonisation or to handle the transition to Ind-AS. The recommendations of the Committee are therefore not in accordance with its terms of reference. It is suggested that rather than having TAS which indirectly effect such amendments in the law, the law itself should be amended to overcome the ratio of those judgments, wherever it is thought that the law needs to be otherwise.

6. TAS will give rise to an enormous amount of litigation, as issues are likely to arise as to the meaning of various provisions of TAS. It is therefore suggested that there is no need for separate TAS, and amendments to the law would serve the purpose far better.

7. If at all TAS is to be introduced, all the TAS should not be introduced simultaneously. TAS should be introduced in a phased manner, over a few years, making it applicable first only to large companies, which have the wherewithal to implement TAS. Thereafter, applicability to other taxpayers may be considered, after taking into account the experience of implementation of TAS by large companies.

8. There are various disclosure requirements in various TAS. If accounts are not required to be drawn up in accordance with TAS, the question of any disclosure should not arise, particularly as there is currently no scope for any disclosures in the return of income. The disclosure requirements should therefore be deleted from TAS.

9. The notification No 9949 dated 25th January 1996 notifying the earlier two accounting standards under section 145(2) had clarified that those accounting standards applied only to taxpayers following the mercantile system of accounting. The interim draft of TAS also had such clarification. Such clarification is missing in the present draft, and needs to be rectified by clarifying that TAS do not apply to taxpayers following the cash method of accounting.

10. It is accepted internationally that small and medium enterprises should not have to follow the same complex accounting standards as those required for large companies, and there are therefore different and simpler accounting standards for such entities, besides exemption from certain standards. It is suggested that small and medium enterprises should be exempted from TAS as well, as they do not have the infrastructure or expertise to handle complex adjustments required by TAS.

11. It needs to be clarified that not following of TAS should not result in rejection of books of account under section 145(3), but result only in adjustment to the total income. Section 145(3) needs to be amended accordingly.

Chapter 3 – App roach Provision (1)(i) To avoid the requirement of maintaining two sets of books of account by the taxpayer, the Committee recommends that the accounting standards notified under the Act should be made applicable only to the computation of taxable income and a taxpayer should not be required to maintain books of account on the basis of accounting standards to be notified under the Act. Comments While such recommendation of not having to maintain separate books of account under TAS is laudable in theory, it is practically unworkable. The proposed Tax Accounting Standards (TAS) would result in wide variance between the figures as per the books of accounts and the figures for taxation purposes. Many of the recommended TAS would require maintenance of separate books of accounts in order to ensure that the computation is correct and proper.

For example, TAS (AP) removes the concept of materiality. Therefore, the expenditure debited in the books of accounts would be different from the expenditure claimed for tax purposes. In order to ensure that the valuation of stock under TAS (VI) takes into account all such expenditure claimed under TAS only, and not expenditure debited in the books of accounts, it would be necessary to maintain separate books of accounts under TAS. Similarly, in the case of TAS (CC), the requirement of expenses being capable of measured reliably is not a condition as it is under AS 7. There are various other deviations in the case of TAS (CC) from AS 7, which cannot effectively be computed properly without maintaining books of accounts in accordance with TAS. This would place an enormous compliance burden on all businesses, which are already suffering from excessive compliance requirements necessitating substantial expenditure and whose profitability is already under severe pressure on account of the global slowdown. This additional compliance burden will further reduce the competitiveness of Indian business.

Provision

(5) For ensuring compliance with the provisions of TAS by the taxpayer, the Committee recommends appropriate modification in the return of income. For tax audit cases, the Form 3CD should also be modified so that a tax auditor is required to certify that the computation of taxable income is made in accordance with the provisions of TAS.

Comments

The requirement of having a tax auditor certify that the computation of income is in accordance with TAS would add significantly to the costs of tax audit for taxpayers.

Further, currently the basis of the tax audit report is the books of account and the final accounts prepared from such books, which final accounts are certified or identified by the tax auditor. Since computation of income is not part of the books of account, it would not be possible for a tax auditor to certify that such computation is in accordance with TAS.

It would also be too onerous and an impossible obligation for an auditor to certify compliance with all TAS. Currently, an auditor expresses a true and fair view on the accounts, which are based on accounting standards, because it is impossible to express a true and correct view in respect of accounts. Given the fact that TAS does not recognize the concept of materiality, the auditor would have to certify compliance with each and every clause of TAS, which is an impossibility.

Chapter 4 – Harmonisation of Accounting Standards

AS 14 – Accounting for Amalgamations

Provision
4.4.2.3 The Committee also recommends that suitable amendments be made to the Act to provide certainty on the issue of allowability of depreciation on goodwill arising on amalgamation.

Comments

The Supreme Court, in the case of CIT v Smifs Securities Ltd 348 ITR 302, has already provided certainty on the issue, by holding that depreciation is allowable on such goodwill. There is therefore no need for any further certainty on the issue.

Annexure-D – Tax Accounting Standards [TAS]

Specific Standards

TAS (AP) – Accounting Policies

Provision

2(c) “Accrual’ refers to the assumption that revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the previous year to which they relate.

Comments

If TAS is not to be followed in maintenance of books of accounts, the question of recording such revenues and costs does not arise.

Provision

5.2.1.ii [of Chapter 5] AS- 1 recognises the concept of materiality for selection of accounting policies. Since the Act does not recognise the concept of materiality for the purpose of computation of taxable income, the same has not been incorporated in the TAS (AP).

Comments

Removal of the concept of materiality would result in substantial, impossible and non-productive work of determining adjustment of minor and trivial amounts, the compliance cost of which would far exceed the likely revenue from such adjustments. Besides, any such adjustments would be nullified in the subsequent year, and would ultimately be revenue neutral.

Provision

5(i) The treatment and presentation of transactions and events shall be governed by their substance and not merely by the legal form.

Comments

When TAS is not to be followed in maintenance of books of account, the question of presentation of a transaction or event should not arise. Also, it would be impossible to look at the substance of each and every transaction. The meaning of substance could also be subjective. Tax laws need to be specifically amended to provide for cases where substance is to be seen, rather than the form. For instance, would redeemable preference shares be regarded as borrowing for tax purposes, and dividend thereon be allowed as a deduction in computing taxable income? Would a holding company and its wholly owned subsidiary have to file consolidated tax returns?

Provision

5(ii) Marked to market loss or an expected loss shall not be recognised unless the recognition of such loss is in accordance with the provisions of any other Tax Accounting Standard.

Comments

The purpose seems to be to incorporate Instruction No. 3 of 2010 dated 23.3.2010 in respect of forex derivatives in the TAS. However, it is so widely worded that its scope is not restricted only to marked to market loss from foreign exchange derivative transactions. The words ‘marked to market loss’ or ‘expected loss’ are also not defined expressly in the TAS.

There could be various other situations, which may be interpreted as ‘marked to market loss’ or ‘expected loss’, such as valuation of investments, loss incurred due to fire or fraud, etc.

The provision for ‘marked to market loss’ or ‘expected loss’ should apply only in respect of derivatives transactions and not to any other transactions.

TAS (VI) – Valuation of Inventories

Provision
2(1)(a) Inventories are assets:

……

(iii) in the form of materials or supplies to be consumed in the production process or in the rendering of services.

Comments

The TAS proposes to include service providers also within its ambit, unlike AS-2 which did not cover service providers. Most professional service providers follow cash method of accounting. Accounting for inventory would be contrary to the cash method of accounting followed by them. It needs to be clarified that this provision would not apply to professional service providers, or service providers following cash method of accounting.

Provision

None

Comments

It needs to be kept in mind that valuation of inventory is a commercial concept, which is carried out as an interim measure to break up the income into different accounting periods. Any changes in inventory valuation have an opposite and equal effect in the next accounting period. There is therefore no need to have a separate tax treatment for valuation of inventory, which is different from that followed for accounting purposes. Given the fact that such valuation is tax neutral, the amount of effort required for computing inventory on a separate basis would add to administration costs without any corresponding benefit.

It is therefore suggested that there should be no separate TAS for valuation of inventory.

Provision

None

Comments

The TAS has eliminated Standard Cost as a method of valuation of inventory with a view to reduce litigation and alternatives. However, there has been hardly any litigation on account of an entity following Standard Cost method of valuation of inventory.

Standard cost method is being widely used by most large taxpayers. It is a well recognised method. Many large entities also use ERP like SAP. In such cases it will be next to impossible without incurring unreasonable cost to value inventory on Standard Cost basis for books of account and value the same again on either FIFO basis or Weighted Average basis for TAS.

Standard Cost method should be a permitted alternative under TAS.

TAS(PP) – Prior Period Expense

Provision

3 (2) Prior period expense shall not be considered as allowable deduction in the previous year in which it is recorded unless the person proves that such expense accrued during the said previous year.

Comments

The condition for allowability contained in subparagraph (2) can never be satisfied since, by definition in para 3(1), prior period expense is an error or omission, and therefore cannot have accrued in the previous year.

The portion beginning with “unless” and ending with “the said previous year” is accordingly meaningless, and should be deleted.

TAS(CC) – Construction Contracts Provision
2(1)(d) “Retentions” are amounts of progress billings which are not paid until the satisfaction of conditions specified in the contract for the payment of such amounts or until defects have been rectified.

9. Contract revenue shall comprise of:

(a) the initial amount of revenue agreed in the contract, including retentions;

Comments

Retentions can never be income, because the right to receive such amounts comes into existence only after fulfilment of the specified conditions. It is therefore suggested that retentions should not be treated as part of contract revenue. Further, if retentions are not released but are adjusted, due to the fact that the specified conditions are not met and if retention is regarded as contract revenue under TAS, subsequent non-realisation cannot be claimed as a deduction, since such retentions would not appear in the books of account and cannot be written off in the books of account.

Provision

13. Contract costs include the costs attributable to a contract for the period from the date of securing the contract to the final completion of the contract. Costs that are incurred in securing the contract are also included as part of the contract costs, provided

(a) they can be separately identified; and

(b) it is probable that the contract shall be obtained.

Comments

There could be litigation as to whether costs can be separately identified or not, and whether there is a probability or not that the contract shall be obtained. It is suggested that costs incurred in obtaining the contract should therefore be allowed as a deduction in the period in which they are incurred.

Provision

15. Contract revenue and contract costs associated with the construction contract should be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the reporting date.

16. The recognition of revenue and expenses by reference to the stage of completion of a contract is referred to as the percentage of completion method. Under this method, contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and profit which can be attributed to the proportion of work completed.

17. The stage of completion of a contract shall be determined with reference to:

(a) the proportion that contract costs incurred for work performed up to the reporting date bear to the estimated total contract costs; or…..

Comments

Under the percentage of completion method, revenue is recognized depending upon stage of completion which in turn is determined with reference to costs incurred. Therefore, the question of recognising costs incurred by reference to stage of completion of the contract activity at the reporting date, as is mentioned in para 15, does not arise and should be deleted.

Provision

17. The stage of completion of a contract shall be determined with reference to:

(a) the proportion that contract costs incurred for work performed up to the reporting date bear to the estimated total contract costs; or

(b) surveys of work performed; or

Para 17 of TAS provides for 3 methods of determining stage of completion. Controversies are likely to arise in case the assessee determines the stage of completion by one method and the AO wants to determine the same by another method. The different methods followed may lead to different stages of completion resulting in different amounts to be recognized as contract revenues. The TAS should expressly provide that it shall be the choice of the assessee to follow any one of the above methods.

TAS(RR) – Revenue Recognition Provision
4. Where the ability to assess the ultimate collection with reasonable certainty is lacking at the time of raising any claim for escalation of price and export incentives, revenue recognition in respect of such claim shall be postponed to the extent of uncertainty involved.

Comments

The TAS does not allow postponement of recognition of revenue (other than claims for price escalation and export incentives) in a case where the ability to assess the ultimate collection with reasonable certainty is lacking. This is clearly against the principle of accrual, where there has to be reasonable certainty of receipt for an income to have accrued; and also against the principle of prudence. This is also against the commercial reality of business, whereby an amount which is unlikely to be realized, is not treated as income.

Furthermore, in such cases, the assessee may not be able to make a claim for bad debts, since bad debts are now allowable only in the year in which they are written off in the accounts of the assessee and in the instant case, no write off would be effected in the books of account of the assessee.

It is therefore suggested that the requirement of reasonable certainty of ultimate collection should be the basis for revenue recognition for all types of income.

Provision

5. Revenue from service transactions shall be recognised by the percentage completion method.

Comments

The TAS states that revenue from service transaction sshall be recognised by the percentage completion method, as against AS 9 whereby the revenue from service transactions is recognised either by the proportionate completion method or by the completed service contract method. It is suggested that, in view of complications that may be involved in computing revenue as per the percentage completion method, especially in the case of persons having large number of small independent service contracts, an option may be kept open to the assesses to recognise the revenue from service transactions by the completed service contract method. This is at best a timing issue and as it is for bigger contracts covered by the TAS on Construction contracts, the percentage completion method is mandatory. If at all the percentage completion method is to be mandated, the same should be so mandated only where the total income of the assessee, or the contract value, exceeds a certain threshold, or for long duration contracts, in order to avoid computational hardships.

Professionals and other service providers following cash method of accounting should be excluded from the requirement of following the percentage of completion method.

TAS(FA) – Tangible Fixed Assets

Provision

19. The record of tangible fixed assets shall be maintained in the tangible fixed asset register containing the following details:
……………..

Comments

Currently, there is no statutory requirement of maintaining a fixed assets register by non-corporate entities. Many non-corporate entities may not be able to prepare such a register in the absence of details of Fixed Assets acquired in the past. Further, this does not serve any purpose, since the Income Tax Act does not recognise the individual identity of assets, but treats them as a block of assets. This requirement should be dispensed with, as it would unnecessarily add to compliance costs of small businesses.

Further, as clarified, TAS is not required to be followed in maintenance of books of account. That being the position, how is it possible to maintain fixed assets register under TAS, since fixed assets register is also a book of account?

TAS(FE) – Effects of Changes in Foreign Exchange Rates

Provision

9. The financial statements of an integral foreign operation shall be translated using the principles and procedures in paragraphs 4 to 7 as if the transactions of the foreign operation had been those of the person himself.

10.(1) In translating the financial statements of a non-integral foreign operation for a previous year, the person shall apply the following:
(a)   the assets and liabilities, both monetary and non-monetary, of the non-integral foreign operation shall be translated at the closing rate;
(b)   income and expense items of the non-integral foreign operation shall be translated at exchange rates at the dates of the transactions; and
(c)   all resulting exchange differences shall be recognised as income or as expenses in that previous year.

Comments

In most cases, it would be impossible to convert each and every income and expenditure transaction of an integral or non-integral foreign operation into rupees by applying the daily rates. It needs to be kept in mind that the accounts are maintained by the branch, and not by the Head Office, and this will involve an enormous amount of work of conversion, which may take weeks, if not months, in many cases, adding tremendously to compliance costs. It is suggested that where there are no significant fluctuations in exchange rates, adoption of periodical rates, such as a weekly rate or a monthly rate should be permitted, as permitted under AS 11.

Provision

12(5) Premium, discount or exchange difference on contracts that are intended for trading or speculation purposes, or that are entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction shall be recognised at the time of settlement.

Comments

Provision that `marked to market’ gains or losses will be recognised only on settlement should be eliminated. This only increases divergences between books of account kept on recognised accounting principles.

If at all, such provision should be restricted to contracts intended for trading or speculative purposes, and not to contracts to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction.

TAS(GG) – Government Grants Provision
6. Where the Government grant relates to a non-depreciable asset or assets of a person requiring fulfillment of certain obligations, the grant shall be recognised as income over the same period over which the cost of meeting such obligations is charged to income.

Comments

Such a grant is of a capital nature, and cannot therefore be recognised as income at all. The character of a receipt cannot be changed from capital to revenue, through a mere provision of a TAS.

Provision

4(2) Recognition of Government grant shall not be postponed beyond the date of actual receipt.

6. Where the Government grant relates to a non-depreciable asset or assets of a person requiring fulfillment of certain obligations, the grant shall be recognised as income over the same period over which the cost of meeting such obligations is charged to income.

Comments

The above two provisions are contradictory to each other, in that, one requires accounting for the grant on receipt, while the other permits spreading over of the grant over the period of fulfillment of obligations.

TAS(BC) – Borrowing Costs

Provision

2(1)(b) “qualifying asset” means:
(i) land, building, machinery, plant or furniture, being tangible assets;

(ii) know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature, being intangible assets;

(iii) inventories that require a period of twelve months or more to bring them to a saleable condition.

Comments

Under AS -16, Qualifying Asset is defined to mean an asset that necessarily takes a substantial period of time to get ready for intended use or sale. Substantial period of time is taken to be generally twelve months. Under TAS (BC), all tangible fixed assets and intangible assets are Qualifying Assets. The condition of twelve months to bring the asset to saleable condition is restricted only to items of inventory.

As a result, borrowing costs will have to be capitalised even when there is a short interval between time when funds are borrowed and the asset is put to use. Where the entity has borrowed generally, borrowing costs will have to be capitalised in nearly all cases. This will only complicate the workings and also lead to litigation on account of quantum to be capitalised. This is also contrary to the proviso to s.36(1)(iii), where interest paid for acquisition of an asset only for extension of existing business or profession is not treated as a revenue expenditure.

Provision

3. Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset shall be capitalised as part of the cost of that asset.

Comments

TAS (BC) contemplates capitalisation of borrowing cost to land as well. This will lead to substantial litigation on difference in view regarding the point of time when land is put to use. Will capitalisation cease once construction work commences on the land acquired for setting up a project or will it continue till the construction is complete? If some portion of the land is vacant for future expansion, will capitalisation of borrowing costs continue till expansion project is taken up?

It is suggested that borrowing costs relating to purchase of land should not be capitalised to the cost of the land.

Provision

6. “To the extent the funds borrowed generally and utilised for the purposes of acquisition of a qualifying asset, the amount of borrowing costs to be capitalised shall be computed in accordance with the following formula namely :-”

Comments

Paragraph 5.2.11(iv) of the Final Report states that AS-16 provides that judgement should be used for determining whether general borrowings have been utilised to fund Qualifying Assets. For this reason, the Final Report provides for a specific formula.

The formula comes into play only in cases where there are generally borrowed funds and these have been utilised for the purposes of acquisition of a qualifying asset. Accordingly, even under TAS, judgement will have to be used for determining whether borrowed funds have been utilised for acquisition of assets.

The formula prescribed by paragraph 6 of TAS for computing the amount to be capitalised in respect of generally borrowed funds is irrational. It does not take into account the period between the time when funds are borrowed and the asset is put to use (point of time of cessation of capitalisation), and would therefore often give absurd results.

It is therefore suggested that the requirement of capitalisation of general purpose borrowings should not be introduced. It is also contrary to the provisions of section 36(1)(iii).

Provision
None

Comments

Paragraph 5.2.11(v) of the Final Report states that to align with judicial precedents, provision regarding income on temporary investments of funds borrowed has been removed from TAS. During construction period, borrowed funds are utilised for making deposit as margin money, advance to contractors. Such interest earned goes to reduce the amount of interest paid. It is only the net interest paid which should be capitalised. This aspect should be incorporated in TAS.

TAS(IA) – Intangible Assets

Provision

10. When an intangible asset is acquired in exchange for shares or other securities the asset shall be recorded at its fair value or the fair value of the securities issued, whichever is lower.

13. When an intangible asset is acquired in exchange for another asset, its actual cost shall be recorded at its fair value or the fair value of the asset given up, whichever is lower.

[Refer Chapter 7, para 7.1.1]

Comments
It is true that throughout all the TAS, wherever there is an exchange of asset for another asset or securities, lower of the fair market value of the asset acquired and securities or asset given up is adopted. However, in case of an intangible asset, it is difficult to ascertain the fair market value where there is exchange.

Consequentially, it would be difficult to arrive at value which is lower. This would only increase litigation.

TAS(PC) – Provisions, Contingent Liabilities & Contingent Assets

Provision

11. Contingent assets are assessed continually and when it becomes reasonably certain that inflow of economic benefit will arise, the asset and related income are recognised in the previous year in which the change occurs.

Comments

By recognising contingent assets on reasonable certainty in tax computation, but not in books of account, on subsequent non-realisability of such asset, the taxpayer will never get a deduction for write off of such amount, since no entry for such asset is passed in the books of account on account of the fact that there was no virtual certainty when it was recognised for tax purposes.

Nirav Shah

Incorporation of the Corporate Social Responsibility Provision in the New Companies Bill

Clause 135 of the Companies Bill, 2011 inter alia, provides for the specified companies to spend at least 2% of the average net profits (of last 3 years) in pursuance of the company’s Corporate Social Responsibilities (CSR) policy and in case of failure, to specify the reasons for not spending such amount in the Board’s Report. Further, in case the disclosure about such reasons in the Board’s report is not made, the specified class of companies shall be liable for action under the provisions of the Companies Bill, 2011 which require disclosures to be made in the Board’s report. CSR policy is to be undertaken by the companies as specified in schedule VII of the Companies Bill, 2011.

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Nirav Shah

Filing of Balance Sheet and Profit and Loss Account in XBRL mode for the financial year commencing on or after 01.04.2011.

Vide Circular No 39/2012 dated 12.12.2012, the Ministry of Corporate Affairs has extended the time limit for filing of financial Statements in the XBRL mode without any additional fee/penalty to 15th January 2013 or within 30 days from the date of the AGM, whichever is later. Further the other terms and conditions of General Circular No 16/2012 dated 06.07.2012 will remain the same.

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Nirav Shah

A. P. (DIR Series) Circular No. 63 dated 20th December, 2012 External Commercial Borrowings (ECB) for Micro Finance Institutions (MFIs) and Non-Government Organizations (NGOs) – engaged in micro finance activities under Automatic Route

This circular requires Banks to ensure, at the time of drawn down of ECB, that the foreign exchange exposure of Micro Finance Institutions and Non-Government Organisations engaged in micro finance activities is fully hedged.

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Nirav Shah

A. P. (DIR Series) Circular No. 60 dated 14th December, 2012

External Commercial Borrowings (ECB) Policy – Review of all-in-cost ceiling

This circular states that the present all-in-cost ceiling for ECB, as mentioned below, will continue till 31st March, 2013: –

Sr.

No.

Average
Maturity Period

All-in-cost
over 6 month LIBOR for the respective currency of borrowing or
applicable benchmark

Three
years and up to five years

350
bps

More
than five years

500
bps

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Nirav Shah

Tax Accounting Standards: A new way of computing taxable income

In our previous article, we had covered the approach for formulation of the Tax Accounting Standards by the CBDT Committee (the Committee), final recommendations of the Committee and some of the important implications of the TAS around areas such as accounting policies, inventories, prior period expenses, construction contracts, revenue recognition and fixed assets. In this article, we will cover some other important areas which would be impacted and lead to different taxable incomes under the proposed TAS regime.

The effects of changes in foreign exchange rates

• Unlike AS 11, under TAS all foreign currency transactions will have to be recorded at the exchange rate prevalent on the date of the transactions. TAS eliminates the option for entities to recognise foreign currency transactions at an average rate for a week or month when the exchange rate does not fluctuate significantly. This may lead to practical challenges with no significant benefits in reporting.

• Unlike AS 11 wherein exchange differences on translation of non-integral foreign operations are required to be recorded in reserves i.e. foreign currency translation reserve account, TAS requires these exchange differences to be recognised in the profit and loss account as income or expense. This treatment appears to be based on the analysis that the Income Tax Act, 1961 (‘the Act’) does not distinguish between the tax treatment of incorporating the results of branches that may qualify as non-integral from those that qualify as integral. However, as per TAS, there is a measurement difference in quantification of impact of exchange differences between integral and non-integral foreign operation.

For instance, fixed assets and other non-monetary assets of non-integral foreign operations are measured at closing rates whereas such assets are not re-measured in case of integral operations. Prior to the TAS, where the foreign currency exposures on existing monetary items were hedged through options, any exchange loss on the foreign currency monetary item was claimed as a deduction, but any corresponding unrecognised gain on the option contract may have been ignored, if the company determined that such contracts were not directly covered by AS 11.

However, the TAS now includes foreign currency option contracts and other similar contracts within the ambit of forward exchange contracts. When these contracts are entered into for hedging recognised assets or liabilities, the premium or discount is amortised over the life of the contract and the spot exchange differences are recognised in the computation of taxable income. Although this treatment may not be in line with current accounting and tax practices, it brings in uniformity in the treatment of foreign currency options and forward contracts to the extent that they seek to hedge a recognised asset or liability.

• The premium, discount or exchange differences on all foreign currency derivatives that are intended for trading or speculation purposes or that are entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction are to be recognised only at the time of settlement of the contract. This is consistent with other provisions of the TAS to not recognise unrealised gains and losses.

• As per TAS, exchange differences on foreign currency borrowings, other than those specifically covered u/s. 43 A will be allowed as a deduction or will be taxed based on translation at the year-end spot rate.

Government grants

• As per AS 12, grants in the nature of promoters’ contribution are recorded directly in shareholders’ funds as a capital reserve. However, TAS does not permit the above capital approach for recording government grants.

• Under the TAS, all grants will either be reduced from the cost of the asset, or recorded over a period as income, or recorded as income immediately, depending on the nature of the grant.

• Under the TAS, grants related to non-depreciable assets such as land, shall be recognised as income over the same period over which the costs of meeting any underlying obligations are charged to income.

• AS 12 specifically provides that mere receipt of a grant is not necessarily conclusive evidence that conditions related to the grant will be fulfilled. Unlike AS 12, the TAS provides that the initial recognition of the grant cannot be postponed beyond the date of actual receipt.

Securities

• Unlike AS 13, the TAS covers securities held as stock–in-trade, but does not cover other securities.

• TAS provides that where an asset is acquired in exchange for another asset, shares or securities, its actual cost shall be the lower of the fair market value of the securities acquired or the assets/securities given up/issued. Unlike TAS, AS 13 requires that the actual cost in such cases shall be determined generally by reference to the fair market value of the consideration given.

• The TAS requires the comparison of cost and net realisable value for securities held as stock-in-trade to be assessed category-wise and not for each individual security. This may represent a significant change in practice for entities that currently do this comparison for each individual security.

• The TAS also provides that securities that are not quoted or are quoted irregularly shall be valued at cost. This could also represent a change in practice for some entities.

• Unlike AS 13 which allows the weighted average cost method for determination of cost for securities sold, TAS provides that the determination of such costs shall be made using the First in First Out method.

Borrowing costs

• Unlike AS 16, TAS requires capitalisation of borrowing costs for all covered assets irrespective of the period of construction. The only exception to this rule is for inventories, where the TAS requires capitalisation of borrowing costs to inventories that require more than 12 months to complete. In comparison, AS 16 defines a qualifying asset as an asset that necessarily takes a substantial period of time (generally understood as 12 months) to be ready for its intended use or sale. This could result in significant practical challenges to compute capitalisation of borrowing costs in all such cases. Under the TAS, the actual overall borrowing cost (other than borrowing costs on loans taken specifically for a qualifying asset) is allocated to qualifying asset (other than those funded through specific borrowings) based on the ratio of their average carrying value to the average total assets of the company. It should be noted that, while this allocation approach may be simple to apply, it may result in unintended consequences.

For example, assume that construction on a qualifying asset commences on 2nd April and the asset is put to use on 30th March of a previous year. Under the proposed approach, since the qualifying asset is not under construction either on the first day or the last day of the previous year, the average cost may be determined to be Nil. This could result in no allocation of borrowing costs to such an asset.

• Under TAS, in the case of loans borrowed specifically for acquisition of qualifying asset, capitalisation of borrowing costs commences from the date on which the funds are borrowed. Whereas under AS 16, capitalisation of borrowing cost commences only if all three conditions are satisfied (a) expenditure on qualifying asset is being incurred (b) borrowing costs are being incurred and (c) activities that are necessary to prepare the asset for its intended use or sale are in progress.

• Currently, there is inconsistency in treatment of income from temporary deployment of unutilised funds from specific loans (to be considered as an adjustment to borrowing costs incurred or considered as a separate income). The TAS now provides that in case of specific loans, any income from temporary deployment of unutilised funds shall be treated as income. Along with the provision relating to capitalisation of borrowing costs on specific loans even in period prior to the construction activity, this may have a significant impact on the practices currently followed.

• TAS requires capitalisation of borrowing costs even if the active development is interrupted. Under AS 16, the capitalisation of borrowing cost is suspended during extended periods in which active development is interrupted. However, this provision in the TAS seems to clarify the requirements that already exist in the Act.

Leases

• Under the TAS, the lessor would not be entitled to depreciation on assets that are given on finance lease. TAS now provides that assets covered by a finance lease shall be capitalised and depreciated by the lessee like any other owned asset. Presently, the Act permits depreciation only on those assets that are owned by the assessee. As such, for a finance lease arrangement, it is generally the lessor that is entitled to the depreciation deduction and the lease rentals are taxed as income in the hands of the lessor. Since the Act overrides the TAS, suitable amendments may be required to the Act to facilitate this provision of the TAS.

• Similarly, assets given on finance lease by the manufacturer lessor would be considered as sold by lessor with a corresponding recognition of revenues and profits. The finance income component of the lease rental would be recognised as income over the lease term.

• The consequential impact of the above changes under various other provisions such as Tax Deduction at Source and benefits under Double Taxation Avoidance Agreements would need to be considered prior to implementation of the TAS.

• Under the TAS, same lease classification shall be made by the lessor and lessee for the lease transaction. A joint confirmation to that extent will have to be executed in a timely manner, in the absence of which the lessee would not be entitled to a depreciation deduction on such assets. It is currently unclear on whether the lessor would be eligible for a depreciation deduction in such cases.

• AS 19 requires a lease to be classified as a finance lease, if there is a transfer of substantial risks and rewards relating to the ownership of the leased asset. AS 19 accordingly provides several indicators for finance lease classification that have to be considered in totality based on the substance of the arrangement. These indicators do not necessarily individually result in classification as a finance lease. However, the TAS considers the existence of any one of the specified indicators as sufficient evidence for finance lease classification. This may result in a change in lease classification as compared to current practice, with a greater number of lease arrangements meeting the finance lease classification criteria.

• Under the TAS, the definition of minimum lease payment does not include residual value guaranteed by any party other than the lessee. This is to ensure that there is a uniform lease classification. Whereas under AS 19, in case of a lessor, the definition of minimum lease payment (which affects the lease classification into operating or finance lease) includes residual value guaranteed by the lessee or any other party. However, in case of the lessee, the definition of minimum lease payment includes only the residual value guaranteed by the lessee. This difference may at times result in different lease classification for lessor and lessee under AS 19.

• Unlike AS 19 where initial direct costs incurred in negotiating and arranging a lease can be recognised upfront or over time, under TAS the upfront recognition of initial direct cost for the lessor is not permitted. Prior to TAS, in the absence of specific guidance under the Act, the tax treatment was in line with the requirements of the accounting standards.

Intangible assets

• TAS excludes goodwill from its scope, whereas AS 26 includes goodwill arising on acquisition of a group of assets that constitute a business (for example, slump sale). In the absence of specific provisions in the TAS, the current practice in this area (that has emerged based on judicial pronouncements) may prevail.

• For internally developed intangible assets, TAS does not provide any guidance on scenarios, where the development phase of a project cannot be distinguished from the research phase. Hence, the assessee would need to establish clearly whether the costs relate to the research phase or the development phase. Unlike TAS, AS 26 provides that in case the development phase of a project cannot be distinguished from the research phase, then the entire costs are recognised as part of research phase and consequently charged as expense.

• Under the TAS, development costs cannot be expensed merely on grounds of uncertainty around the commercial feasibility. If other criteria for capitalisation are met, the same should be capitalised. Unlike TAS, AS 26 requires companies to establish commercial feasibility of the project for determining capitalisation of development costs.

• Under the TAS, in the case of acquisition of an intangible asset in exchange for another asset, shares or other securities, the actual cost shall be the lower of the fair market value of the asset acquired or the fair value of the asset given up/securities issued. Unlike TAS, AS 26 provides that in such cases, the fair value of the asset/securities given up or fair value of the asset acquired, whichever is more clearly evident, should be recorded as actual cost.

Provisions, contingent liabilities and contingent assets

• AS 29 provides for recognising losses on onerous executory contracts, when the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. TAS excludes all executory contracts, including onerous contracts, from its scope. Accordingly, such unavoidable future losses cannot be currently recognised under the TAS. This is consistent with the general provisions under the TAS, which preclude recognition of unrealised gains and losses.

• Under the TAS, provision is required to be recognised if its existence is reasonably certain. In comparison, AS 29 requires the recognition of a provision if its existence is considered probable (more likely than not). This change from ‘probable’ to ‘reasonably certain’ may result in new interpretation issues.

• Under AS 29, contingent assets are not recognised unless the virtual certainty criteria is met. This is a very high threshold and generally such assets are not recognised until realised. However, under TAS, contingent assets are recognised when it is reasonably certain that an inflow of economic benefits will arise. Thus, the provisions of the TAS may accelerate the recognition of contingent assets and related income. This provision seems to have been inserted to bring in parity between the treatment of provisions for contingencies and treatment of contingent assets.

Summary

The final report of the Committee along with the draft TAS, represents a significant move towards providing a uniform basis for computation of tax-able income. Many of the differences between the TAS and the AS are intended to harmonise the basis for computation of taxable profits with the existing provisions of the Act. Companies would therefore have a comprehensive framework based on which adjustments may be made each year to their accounting profits to determine taxable income.

Some of the provisions of the TAS also represent a significant change or clarification in the tax position as compared to currently prevailing practices. These are broadly intended to cover aspects that have historically been a subject matter of litigation and diversity. Depending on the practices currently followed, a company may be affected significantly by these changes.

The report also indicates that additional guidance would be provided through TAS where there is currently no guidance, including areas such as real estate accounting, service concessions, financial instruments, share based payments and exploration activities. This will further strengthen the TAS framework in the future.

The draft TAS will also remove one of the significant impediments to adoption of Ind AS, since the TAS provides an independent framework for computation of taxable income, regardless of the accounting framework adopted by companies (Indian GAAP or Ind AS). However, an important consideration for adoption of Ind AS is the impact it will have on computation of the Minimum Alternate Tax (MAT), which is based on the accounting profits. The Committee did not address this issue in its Final Report. The main reasons cited were the uncertainty around the implementation date for Ind AS as well as the forthcoming changes in IFRS. The Committee has recommended that transition to Ind AS should be closely monitored and appropriate amendments relating to MAT should be considered in the future based on these developments.

The real benefit of providing a uniform framework for computing taxable income will only be achieved through a uniform and impartial implementation of TAS by the tax authorities and the judiciary. The tax authorities may consider issuance of internal implementation guidelines and training to ensure that the TAS are correctly applied and implemented at the field level.

Nirav Shah

GAP in GAAP ESOP issued by parent to the employees of unlisted subsidiary

The accounting for employee share-based payments is determined by two authoritative pronouncements, namely, SEBI’s Employee Stock Option Scheme and Employee Stock Purchase Scheme Guidelines, 1999, and ICAI’s guidance note on Employee Share-based Payments. Clause 3 of the SEBI’s guidelines states as follows: “these Guidelines shall apply to any company whose shares are listed on any recognised stock exchange in India.” Unlike SEBI guidelines, ICAI’s guidance note applies to all reporting entities whether listed or unlisted.

Consider a scenario, where a parent company issues ESOP’s to employees of its subsidiary. The question is who records the ESOP cost; the parent, the subsidiary or no one. As per the SEBI guidelines (which are applicable to all listed entities) the parent recognises the ESOP compensation cost because under the SEBI guidelines, an employee of a subsidiary is treated as an employee of the parent company for this purpose. Thus, if the parent of a listed subsidiary issues ESOPs to the subsidiaries employees, the listed subsidiary should not recognise the ESOP expense. As per the SEBI guidelines, the parent company is required to record the compensation cost. Typically, the requirement with respect to the parent recognising the ESOP compensation cost can be enforced only when the parent itself is a listed entity in India within the jurisdiction of SEBI. However, it cannot be enforced when the parent is in a foreign jurisdiction or is in India but is an unlisted entity.

In contrast to the SEBI guidelines, the ICAI guidance note provides as follows:

“10. An enterprise should recognise as an expense (except where service received qualifies to be included as a part of the cost of an asset) the services received in an equity-settled employee share-based payment plan when it receives the services, with a corresponding credit to an appropriate equity account, say, ‘ Stock Options Outstanding Account’. This account is transitional in nature as it gets ultimately transferred to another equity account such as share capital, securities premium account and/or general reserve as recommended in the subsequent paragraphs of this Guidance Note.

The underlying principle of the ICAI guidance note is that the ESOP related compensation costs should be accounted for as expense in the books of the enterprise whose employees receive the ESOP’s.

Further, paragraph 4 of the ICAI’s guidance note states as below:

“For the purposes of this Guidance Note, a transfer of shares or stock options of an enterprise by its shareholders to its employees is also an employee share-based payment, unless the transfer is clearly for a purpose other than payment for services rendered to the enterprise. This also applies to transfers of shares or stock options of the parent of the enterprise, or shares or stock options of another enterprise in the same group as the enterprise, to the employees of the enterprise”.

It can be inferred from the basic principle discussed in paragraphs above, that the ICAI guidance note requires a subsidiary company to recognise share based options granted by the parent company to its employees, even if the subsidiary does not have to settle the cost by making a payment to the parent. This position is consistent with the requirements of International Financial Reporting Standards (IFRS). Under IFRS,the recipient of services will record the cost of those services or benefits.

What is the issue?

In India, legislation prevails over the requirements of the accounting standards and other accounting promulgations such as the guidance notes issued by ICAI. Thus, SEBI guidelines would prevail over the ICAI guidance notes. Therefore, a listed subsidiary will not record ESOP costs, if the ESOPs were issued by the parent company to the employees of the subsidiary company.

Now, in the above example, what happens if the subsidiary is not a listed company in India. In such a case, SEBI guidelines are not applicable to unlisted companies but ICAI guidance note would certainly apply. When the ESOPs are issued by the parent company to the employees of the subsidiary, is it fair to require expensing of ESOP compensation cost in the case of an unlisted subsidiary, but not in the case of a listed subsidiary?

Under the circumstances, the author’s view is that “what is good for the goose, should be good for the gander”. In other words, the author does not support different accounting consequences purely on the basis of the listing status of the reporting entity. Thus, the author believes that the unlisted subsidiary company may not record ESOP compensation cost. This view can also be supported by the fact that the unlisted subsidiary company does not have any settlement obligation with the parent company.

In practice, there is diversity and it is noticed that there are some unlisted subsidiary companies which have recognised the ESOP compensation costs whilst other unlisted subsidiary companies have not. One challenge faced by the subsidiary companies when they record the ESOP compensation cost is with respect to the utilisation of capital reserves. Since the shares issued under the ESOP are of the parent company, in the absence of a re-charge by the parent to the subsidiary, the corresponding credit will be given to the capital reserve (akin to an investment made by the parent company in the subsidiary). This reserve will accumulate over the years. However, the utilisation or remittance of this reserve back to its parent company in the future, would not be easy in the light of restrictions under Companies Act, 1956, the Income Tax Act, 1961, FEMA, etc.

Conclusion

At this juncture, there is an accounting arbitrage available to unlisted subsidiary companies because of different accounting rules under the SEBI guidelines and the ICAI guidance note. For the future, SEBI should withdraw its guidelines, so that the arbitrage is removed and the ICAI guidance note which is based on true and fair view principles and aligned to IFRS (in this case) should be given preference.

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Nirav Shah

Social networking – Be careful out there – I

About this Article

Social networking is “hep” and the “in thing” nowadays. Entire generation Y is hooked on it. Undoubtedly, it is a convenient way to connect with family, friends and other people. But that’s the bright side, what most people don’t realise is that there is a dark side too. This article is aimed at highlighting some of the perils of social networking sites specifically related to the privacy of the account holder.

Background

Today, it’s a common feature to see teenagers hooked on to social networking sites all the time, as if it were a life support system. What’s more, teenagers are likely have several friends and connections online or in the virtual world, even when continents, distances and time zones may separate them. Sometimes, it is at the cost of having friends in the physical (or real) world.

Come to think of it, it really isn’t all that different from the past. I mean that, once upon a time it was “hep” to have pen friends, then email, bulletin boards and chat rooms became a fad. One could say that it’s the same old wine in a new bottle – today you have friends, followers and connections on Facebook, Twitter and Linkedin (to name a few popular social networking sites).

Agreed, it’s a convenient way to connect with family, friends and other people with common interest. And with the technological advances today, it’s almost effortless, because the site does all the work of finding all your “long lost” friends, colleagues and relatives. Many times, these sites offer “suggestions” regarding people you may be interested in connecting to or groups you may want to follow. This, you may say, is the bright side of social network. How- ever, what people don’t know (or care enough to know) is that there is a dark side as well.

“Nahhh!!!!! Can’t be!!!! Social networking is harmless banter, we are jus hangin out, what’s wrong with that?????

Chill yaar, you are just being paranoid.” I am sure that you have heard this before. Well, you are about to get a rude awakening.

The Dark Side

Couple of weeks ago, a furore was raised in the press and all over the internet, when 2 teenaged girls were hauled to the police station for posting some innocuous status updates on one of the popular social networking sites. While a lot is written on how the law enforcers should have acted, how draconian the internet law is when it came to the freedom of speech and of course, the whole debate of what should be done (or should not be done) and who is responsible (or irresponsible). Despite all this noise and chatter about the who, what, where and when, most people missed out on a little known ‘open secret’. What’s this ‘open secret’ you may ask.

Well, forget all the chatter and the noise for a moment and think, how many people actually gave a thought to the following:

• How did the mob come to know of the “personal” post?

• Were they friends with the teen who posted the message?

• Did the teen intend that persons other than her “friends” see the post/tweet?

• Can persons other than one’s friends see his/ her posts/tweets?

• How can anyone see my posts /tweets?

• And of course, the million dollar question that begs to be answered –

How did they get the address of the teen who posted the update and the vital information that the teen was located within (ahem) striking distance? This question becomes a ten million dollar question when you ask, if they were not friends and they were not connected, were they supposed (allowed) to see such personal information (i.e., Location of the person putting up the post).

In all the printed press, news reports, countless Tweets and Facebook updates there is hardly a peep into these questions. If you were a conspiracy theorist, you would know for sure that “something just ain’t right here”. You may have guessed it by now …. Nobody noticed (and all probability likely to remain unnoticed) that the real transgression was the “a compromise of the privacy of your personal data”.

By the way, if you didn’t ask this question earlier, then it would be a good indicator that you too have chosen to remain blissfully unaware of “what’s out there”.

The Ugly Truth

SOCIAL NETWORKS AREN’T RESPONSIBLE FOR YOUR PRIVACY – YOU ARE. What most people (individuals who use social media regularly and extensively) is that you are parting with some very vital and sensitive personal information right from the time that you open an account with these social networking sites. It’s pretty standard to give information such as your full name, where you live, what you do, what you like (or dislike), your date of birth. You post pictures of you and your family, your precious possessions, your triumphs, etc. And to top it all, you literally “strive” to keep this information updated every day (and in some cases-every waking moment). You take solace (my view–choose to remain blissfully unaware) in thinking that:

• this information is with the site;

• it’s secure, behind layers of security;

• they have a privacy policy, they can’t share it with any one;

• only my friends and connection can see it;

• It’s harmless banter (yeah!!!, really!!! Do make it a point to tell it to the mob when they come visiting);

• I will delete it after some time But as they say “Ideal and real” are two completely different and mutually exclusive things. Some open secrets that you must know:

Default Settings:

When you sign up, the social networking site sets your privacy controls to “default settings”. I am sure there would be several instances wherein you have accepted the prompt that the settings are at default albeit without really checking or understanding what “default settings” really means. In some cases, default means that everyone can read your post and access all the information that you give the site.

Changes in Privacy Policies

While some people are wise enough to check what the default setting is, they sometimes fail to keep track of changes in the privacy policy of the social networking site. What people do not account for is that Privacy Policies can change. In some cases, these site notify you, but in many cases, by continuing to access the site or using the service you “by default” agree to the revised Privacy Policy. How is that possible you ask, I have a right to be informed, they have to tell me !!!.

Don’t they ?????? All these questions are the types you ask after reality knocks you down. The truth is that, it all boils down to terms and conditions of service, YESSSSS, the one’s where you click “AGREED” without even bothering to read what they say, let alone understanding what the implications are.

Somewhere in the fine print, there are terms which say that “the service provider is at a liberty to alter the terms of Privacy Policy and that it is your obligation to look them up on a regular basis. Further that, if you continue to use the site, it will be presumed that you have read the Privacy Policy and have agreed to the revised terms.

Here is a question for you. Google and Facebook both have revised the terms of the Privacy Policy (mainly their Policy on what data will be collected and how they intend to use it). They were “kind” enough to send a mail/notification about the change and date from when the policy will become effective. How many of you saw this mail in your inbox/notification when you visited the site? More importantly, how many of you made an attempt to see “broadly” what changes are likely to take place. If you haven’t done it as yet, then be rest assured that you will have no one but yourself to blame.

Apps and Games

If you think that you have covered all bases by reading the Privacy Policy and having understood the terms have agreed to it and acted very cautiously, even then one could say you have left yourself exposed. Sure you read the Policy for the hosting site, but what about the apps/ games that are made available on the site? More often that not, if your friend has been using it or recommends it, you too sign up because you want to be with the gang and cannot fall behind. Well, if that is the case, I would say you covered the pin holes, but left the manholes wide open. It is quite possible that these app/ games/utilities may have a policy which is quite different from the hosting site and it might not be very protective.

Difference Between Free and Freemium

Just because the service is free or it doesn’t cost you anything doesn’t mean that there is no cost attached. It only means that the cost of providing service to you is being borne/ subsidised by someone else i.e. what is offered to you for free is sold to someone else for a premium (hence the word freemium). Everybody and I mean everybody (there may be a few exceptions like the Khan Academy) who is providing some free service to you, is selling the data that you generate, in one way or the other, to somebody else. You may not believe it, but every time you say “you like something”, this data is collected, collated and analysed for future sale. Every comment about a product, a service, a brand, etc be it good or bad, is tracked and stored for future sale. Not only this, if you like a brand, there is a very high probability that the very same social networking site (if not this one then some other site also) will help the brand to sell “what you like” to your friends.

Paradox of Social Networking and Privacy:

It’s a paradox because, you are posting your personal and private data on a media whose reason for existence is to promote “openness”. So, on one hand you want the data to be in the public domain and at the same time, you don’t want anyone to see it. Funny isn’t it!!!! Reminds me of the famous quote from Shakespeare’s Hamlet “To be or not to be, that is the question”.

While there are several issues that still need to be dealt with, but woh kissa phir kabhie.

The next part of this series will focus on some tips on dos and don’ts while posting on social networking sites.

Disclaimer: The information/issues discussed in the above write-up is based on several news reports, articles, etc., available in the public domain. The purpose of this write- up is not to promote or malign any person or company or entity. The purpose is merely to create awareness and share the knowledge that is already available in the public domain.

Nirav Shah

Who am i?

Man has been eternally asking the question “Who am I?” Man is a seeker, a seeker who is in search of himself. Many seek, however, only a few find the answer.

Whenever someone asks us as to who we are, we give, in reply, our name, qualifications, age, position in life and sometimes our religion, our caste and the state and our country.

We give our visiting card which gives our name, education qualifications and organisation to which we belong and the position that we hold in the organisation. But the issue still remains: What are we! This is because even if all these are taken away, we still remain.

‘I’ is the word we use more than any other word in our day to day living. We say: I slept well. I said this, I did that, I enjoyed my meal; I like my work. It is always ‘I’ and ‘I’. I prevails our life and yet we never pause to enquire: who is this ‘I’: what is this ‘I’. In other words, we fail to enquire: Who am I.

“Know Thyself” is the message Socrates, the great philosopher gave to his pupils ages back. Bhagwan Shri Ramana Maharshi asks us to undertake a self enquiry as to “who am I?”

“I am that” Brihadaranyaka Upanishad thunders. It says. “That in whom reside all beings and who resides in all beings, who is the giver of grace to all, the supreme soul of the universe, the limitless beings – I am that.”

“you are that” says Chandogya Upanishad “That which permeates all, which nothing transcends and which, like the universal space around us, fills everything completely from within and without, that supreme non-dual Brahman – that thou art” – says Shankaracharya.

Sri Nisargadatta Maharaj says “give up all questions save one: Who Am I. After all the only fact you are sure of, is that ‘you are’. The “I am” is certain. The “I am this” is not. He teaches that to know who you are you must first investigate: what you are not. In our younger days we used to play a game of “Ten Questions” – The group was divided into two teams. The first selected some eminent personality and the other group had to find this out. This was done by asking ten questions. The answer was only to be given in terms of ‘Yes” or ‘No’ – By asking right questions, one went on eliminating possibilities, to find out the person selected by the first team.

The scriptures adopt a similar art of reasoning. We have to discover our self by finding out what we are not. The key to understand is : What is mine cannot be me. Your bungalow, your car, your diamond necklace are not you but they belong to you. Similarly it is true about our body. We speak of “my body”. The question is whose body? The moment we say that the body is mine, we accept that we are not the body. Whatever can be perceived or felt is an object. What perceives or feels is the subject. That is I. Similarly a thought also is an object, the thinker is the subject. Who is the perceiver, fetcher, thinker? We have to discover ‘him’ within us.

Reading that we are a soul and not the body, is one thing, understanding and accepting this is another thing and realising this is still another thing. For example – reading that Mount Everest is the highest mountain in the world and seeing Mount Everest are relatively easy but climbing Mount Everest is different. It is difficult and only a few courageous, adventurous persons can achieve this – the same is with finding: Who am I.

Let us be amongst the few who understand and accept that we are “not a body having soul but a soul having a body. This realisation will lead us to know : Who I am and experience true bliss – the bliss which lies within us. As Brahmakumaris teaches us “I am a peaceful soul”.

Bhagwat Gita explains in very simply terms:

“I am that which will still remain even when my body is cremated and reduced to ashes.”

Let us yearn, pray and succeed in searching and finding the answer to the eternal question: who am I? I conclude by quoting from Shankara’s Nirvana Shatakam:

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Nirav Shah

Merieux Alliance & Groupe Industrial Marcel Dassault, In re (Unreported) AAR Nos. 846 & 847 of 2009 Article 14(5) of India-French DTAA Dated: 28-11-2011 Counsel for assessee/revenue: Porus Kaka, Manish Kanth, B. M. Singh, Dominique Tazikawa, Rohan Shah, Rohit Jain, Parth Contractor, Kumar Visalaksh/Girish Dave, Gangadhar Panda

French residents transferred shares of a French company to another French resident. The only business/asset of the French company were shares comprising 80% equity shares in an Indian company. Since the transfer resulted in transfer of underlying assets and control of Indian company, on purposive interpretation, gains arising from the transfer were liable to tax in India.

Facts:
Merieux Alliance (‘MA’) & Groupe Industrial Marcel Dassault (‘GIMD’) (jointly referred to as the applicants) were French companies. MA incorporated wholly-owned subsidiary (‘ShanH’) in France. MA acquired 80% equity shares of an Indian company (‘Shantha’) from shareholders of Shantha in the name of ShanH. Due diligence, funding and payment of stamp duty for the purchase was done by MA. Subsequently, GIMD and a foreign individual acquired 20% of the shares in ShanH from MA. In 2009, MA and GIMD sold their holding in ShanH to Sanofi, another French company.

On the basis of the information available with it, the tax authority initiated proceedings against Sanofi for failure to withhold tax from payment made to MA and GIMD. In view of the proceedings, the applicant approached AAR for its ruling on the following issues:

(i) Whether capital gains arising from transfer of shares of ShanH, a French company, were changeable to tax in India, either under the Act or under the DTAA?

(ii) Without prejudice to (i), whether transfer of controlling interest (assuming, while denying that it is a separate asset) is liable to be taxed in France under Article 14(6) of the DTAA?

The applicant contended as follows :

The shares transferred were of a French company and therefore, such transfer cannot be taxed either under the Act or under the DTAA.

Acquiring shares of Shantha through a subsidiary was a legitimate business route.

As per the Supreme Court in Azadi Bachao Andolan, the Revenue cannot go behind the transaction since it was not permissible to ignore the corporate structure, the tax residency certificate and the fact that the transaction was recognised by the Government of India.

As the capital gains from transfer of shares of a French company were taxable in France, there was no question of tax evasion or treaty shopping.

A taxing statute should be construed strictly and nothing is to be added and subtracted. The concepts of ‘underlying assets’ and ‘controlling interest’ cannot be reckoned while interpreting a taxing statute and transactions not directly hit by the taxing statute cannot be roped in based on presumed intention or purpose.

The tax authority contended as follows :

As the withholding tax proceeding against Sanofi were pending and the transaction was, prima facie, a tax avoidance scheme, in terms of section 245(4) of the Act, no ruling could be given by AAR.

ShanH had no substance, it was a front, a paper company, having no office, no employees, no business and no asset except the share in Shantha and was created only for dealing with the share of Shantha.

Alienation is a word of wide import. Alienation of shares coupled with a participation of at least 10% in a company implies that under Article 14(5) of the DTAA, such participation would attract tax in India if the participation interest is in an Indian company. ‘Participation’ would mean right to vote, to nominate directors, control and management, day-to-day decision making and right to get profits distributed. All these rights in Shantha were with MA and GIMD, which were transferred pursuant to the transfer of shares of ShanH.

The transfer of shares of ShanH involved alienation of assets and controlling interest of an Indian company, gains from which was taxable in India.

Held:
AAR observed and held as follows :

(i) Maintainability of application:

Initiation of proceedings u/s.195/197 of the Act or even final order passed were preliminary and were not conclusive and it was no bar on considering an application. ? Merely because there was no tax avoidance as the transaction was taxable in France, AAR can yet examine whether the scheme was designed, prima facie, for Indian tax avoidance.

(ii) Tax avoidance:

While the Supreme Court decision in Azadi Bachao Andolan is binding on AAR, it may not be the final word in a given situation. In considering the question of prima facie tax avoidance, AAR is not piercing the corporate veil, but examining whether the steps taken had any business purpose.

Usually adopted scheme can be treated as an attempt at avoidance of tax depending on the effect of the scheme in entirety on liability of the entity to be taxed.

The series of transactions commencing from formation of ShanH appears to be a preordained scheme to produce a given result, viz., to deal with assets and control of Shantha, without actually dealing with the shares of Shantha. A gain is generated by this transaction. If the transaction is accepted at face value, by repeating the process, control over Indian assets and business can pass from hand to hand without incurring any tax liability in India.

(iii) Corporate veil and controlling interest:

Since ShanH had no business or assets other than shares in Shantha, the transaction resulted in transfer of underlying assets, business and control of Shantha.

Based on literal construction of Article 14(5) of the DTAA, the transfer of shares in ShanH can be taxed only in France. However, since the transaction involved alienation of assets and controlling interest of an Indian company, on purposive construction of Article 14(5), capital gains arising from the transaction would be taxable in India. The question as to whether controlling interest is an asset taxable in France under Article 14(6) of the DTAA is not required to be answered.

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Nirav Shah

S. 40A(2)(b) — Discount on sales given to sister concern not covered.

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Part B — Unreported Decisions

(Full texts of the following Tribunal decisions are available
at the Society’s office on written request. For members desiring that the
Society mails a copy to them, Rs.30 per decision will be charged for
photocopying and postage.)

20 DCIT v. Orgo Chem Guj. Pvt.
Ltd.

ITAT ‘H’ Bench, Mumbai

Before K. C. Singhal (JM) and

A. K. Garodia (AM)

ITA No. 7872 /Mum./2004

A.Y. : 2001-02. Decided on : 17-8-2007

Counsel for revenue/assessee : D. K. Rao/

Mayur A. Shah

S. 40A(2)(b) of the Income-tax Act, 1961 — Payments to
relatives — Discount on sales given to sister concern — Whether covered under
the provisions — Held, No.

Per K. C. Singhal :

Facts :

The assessee had given sales discount of Rs. 19.3 lacs to its
sister concern. Since no such discount was given to other parties, the AO
treated the same as unreasonable and disallowed it u/s.40A(2)(b). On appeal, the
CIT(A) noted that the sales to other parties were only of meager amount, while
the sale to sister concern was in bulk. Accordingly, the assessee’s appeal was
alllowed.

Held :

According to the Tribunal, a bare reading of the provisions
reveals that such provision could be invoked only where an expenditure was
incurred in respect of which, payment was to be made to the sister concern. In
case of discount on sales, no payment was made by the assessee as it only
reduced the sale price. Therefore, relying on the Madhya Pradesh High Court
decision in the case of Udhaji Shrikrishanadas, it held that the assessee’s case
was not covered u/s.40A(2)(b).

Case referred to :

Udhaji Shrikrishanadas, 139 ITR 827 (M.P.)

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Nirav Shah

S. 14A — Whether any part of expenses claimed against remuneration from a partnership firm can be disallowed on account of exempt share of profit — Held, No.

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Part B — Unreported Decisions

19 Hitesh D. Gajaria v. ACIT,
11(2)

ITAT ‘H’ Bench, Mumbai

Before J. Sudhakar Reddy (AM) and

P. Madhavidevi (JM)

ITA No. 993/Mum./2007

A.Y. : 2003-04. Decided on : 14-11-2008

Counsel for assessee/revenue : Arvind Sonde/Mayank
Priyadarshi

S. 14A of the Income-tax Act, 1961 (‘the Act’) — Whether
expenditure can be disallowed out of expenses claimed against business income
being remuneration from a partnership firm in which assessee is a partner on the
ground that share of profit received from the firm is claimed as exempt u/s.
10(2A) of the Act — Held, No.

Per Sudhakar Reddy :

Facts :

The assessee while filing his return of income claimed a
deduction of Rs.3,90,268 against his business income being remuneration from a
partnership firm in which he was a partner. The assessee had claimed share of
income from partnership firm as being exempt u/s.10(2A). The Assessing Officer
(AO) apportioned the expenditure claimed and disallowed a sum of Rs.1,16,752 by
invoking provisions of S. 14A of the Act. The CIT(A) upheld the action of the
AO. On an appeal by the assessee to the Tribunal.

Held :

The Tribunal found that similar issue was considered and
decided in favor of the assessee by Mumbai Bench of the Tribunal in the case of
Sudhir Kapadia (ITA No. 7888/Mum./2003 and Bharat S. Raut (ITA No.
9212/Mum./2004). Following these two precedents the tribunal deleted the
disallowance.

Cases referred to :

1. Sudhir Kapadia v. ITO — Mum. ‘C’ Bench, ITA No.
7888/M/03 dated 26-2-2003

2. Bharat S. Raut — Mum ‘E’ Bench, ITA No.
9212/Mum./2004 and CO No. 212/Mum./2005

Note :

In the case of Sudhir Kapadia (ITA No. 7888/Mum./2003) the
Tribunal after considering various decisions concluded that it is not possible
to hold the view that share income in the hands of a partner of a partnership
firm is altogether tax free. It held that share of profit in the hands of a
partner is income which has suffered tax in the hands of the firm and found that
the share of profit from the firm is exempt from tax u/s.10(2A) not in absolute
sense but with a view to avoid double taxation. Accordingly, it concluded that
S. 14A is not applicable to the facts of the case.

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Nirav Shah

S. 139(5) read with S. 132(9) — Defects in Return filed cured during extended period requested for by assessee — AO not justified in treating Return as defective

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Part B — Unreported Decisions

18 ITO v. PIC (Gujarat) Ltd.

ITAT Ahmedabad Bench ‘B’

Before I. S. Verma (JM) and

N. S. Saini (AM)

ITA No. 3058/Ahd./2002

A.Y. : 1990-91. Decided on : 4-1-2008

Counsel for revenue/assessee : R. I. Patel/

Jitendra Jain and Sachin Romani

S. 139(5) read with S. 132(9) of the Income-tax Act, 1961 —
Return of loss filed based on un-audited accounts considered as defective —
Assessee asked to file audited accounts within 15 days and rectify the defect —
Assessee requested for two months time and filed the accounts within the time
requested for — Without rejecting the assessee’s request, AO treated the
original return filed as defective and the revised return filed as belated
return — Whether AO justified — Held, No.

Per I. S. Verma :

Facts :

For the year under appeal the return of income, declaring
loss of Rs.12 lacs, was filed based on the basis of the un-audited accounts,
which according to the AO, was defective return. Hence, by notice u/s.139(a),
dated 22-1-1991 (served on 1-2-1991), the assessee was asked to file the audited
accounts within 15 days and rectify the defect. By its letter dated 15-2-1991,
the assessee requested the AO to extend the time for rectifying the defect by
two months. Thereafter, the audited accounts were filed on 15-3-1991 and the
revised (loss) return was also filed on 25-3-1991. The revised return was
processed u/s.143(1) and the refund due to the assessee was granted.

Later on, the return was processed u/s.143(3) and the loss
claimed by the assessee was rejected, on the ground that the original return
filed was defective, hence invalid. And the revised return filed was treated as
original and since it was filed late, the carry forward of loss was disallowed.
On appeal, the CIT(A) directed the AO to consider the assessee’s revised return
as valid.

Held :

The Tribunal noted that the assessee’s request for extension
of time was if rejected by the AO, the order of rejection was never intimated to
the assessee. Therefore, it held that the CIT(A) was quite justified in
accepting the assessee’s plea that the original return was a valid return and,
and therefore, revised return was also valid.

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Nirav Shah

S. 28(iv) & 145 —(i) Dividend on shares held in assessee’s name pending settlement of dispute cannot be taxed in the assessee’s hand u/s.28(iv). (ii) In the absence of trading during the year shares held as stock-in-trade can still be valued at lower of

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Part B — Unreported Decisions

17 ACIT v. Pal Enterprises
Pvt. Ltd.

ITAT ‘H’ Bench, Mumbai

Before M. A. Bakshi (VP) and

V. K. Gupta (JM)

ITA No. 1994/Mum./2005

A.Y. : 2001-02. Decided on : 20-10-2008

Counsel for revenue/assessee : Anadi Nath Mishra/ Jayesh
Dadiya

(i) S. 28(iv) of the Income-tax Act, 1961 — Dividend
on shares held in assessee’s name pending settlement of dispute — Whether such
receipt could be taxed in the assessee’s hand u/s.28(iv) — Held, No.

(ii) S. 145 of the Income-tax Act, 1961 — Shares held
as stock-in-trade valued at lower of cost or market price — In the absence of
trading during the year whether loss on account of lower market price could be
disallowed — Held, No.

Per V. K. Gupta :

Facts :

(A) Re : Dividend received on shares :

In terms of the family settlement certain shares held by the
assessee were to be transferred to Walchand & Co. Pvt. Ltd. However, on account
of certain reasons, the same could not be transferred. However, the physical
possession of the share certificates was handed over to the solicitors. The
dividend received by the assessee during the intervening period was shown as
liability in its accounts. According to the AO, had there been a dispute, the
same would have been so disclosed in the accounts of the assessee. Therefore, in
the absence thereof, the AO treated the same as benefit or perquisite chargeable
to tax u/s.28(iv) of the Act.

On appeal the CIT(A) held that the provisions of S. 28(iv)
could be applied only in a case where benefit or perquisite was received in kind
or when the assessee had credited such amount in the profit and loss account.
Accordingly, the addition made was deleted.

(B) Re : Loss arising on account of valuation of shares held as
stock-in-trade at market value :

The assessee was holding shares of Premier Automobile Ltd. —
both as investment and as stock-in-trade. As per its method of valuation, the
stock was valued at lower of cost or market price. On account of fall in the
market price of the shares, the shares held as stock were valued at the lower
figure which was claimed as loss. According to the AO, the assessee who belonged
to the promoter group of Premier Automobiles, would be holding the shares with
the sole motive of retaining the control. Therefore, it cannot be recognised as
stock-in-trade.

On appeal the CIT(A) noted that the assessee was an
investment company and these shares were held as stock-in-trade which were
valued at lower of cost or market price in accordance with the method
consistently followed, hence there was no justification in making addition on
account of the same.

Before the Tribunal, the Revenue justified the order of the
AO, on the ground that the shares held as stock-in-trade, without any
transaction of sale and purchase, could not be a proper source of loss, hence
the same was not allowable.

Held :

(A) The Tribunal noted that the impugned sum represented
dividend which was received from the year starting from F.Y. 1995-96 and
secondly, in some of those years, dividend income was exempt. Further,
according to the Tribunal, the provisions of S. 28(iv) could be applied only
in a case where an actual income was received by the assessee in the garb of
some benefits or perquisites and which were not shown as chargeable to tax.
According to the Tribunal, that was not so in the case of the assessee.
Accordingly, the order of the CIT(A) was upheld and the addition made on this
account was deleted.

(B) The Tribunal noted the facts that the assessee was
having shares — both as investment as well as stock-in-trade. The method of
valuation of stock was one consistently followed and accepted. Further, it
noted that the assessee was having substantial brought forward loss. Hence,
the practice followed cannot be termed as tax saving device. In view thereof,
the order of the CIT(A) was upheld.

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Nirav Shah

Poonawalla Aviation Private Limited, in re (Unreported) AAR No. 953 of 2010 Article 12(3)(b) of India-France DTAA; Section 195 of Income-tax Act Dated: 5-12-2011 Counsel for assessee/revenue: Rajan Vora, Rahul Kashikar, Siddharth Kaul, Arijit Charkravarty/Mukundraj M. Chate

(i) Although ‘insuring’ of the loan is not equivalent to ‘endorsing’, having regard to the MFN clause and corresponding provision in other DTAAs, exemption under Article 12(3)(b) would apply.

(ii) Exemption under Article 12(3)(b) would apply even if the interest was paid into a bank account outside France since the interest was beneficially owned by a French resident.

Facts:
The applicant was an Indian company. It entered into an agreement with a French company (‘FrenchCo’) for purchase of aircraft for which price was deferred and was to be paid over 6 years’ time. Subsequently, COFACE (an agency of France Government) agreed to insure credit facility to be extended by FrenchCo. The applicant executed promissory notes covering principal and interest in favour of FrenchCo. FrenchCo irrevocably and unconditionally assigned the promissory notes to a French bank. Thereafter, the applicant made payments into the account of the PE of the French bank in the USA. The issues before AAR were as follows:

(i) Whether interest payable to FrenchCo was taxable in view of Article 12(3)(b) of the DTAA?

(ii) Whether interest payable to the French bank (after assignment of promissory note by FrenchCo to French bank) would be taxable in view of Article 12(3)(b) of the DTAA?

(iii) Whether the applicant was required to withhold tax u/s.195 of the Income-tax Act in respect of the interest paid to FrenchCo or French bank?

The applicant contended that Article 12(3)(b) of the DTAA provides for exemption in respect of interest beneficially owned by a French resident in connection with a loan or credit extended or endorsed by COFACE. Hence, the applicant contended that the interest paid, was exempt since the loan was insured by COFACE. The word ‘endorse’ was of wide amplitude and also covered providing of insurance cover on loan. The applicant also claimed benefit of MFN clause in the Protocol to the DTAA.

The tax authority contended that the interest was not derived in connection with a loan or credit intended by or endorsed by COFACE, but COFACE had only provided export credit insurance and further, as the instalments were payable in the USA and not in France, the DTAA was not applicable.

Held:
AAR observed and ruled as follows:

(i) Mere fact of COFACE having ‘insured’ the credit extended to the applicant does not mean ‘endorsement’ of credit. The DTAA between France and other countries mentioned ‘guaranteed or assured’ or ‘guaranteed or insured’ by COFACE. However, the DTAA with India has not used such expression. Accordingly, mere extending of insurance cover by COFACE does not amount to ‘extending or endorsing’ the loan or credit by COFACE as required in Article 12(3)(b) to quality for exemption.

(ii) India’s DTAA as with Canada, Hungary, Ireland (which were entered into after the DTAA) include loans or credits ‘insured’ for the purpose of exemption. Therefore, based on MFN clause, the protection is understood as extended to loan or credit ‘insured’ by COFACE and hence, it would come within the purview in exemption of Article 12(3)(b). Accordingly, payment of interest to FrenchCo is exempt under Article 12(3)(b).

(iii) The beneficial ownership of the French bank is not endorsed or assigned to its branch in the USA. Accordingly, interest payable to French bank pursuant to the endorsement of the promissory note by FrenchCo is exempt under Article 12(3)(b) as interest beneficially belongs to French resident.

(iv) In view of the exemption of interest, withholding obligation u/s.195 will not arise.

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Nirav Shah

Fes for Technical Services — Exclusions provided in Section 9(1)(vii)(b)

Taxation of Fees for Technical Services (FTS) has assumed great significance in the Indian context. In this Article, we wish to highlight and discuss the issues concerning the exclusions provided in section 9(1)(vii) (b), which are of very practical utility and relevance.

It is important to note that in this article we have not dealt with the exclusions contained in the definition of the term ‘Fees for Technical Services’ given in Explanation 2 to section 9(1)(vii), relating to noninclusion of consideration for any construction, assembly, mining or like project undertaken by the recipient of such consideration.

We invite the readers to provide their useful comments and feedback in respect of the same.

1. Introduction

1.1 Section 5 of the Act dealing with scope of total income provides that both in the case of a resident as well as non-resident, total income would include all income from whatever source derived which accrues or arises or is deemed to accrue or arise to him in India during such year.

1.2 Section 9 of the Act contains the provisions relating to income deemed to accrue or arise in India.

Section 9(1)(vii)(b) of the Act reads as under:

“(1) The following income shall be deemed to accrue or arise in India:

(vii) income by way of fees for technical services payable by —

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

Thus the exclusionary part of clause (b) makes it clear that in order to be eligible for the benefit provided, the following conditions needs to be fulfilled:

(a) amount is paid as fees for technical services.
(b) such services are utilised:

(i) in a business or profession carried on by such person outside India, or

(ii) for the purpose of making or earning any income from any source outside India.

1.3 The language of the second limb of the exclusionary part of section 9(1)(vi)(b) of the Act providing source rule for royalties, is almost identical and accordingly, the discussion in respect of second limb of the exclusionary part of section 9(1)(vii)(b) relating to FTS would equally apply to royalties also.

1.4 From the plain reading of the provisions of section 9(1)(vii)(b), it is evident that if any payment of fees falls within the exclusionary portion of the clause (b), then the payment of such fees made by a person who is resident, would not be deemed to accrue or arise in India and accordingly would not be taxable in India.

1.5 The exclusionary portion of the clause (b) contains two important limbs which are as follows:

(a) where the fees are payable in respect of services utilised in a business or profession carried on by such person outside India, or

(b) for the purposes of making or earning any income from any source outside India.

1.6 In the first limb of exclusionary part of clause (b) mentioned above would apply in a case where the FTS are payable by a resident in respect of services utilised in a business or profession carried on by such person outside India.

Thus, for example, A Ltd., an Indian company, has a branch in Dubai and makes payment of FTS to a third party in London for the services which are utilised in the business carried by the Dubai branch of the Indian company. Such payment would be covered by the first limb of exclusionary clause (b) mentioned above and the same would not be deemed to accrue or arise in India.

It is important to note that the services have to be utilised in a business or profession carried on by such a person outside India. In this connection, two important questions arise which are as follows:

(a) The first question in this context would be as to when can a resident be said to be ‘carrying on a business or profession outside India’?

In the view of the authors, if the business is carried on outside India by a branch, liaison office, project office or Permanent Establishment (PE) in any form of the person resident in India, then it could be assumed that the resident is ‘carrying on a business or profession outside India’. It is difficult to think of a situation where without a branch, liaison office, project office or PE, a resident could be said to be ‘carrying on a business or profession outside India’.

It is an open question whether business carried on by a person resident in India through the means of e-commerce can be considered to be carried on outside India for the purposes of the first limb of the exclusionary part of clause (b)?

(b) The second question arises which is very relevant is: What is the meaning of the words ‘such person’ appearing in the first limb of exclusionary clause (b)? Does the same refer to the payer of the fees or the recipient of the fees?

On a plain reading of the opening part of the clause (b) along with the first limb of the of exclusionary clause (b), it would be apparent that the words ‘such person’ should refer to the payer of the fees.

However, the Bombay High Court in the case of Grasim Industries Ltd. v. S. M. Mishra, CIT (Bombay High Court), (2011) 332 ITR 276, while disposing of the writ petition, has held that the words ‘such person’ would mean the recipient of the fees and not the payer of the fees. The aforesaid case is discussed below.

1.7 The second limb of exclusionary part of clause (b) mentioned above would apply in a case where the FTS is payable by a resident in respect of services utilised for the purposes of making or earning any income from any source outside India. In this connection also, two important questions arise as follows:

(a) Firstly, for the purposes of second limb of exclusionary clause (b), it is extremely important to determine the true meaning of the words ‘source outside India’. For this purposes it is very important to determine: What is meant by the word ‘source’ and when can a ‘source’ be said to be ‘outside India’? Can the ‘export of goods and services’ to customers out side India be said to be ‘source outside India’?

(b) The second question which arises for consideration is: Whether the ‘source’ has to be an ‘existing source’ or it could be even for a ‘future source’ of income?

2. Judicial pronouncements

A. Judicial pronouncements relating to first limb of exclusionary part of clause (b)

2.1 332 ITR 276 — Grasim Industries Ltd. v. S. M. Mishra, CIT (Bombay High Court)

(a) Nature of payment

Receipt of Fees for Technical services rendered by a non-resident outside India

(b) Brief facts

The assessee company was a company incorporated in India in which public was substantially interested and had its principal place of business at Mumbai. The petitioner No. 2 was a company incorporated under the laws of Delaware and had its principal place of business in Pennsylvania, USA. The U.S. company did not have any office or place of business in India and was not resident in India.

The Indian company being desirous of setting up a sponge-iron plant approached the U.S. company for technical assistance. By a basic engineering and training agreement the U.S. company agreed to render to the Indian company outside India certain engineering and other related services in relation to the sponge-iron plant.

By another agreement (the supervisory agreement), the U.S. company agreed to provide certain supervisory services to the Indian company in India. By the basic engineering and training agreement, the U.S. company was to prepare basic engineering drawings specifications, calculations and other documents and design and also prepare monthly schedule of non-Indian activities outside India.

The U.S. company was to deliver to the authorised representative of the Indian company the designs, drawings and data outside India. The U.S. company also agreed to train outside India a certain number of employees of the Indian company in order to make available to such employees scientific knowledge, technical information, expertise and technology necessary for commissioning, operation and maintenance of the sponge-iron plant.

As a consideration, the Indian company agreed to pay to the U.S. company a sum of US $ 16,231,000, net of Indian income-tax, if any, leviable. In accordance with the basic engineering and training agreement, the U.S. company delivered the total basic engineering package to the representative of the Indian company in Pennsylvania (USA) between November 1989 and August 1990. The U.S. company also imparted training to 22 key personnel of the Indian company at the plant in Mexico as provided in the basic engineering and training agreement.

The Assessing Officer charged the consideration received by the U.S. company to tax. The U.S. company did not dispute that the services under supervisory services were rendered in India and as such the income received therefrom was liable to income-tax. The dispute related only to the amount paid by the Indian company to the U.S. company under the basic engineering and training agreement dated October 22, 1989.

c) Key issue in relation to section 9(1)(vii)(b)

Does the expression ‘by such person’ appearing in section 9(1)(vii)(b) refers to the recipient of income and not to the person making the payment?

d) Decision

The Bombay High Court held in the assessee’s favour as follows:

“Section 9(1)(vii) of the Act says that the income by way of fees for technical services payable by three classes of persons shall be deemed to have accrued or arisen to the recipient in India. The three classes of payees are described in three sub-clauses, viz. (a), (b) and (c) of clause (vii). Sub-clause (a) is in respect of an income received by way of fees payable by the Government. Sub-clause (b) is regarding the income by way of fees payable by a person who is a resident in India and sub-clause (c) is in respect of an income by way of fees payable by a person who is a non-resident.

So far as sub-clause (a) is concerned, it admits of no exception and every rupee received as an income by way of fees for technical services paid by the Government to him is deemed to have accrued or arisen to the recipient in India.

So far as sub-clause (b) is concerned, income by way of fees for technical services payable by a person who is a non-resident (should be read as ‘Resident’) is deemed to have accrued or arisen to the recipient in India ‘except where the fees are payable in respect of services utilised in a business or profession carried on by such person outside India or for the purpose of making or earning any income from any source outside India.’

The expression ‘by such person’ appearing in section 9(1)(vii)(b), in our opinion, refer to the recipient of the income and not to the person making the payment. This would be clear if one looks to the opening words of s.s (1) of section 9 which reads ‘the following income shall be deemed to accrue or arise in India’. Section 9(1) refers to the income which is deemed to have accrued or arisen in India by the recipient of the income. The expression ‘such person’ appearing in sub-clause of section 9(1)(vii) therefore refer to the recipient, because one has to consider whether the income received by him (the recipient) is deemed to have accrued or arisen in India. Section 9 does not contemplate taxing the payer but contemplates taxing the recipient for the income received by him. In our considered view, the expression ‘such person’ appearing in sub-clause of section 9(1)(vii) refers to the recipient of the income and not to the payer. If we were to construe the expression ‘such person’ appearing in section 9(1)(vii)(b) as to the person who makes the payment for technical services it would give rise to a startling results.

We would demonstrate this by means of an illustration. Take a case where a resident Indian goes abroad, falls sick, and avails services of a pathological laboratory for testing his blood and pays the fees to the laboratory for the technical services of blood analysis performed by it. Obviously, the payment made by the Indian resident for the technical services payable to the owner of the laboratory who is a non-resident would fall in the first part of sub-clause (b) of section 9(1)(vii) of the Act and the fee received by the owner of the laboratory would be subject to the Indian income-tax unless it falls within the exception provided under sub-clause (b) itself. If we were to read the expression ‘such person’ in sub-clause (b) to refer the person making the payment i.e., the resident Indian, then obviously the case would not fall within the exception, because the fees were not payable in respect of any business or profession carried on by ‘such resident Indian’ outside India. Consequently, the income received by the owner of the pathology laboratory would be subject to Indian income-tax. By no stretch of imagination, the owner of the pathology laboratory who is a non-resident Indian can be subjected to income-tax because Parliament obviously would have no legislative competence to tax him in respect of services rendered by him (who is a non-resident and non-citizen) outside Indian territory. However, if the expression ‘such person’ appearing in sub-clause (b) of section 9(1)(vii) is construed to refer to the recipient of the fees, then he would be covered by the exception and not liable to pay Indian income-tax.

If we apply sub-clause (b) of section 9(1)(vii) of the Act so construed to the facts of the case at hand, the fees received by petitioner No. 2 for technical services from petitioner No. 1 would fall within the exception carried out by sub-clause (b) of section 9(1)(vii) of the Act and not taxable in India.”

Thus, the Bombay High Court has provided a completely new perspective to the interpretation of the words ‘such person’ appearing in section 9(1) (vii)(b). In the authors’ humble opinion, on a holistic view of the purpose and intention of insertion of section 9 and also of the exclusionary provisions contained in section 9(1)(vii)(b), the view taken by the Bombay High Court appears to be erroneous and the same may have to be tested in the Supreme Court.

Further, it is important to note that while disposing of the writ petition, the Bombay High Court did not consider the implications of the Explanation inserted by the Finance Act, 2010 at the end of section 9.

B. Judicial pronouncements relating to second limb of exclusionary part of clause (b)

2.2 (2002) 125 Taxman 928 (Mad.) — CIT v. Aktiengesellschaft Kuhnle Kopp and Kausch W. Germany by BHEL

a) Nature of payment

Royalty paid to a non-resident in respect of export sales.

b) Brief facts

Pursuant to a collaboration agreement with an Indian company the assessee, a non-resident company, received payment on account of royalty. The Tribunal held that the royalty payable on export sales could not be regarded as deemed to have accrued in India within the meaning of section 9(1) (vi).

c) Key issue in relation to section 9(1)(vii)(b)

Whether royalty could not be said to be deemed to have accrued or arisen in India u/s.9(1)(vi) as the same was paid out of ‘exports sales’ and hence the source for royalty was the sales outside India?

d) Decision

The Madras High Court held that as far as royalty on export sales is concerned, that amount is also exempt u/s.9(1)(vi). Though the royalty was paid by a resident in India, it cannot be said that it was deemed to have accrued or arisen in India as the royalty was paid out of the export sales and hence, the source for royalty is the sales outside India. Since the source for royalty is from the source situated outside India, the royalty paid on export sales is not taxable. The Appellate Tribunal was therefore correct in holding that the royalty on export sales is not taxable within the meaning of section 9(1)(vi).

2.3 Lufthansa Cargo India (P.) Ltd. v. DCIT, (2004) 91 ITD 133 (Delhi)

a) Nature of payment

Payments to a non-resident for aircrafts overhauling and repairs

b) Brief facts

The assessee, a domestic company, had acquired four boeing cargo aircrafts from a foreign company and obtained licence from licensing authority to operate those aircrafts on international routes only. It also engaged crew, technical personnel, engineers and other ground staff and wet-leased aircrafts to a foreign cargo company. Under wet-lease agreement, responsibility for maintaining crew and aircrafts in airworthy condition was that of the assessee and the lessee was to pay rental on basis of number of flying hours during period subject to minimum guarantee. The assessee periodically made payments to a non-resident company on account of overhaul, repairs of its aircrafts, engines sub-assemblies and rotables (components) in workshops abroad. The assessee did not deduct tax at source on such payments.

c) Key issue in relation to section 9(1)(vii)(b)

Whether the payments for repairs and maintenance charges would not be chargeable to tax in India as they were made for earning income outside India and therefore the would fall within the purview of exclusionary part of section 9(1)(vii)(b)?

d) Decision

The ITAT held that the sources from which the assessee has earned income are outside India as the income-earning activity is situated outside India. It is towards this income-earning activity that the payments for repairs have been made outside India. The payments therefore fall within the purview of the exclusionary clause of section 9(1)(vii)(b).

Thus, even assuming that the payments for such maintenance repairs were in the nature of fees for technical services, it would not be chargeable to tax.

These payments are not taxable for the reason that they have been made for earning income from sources outside India and therefore fall within exclusionary clause of section 9(1)(vii)(b).

2.4 Titan Industries Ltd. v. ITO, (2007) 11 SOT 206 (Bang.)

a) Nature of payment

Payment of Professional Fees in Hongkong for patent registration

b) Brief facts

The assessee-company was engaged in the manufacture of watches and was selling the same under its patent name ‘Titan’. An associate company of the assessee, incorporated in Singapore, was engaged in promoting the sales of ‘Titan’ watches in the Asia Pacific region. The assessee from the business point of view got its patent name registered in Hongkong through ‘C’ , a firm of professionals of Hongkong and paid to ‘C’ certain fees for technical services rendered by it. The assessee claimed that since the services had been utilised in its business abroad, the payment made to ‘C’ was covered in exception provided in section 9(1)(vii)(b) and, hence, it was not required to deduct tax at source in respect of the payment made to ‘C’.

c) Key issue in relation to section 9(1)(vii)(b)

Can the payment made for registration of a patent outside India for the purposes of exports, be considered as for the purposes of making or earning income from a ‘Source outside India’?

d) Decision

The Tribunal held that carrying on business means having an interest in a business at that place, a voice in what is done, a share in the gain or loss and some control, if not over the actual method of working, at any ratio, upon the existence of business.

The carrying on of a business is a bundle of activities and marketing is one of such activity. If the products are marketed outside India, then it cannot be said that there is no business activity.

Patent was registered outside the country for making an income from a source outside the country. The amounts paid are covered in exception provided in section 9(1)(vii)(b).

2.5 Income-tax Officer (IT) TDS-3 v. Bajaj Hindustan Ltd., (2011) 13 taxmann.com 13 (Mum.)

a) Nature of payment

Payment of Advisory Fees to a non-resident for acquisition of sugar mills/distilleries in Brazil

b) Brief facts

The assessee-company is engaged in the business of manufacturing of sugar. It engaged the services of KPMG, Brazil to advice and assist it in acquisition of sugar mills/distilleries in Brazil. In connection with the services rendered by KPMG for the said purpose, the assessee had made payment to KPMG. The Assessing Officer was of the view that the assessee ought to have deducted tax at source on the payment made to KPMG. According to him the amount received from the assessee by KPMG was in the nature of fees for technical services rendered. He was also of the view that in terms of section 9(1) income by way of Fees for Technical Services (FTS) payable by a person who is a resident shall be income deemed to accrue or arise in India.

c) Key issue in relation to section 9(1)(vii)(b)

Whether application of section 9(1)(vii)(b) is restricted only to an ‘existing source’ of income outside India or whether the same could be applied even in relation to a ‘future source’ of income?

d) Decision

The ITAT held that the payment in question made by the assessee to KPMG is in respect of services which otherwise fell within the definition of FTS as given in the Act. The dispute is whether the exceptions mentioned in clause (b) to section 9(1)(vii) would apply so that it can be said that the fees in the nature of FTS has not accrued or arisen to KPMG in India. As far as the first exception in section 9(1)(vii) clause is concerned viz., ‘where the fees are payable in respect of services utilised in a business or profession carried on by such person outside India’, it is found that the assessee carried on business in India and has utilised the services of KPMG in connection with such business. Therefore, the case of the assessee would not fall within the first exception, notwithstanding the fact that services were rendered only in Brazil. As far as the second exception mentioned in section 9(1)(vii) clause (b) is concerned viz., ‘for the purposes of earning any income from any source outside India’, the undisputed facts are that the assessee wanted to acquire sugar mills/distillery plants in Brazil and for that purpose also wanted to set up a subsidiary company. In fact, the assessee had set up a subsidiary company on 8-8-2006 in Brazil. Thus the assessee was contemplating to create a source for earning income outside India. It is no doubt true that the source of income had not come into existence. But there is nothing in section 9(1)(vii) clause (b) to show that the source of income should have come into existence so as to except the payment of fees for technical services. The expression used is ‘for the purpose of earning any income from any source outside India’. There is nothing in the language of section 9(1)(vii) clause (b), which would go to show that the same is restricted only to an existing source of income. It was held that the payment by the assessee of fees for technical services rendered by KPMG was outside the scope of section 9(1)(vii). Hence, it cannot be considered as income deemed to have accrued in India and not chargeable to tax in India and hence the assessee was not liable to deduct tax u/s.195.

2.6 Havells India Ltd. v. ADCIT, (2011) 13 taxmann. com 64 (Delhi)

a) Nature of payment

Payment to a non-resident for Testing & Certification Services used in relation to Export Sales

b) Brief facts

The assessee-company paid certain amount to a foreign company incorporated in the USA, namely, ‘C’, for getting testing and certification services and claimed deduction of the same as business expenditure. It had not deducted tax at source from payment made to ‘C’. The Assessing Officer referring to provisions of section 9(1)(vii)(b) and
further taking view that testing and certification services provided by ‘C’ were utilised in manufacture and sale of products by the assessee in India, held that section 195 was applicable to payment made to ‘C’. He, therefore, disallowed impugned payment invoking provisions of section 40(a)(i). The assessee contended before the Tribunal that in order to invoke provisions of section 40(a)(i) amount paid should be chargeable to tax under the Income-tax Act, and that fee for technical services paid by it to ‘C’ was not chargeable to tax in India, due to exception contained in section 9(1)(vii)(b).

c) Key issue in relation to section 9(1)(vii)(b)

Whether payments made for the testing and certification services provided by a non-resident and utilised by the assessee only for its ‘exports’ activities were not chargeable to tax in India in view of section 9(1)(vii)(b)?

d) Decision

The Tribunal held in the assessee’s favour as follows: “In order to fall within exception of section 9(1)(vii) (b), the technical services, for which, the fees have been paid, ought to have been utilised by a resident in a business outside India or for the purposes of making or earning any income from any source outside India.

The KEMA certification obtained by the assessee from ‘C’ for enabling exports of its products was unassailed. The sole stand of the Department was that this service of testing and certification had been applied by the assessee for its manufacturing activity within India.

The initial onus u/s.9(1)(vii)(b) lay squarely on the assessee to prove that the exemption available thereunder was in fact available to it. The assessee had maintained throughout that the testing and certification services provided by ‘C’ were utilised only for its export activity and that the same were not utilised for its business activities of production in India. Thus, the assessee had discharged the onus, which lay on it u/s.9(1)(vii)(b). Therefore, the impugned payment made by the assessee to ‘C’ was not chargeable to tax in India.”

2.7 (2008) 305 ITR 37 — Dell International Services (India) P. Ltd., in re v. (AAR)

a) Nature of payment

Bandwidth charges paid to non-resident telecom service provider for use in relation to data processing and information technology support services provided to group companies abroad.

b) Brief facts

The applicant, a private company registered in India, was a part of the Dell group of companies. It was mainly engaged in the business of providing call centre, data processing and information technology support services to the Dell group companies. The applicant’s parent company had entered into an agreement with BT, a non-resident company formed and registered in the USA, under which BT, the non-resident company, provided the applicant with two-way transmission of voice and data through telecom bandwidth. While BT was to provide the international half-circuit from the USA/Ireland, the Indian half-circuit was provided by VSNL, an Indian telecom company. Apart from installation charges payable initially, fixed monthly recurring charges for the circuit between the USA and Ireland and for the circuit between Ireland and India were payable by the applicant to BT, and this was net of Indian taxes. BT raised its invoice directly on the applicant and the applicant made the payment directly to BT. The applicant was paying tax in India in relation to the recurring charges in accordance with section 195 of the Income-tax Act, 1961. There was no equipment of BT in the applicant’s premises and the applicant had no right over any equipment held by BT for providing the bandwidth. Fibre link cables and other equipment were used for all customers including the applicant. The bandwidth was provided through a huge network of optical fibre cables laid under seas across several countries of which BT used only a small fraction. There was no dedicated machinery or equipment identified or allowed to be used in the hands of the applicant; a common infrastructure was being utilised by various operators to provide service to various service recipients and the applicant was one among them receiving the service. The landing site was at Mumbai, and the Indian leg thereof to Bangalore, including the last mile connectivity to the premises of the applicant, was catered to by Bharti Telecom. On these facts the applicant sought the ruling of the Authority on questions relating to the tax liability of BT and the applicant’s duty to deduct tax at source.

c) Key issue in relation to section 9(1)(vii)(b)

What is the true meaning and ambit of the phrase ‘for the purposes of making or earning any income from any source outside India’ occurring in section 9(1)(vi)(b)/9(1)(vii)(b) of the Act?

d) Decision

The AAR observed and held as follows: “Sub-clause (b) of clause (vi) of section 9 carves out an ‘exception’ to the taxability of royalty paid by a resident. According to the ‘exception’, the royalty payable in respect of any right, property or information used or services utilised (a) for the purpose of business or profession carried out by such person outside India, or (b) for the purpose of making or earning any income from any source outside India is not an income that falls within the net of section 9. The applicant is relying on the second part of the exception i.e., ‘for the purposes of making or earning any income from any source outside India’. It is the case of the applicant that its business principally comprises of export revenue in the sense that it provides data processing and information technology support services to its group companies abroad and receives payment in foreign exchange against such exports. Therefore, although its business is carried out from India, the income it gets is from a source outside India and the payment it makes to BTA is for the purpose of earning income from a source outside India. Hence, according to the applicant, the benefit of exception envisaged by section 9(1)(vii)(b) will be available to it. In the context of this argument, it is pointed out by the learned counsel for the applicant that the two limbs of clauses (a) and (b) supra are distinct and the mere fact that the business is carried on in India and not outside India does not come in the way of invoking the exception provided by the latter limb, i.e., for the purpose of earning income from a source outside India.

We find it difficult to accept the applicant’s contention. No doubt, the factum of the applicant carrying on business in India does not come in the way of getting the benefit of the exception. It is possible to visualise the situations in which the business is carried on principally in India, whereas a particular source of income is wholly outside India, but, that is not the situation here. The income which the applicant earns by data processing and other software export activities cannot be said to be from a source outside India. The ‘source’ of such income is very much within India and the entire business activities and operations triggering the exports take place within India. The source which generates income must necessarily be traced to India. Having regard to the fact that the entire operations are carried on by the applicant in India and the income is earned from such operations taking place in India, it would be futile to contend that the source of earning income is outside India i.e., in the country of the customer. Source is referable to the starting point or the origin or the spot where something springs into existence. The fact that the customer and the payer is a non-resident and the end product is made available to that foreign customer does not mean that the income is earned from a source outside India. As aptly said by Lord Atkin in Rhodesia Metals Ltd. v. Commissioner of Taxes, (1941) 9 ITR (Suppl.) 45 “‘source’ means not a legal concept, but something which a practical man would regard as a real source of income”.”

The applicant’s counsel placed reliance on the decision of the Income-tax Appellate Tribunal in Synopsis India (P.) Ltd. v. ITO, [IT Appeal No. 919 (Bang.) of 2002] and that of the Madras High Court in CIT v. Aktiengesellschaff Kuhnle Kopp & Kausch W. Germany by BHEL, (2002) 125 Taxman 928.

The AAR distinguished these decisions as follows:

“In the case of Synopsis India (P.) Ltd. (supra), the assessee made payments to a foreign company which provided down-linking service to the assessee in connection with the transmission of data through satellite communications. The Tribunal found that the entire turnover of the company was export of software devices/products for which international connectivity was provided by a US company Datacom-Inc. The Tribunal held that the assessee, though carried on business in India, earned income from the sources outside India and the payments made to Datacom-Inc. were to earn income from a source outside India. The Tribunal apparently relied on two factors (i) the entire turnover of the assessee-company is derived from export of software, and (ii) such export activity was undertaken after ‘obtaining the data from international connectivity’. There is no reasoned discussion on the point whether the source of income was located outside India. The Tribunal proceeded on the premise that in the given set of facts the income was derived from sources outside India. In the second case, the Madras High Court found that the royalty was paid out of export sales and therefore the source for royalty was the sales outside India. It was on such finding of facts that the conclusion was drawn. The ratio of this decision also cannot be applied to the present case.”

3. Conclusion
3.1 From the above discussion, it is evident that there is a divergence of judicial opinion on interpretation of the second limb of the exclusionary part of clause (b) of section 9(1)(vii).

3.2 In the opinion of the authors, technically, the interpretation of the AAR in Dell International’s case (supra) of the words ‘source outside India’ occurring in the said second limb of section 9(1)(vii)(b) in respect of export of goods and services, appears to represent a better view as compared to the view taken by the Madras high Court in the case of (2002) 125 Taxman 928 (Mad.) — CIT v. Aktiengesellschaft Kuhnle Kopp and Kausch, W. Germany by BHEL (supra) in the context of royalties in respect of exports sales.

3.3 In view of above, the moot question then arises is: What is the true scope and ambit of the words ‘source outside India’? Does it mean that it will apply only to sources of income outside India other than relating to business income, such as income from house property, capital gains and income from other sources?

3.4 The true intention of the Legislature in providing the exclusionary limbs of section 9(1)(vii)(b) is not clear form the Memorandum explaining the provisions of the Finance Bill, 1976 or the Notes on Clauses relating to the Finance Bill, 1976. Even the Circular No. 202, dated 5-7-1976 explaining the amendments made by the Finance Act, 1976 does not explain the true nature and purpose of the exclusionary limbs of section 9(1)(vii)(b).

3.5 In the interest of clarity, certainty and to avoid litigation and to effectively reduce cost of export of goods and services, it would be prudent for the Government/CBDT to make necessary amendments and/or clarify that the payment of FTS/royalties for the purposes of exports of goods and services is covered by the exclusionary limbs of section 9(1)(vi)(b)/9(1)(vii)(b).

Nirav Shah

Correction of mistakes made by the dealers — Miscellaneous refunds of excess payment of taxes — Trade Circular 17T of 2011, dated 25-11-2011.

This Circular lays down the procedure for correction of mistakes made while making e-payment of taxes by dealers due to mention of wrong TIN or wrong Act or wrong period. It also lays down procedure for miscellaneous refunds due to double payment of taxes or excess payment of taxes.

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Nirav Shah

(2011) 40 VST 72 (P&H) Swastik Pipes Ltd. v. State of Haryana

Assessment — Dealer participated in assessment — Failure to issue Notice — Not aausing any prejudice — Not a ground for invalid assessment — Section 28(5) of Haryana General Sales Tax Act, 1973.

Facts
The assessment was finalised with co-operation of dealer upon furnishing of information by him, after giving reasonable opportunity of hearing. The dealer raised objection that without issuing statutory notice purchase tax assessment cannot be finalised. The dealer filed reference before the High Court against the decision of the Tribunal confirming the assessment to decide whether second/ separate show-cause notice is mandatory for the levy of purchase tax u/s.28(5) of the Act.

Held
U/s.28(5) of the Act, the assessing authority is obliged to serve notice to the dealer for framing assessment. In this case, the assessment was finalised with the co-operation of the dealer, who had supplied all the relevant information necessary for the quantification of purchase tax liability to the assessing authority. A reasonable opportunity of being heard was given to the dealer. The requirement of section 28(5) of the Act extends only to grant reasonable opportunity of hearing, which is satisfied in this case. Non-issue of notice or mistake in the issue of notice or defect in service of notice does not affect the jurisdiction of the assessing authority, if otherwise reasonable opportunity of being heard is granted. In this case neither any prejudice is caused, nor have the provisions of section 28(5) of the Act been violated. Therefore the High Court answered the reference in favour of the Revenue.

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Nirav Shah

(2011) 39 VST 581 (Bom.) Jay Shree Tea and Industries v. Commissioner of Sales Tax and Others

Limitation — Reassessment — Issue of notice — Barred by limitation — Reassessment order — Set aside — Section 35 of the Bombay Sales Tax Act, 1959.

Facts
The dealers filed writ petition against issue of notice of reassessment dated February 3, 1999 on the ground of limitation and other legal grounds. The original assessment order for the period 1991- 92 was passed on 31-3-1995. The appeal order was passed on 29-10-1996. The revising authority issued notice in Form 40 for revision of appeal order on 22-1-1997, which was subsequently dropped upon submission made by the dealer on 23-4-1997. Thereafter, enforcement branch of the Sales Tax Department visited the place of business of the dealer and based upon documents found at that time, issued notice for reassessment on 3-2-1999. This notice in Form 28 issued by the enforcement branch for reassessment for the period 1991-92 was challenged by the dealer by filing writ petition before the Bombay High Court being barred by limitation.

Held
The notice for reassessment was issued on 3-2-1999 for the period 1991-92. U/s.35 of the BST Act, no notice for reassessment can be issued after expiry of five years from the end of the financial year. The period of limitation for reassessment starts from 31- 3-1992 i.e., the end of the financial year for which the reassessment is sought. If, one calculates five years from 31-3-1992, the period of limitation expires on 31-3-1997. Under the circumstances the notice for reassessment dated 3-2-1999 is clearly barred by limitation. Accordingly, the High Court quashed and set aside the impugned notice for reassessment.

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Nirav Shah

A. P. (DIR Series) Circular No. 61 dated 17th December, 2012

External Commercial Borrowings (ECB) Policy – Review of all-in-cost ceiling This circular permits availing of ECB up to INR62 billion for low cost housing projects under the Approval Route by: –

1. Developers/Builders for construction of low cost affordable housing projects.

2. Housing Finance Companies (HFC) / National Housing Bank (NHB) for financing prospective owners of low cost affordable housing units. NHB can also, in special cases, on-lend to developers of low cost affordable housing projects. ECB cannot be used for acquisition of land. Similarly, borrowing by way of issue of Foreign Currency Convertible Bonds (FCCB) is also not permitted under the scheme. Detailed guidelines are contained in this circular.

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Nirav Shah

A. P. (DIR Series) Circular No. 58 dated 14th December, 2012 Trade Credits for Imports into India – Review of all-in-cost ceiling

This Circular states that for trade credit upto maturity period of three years, the present all-in-cost ceiling of 350 basis points over six months LIBOR for respective currency of credit or applicable benchmark will continue upto 31st March, 2013.

The all-in-cost ceiling will include arranger fee, upfront fee, management fee, handling/processing charges, out of pocket and legal expenses, if any.

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Nirav Shah

A. P. (DIR Series) Circular No. 55 dated 26th November, 2012

Liaison Office (LO)/Branch Office (BO) in India by Foreign Entities – Reporting to Income Tax Authorities

This circular clarifies that: –

a. The Annual Activity Certificate (AAC) to Director General of Income Tax (International Taxation), Drum Shaped Building, I.P. Estate, New Delhi 110002, must be accompanied by audited financial statements including receipt and payment account.

b. Banks must, at the time of renewal of permission of LO, endorse a copy of each such renewal to the office of the DGIT (International Taxation).

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Nirav Shah

A. P. (DIR Series) Circular No. 54 dated 26th November, 2012 External Commercial Borrowings (ECB) Policy for 2G spectrum allocation

This circular contains the revised guidelines for availing ECB up to INR46,414 million per company per financial year under the automatic route by successful bidders in the 2G Spectrum auction: –

(i) Refinancing of Rupee resources

Successful bidders who have made upfront payment for the award of 2G spectrum initially out of Rupee loans availed of from the domestic lenders are eligible to refinance such Rupee loans with a long-term ECB within a period of 18 months from the date of sanction of such Rupee loans for the stated purpose from the domestic lenders after showing proof of upfront payment to the bank.

(ii) Relaxation in ECB-liability ratio and percentage of shareholding

Successful bidders are permitted to avail of ECB from their ultimate parent company without any maximum ECB liability-equity ratio, if the lender holds minimum paid-up equity of 25% in the borrower company, either directly or indirectly.

(iii) Bridge Finance facility

Successful bidders can avail of short term foreign currency loan in the nature of bridge finance under the ‘automatic route’ for the purpose of making upfront payment towards 2G spectrum allocation and replace the same with a long term ECB provided the long term ECB is raised within a period of 18 months from the date of drawdown of bridge finance.

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Nirav Shah

A. P. (DIR Series) Circular No. 52 dated 20th November, 2012 Export of Goods and Software – Realisation and Repatriation of export proceeds – Liberalisation

Presently, the period of realisation and repatriation of export proceeds in respect of export of goods or software, where the goods are exported on or before 20th September, 2012, is twelve months from the date of export.

This circular has extended the period of realisation and repatriation of export proceeds in respect of export of goods or software, where the goods are exported on or before 31st March, 2013, is extended from six months to twelve months from the date of export.

However, period of realisation and repatriation to India of the full export value of goods or software exported by a unit situated in a Special Economic Zone (SEZ) as well as exports made to warehouses established outside India remain unchanged.

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Nirav Shah

Front Running by Non-intermediaries not a Crime – SAT

The Securities Appellate Tribunal has held that front running by investors and others (who are not intermediaries) is not in violation of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 2003 (hereinafter referred to as “PFUTP Regulations”). This is in the case of Shri Dipak Patel vs. SEBI (Appeal No. 216 of 2011, decision dated 9th November 2012).

What is front-running? Though widely discussed in press and earlier here in this column, a quick review of this term is made here. It essentially is using information about major trades by a person and in anticipation of price movements owing to such orders, the front runner himself carries out such trades first. Carried out by an intermediary such as a broker, it takes usually the following form. An investor wants to, say, buy a large quantity of shares of a particular listed company. It is expected that such purchase itself will result in increase of the market price of those shares, at least in the short run, taking various factors such as available liquidity in the market etc. The investor places this order with his broker. The broker, savvy about the implications in the market, places his own orders of purchase first. Say, the ruling market price is Rs. 100. So he buys a large quantity of shares at Rs. 100. This purchase results in the market price moving up to, say, Rs. 102. Then he places the order of his client at, obviously, Rs. 102. He sells his shares in the market and these sales expectedly go mainly to the investor. Thus, the broker is richer by Rs. 2 per share and the investor pays a higher cost of the same amount. The broker thus runs in front of the investor’s orders.

The reverse can also be done when the investor wants to sell shares, where again the broker will gain at the cost of the investor. Of course, it is not only the broker who may do this. Any person who comes to know about the proposed trades of such investor may do it – whether the employee or advisor of the investor, an employee of the broker. Indeed, the broker himself may disguise his trades by use of other names.

Front running is in a sense similar to insider trading since in insider trading too, an insider takes advantage of price sensitive information. However, front running, unlike insider trading, causes a direct and often quantifiable loss to the investor.

There have been a few earlier orders of SEBI of instances of front running, where such front runners were punished and such orders were upheld by the SAT. However, the SAT has sought to make an important distinction in this particular case. SAT has effectively said that front running is punishable only if carried out by an intermediary and not by other persons. Thus, in this case, an employee of the investor who, having come to know of its proposed trades, allegedly carried out front running. SAT held – on grounds discussed herein – that such employee could not be punished.

The facts, as narrated in the SAT order, are simple enough. An employee (“D”), who was designated as a portfolio manager of a certain foreign institutional investor (FII), came to know of certain proposed large trades by such FII. He organised with his cousins in India to carry out their own personal trades ahead of such trades. The next step was to reverse them when the FII itself came to trade. Considering the size of the proposed FII trades, it appeared that if D traded first, he would be able to move the price in a particular direction. This movement, coupled with the trades of the FII, would help them make a profit in the reverse transaction he would carry out with such FII. He (along with his cousins) allegedly made, and consistently too, such profits amounting to approximately Rs. 1.50 crores.

SEBI compiled in great detail the trades of D and the FII in such scrips. It collected information about the trades of the FII and then compared them with the trades of D. The comparison was made in both quantity and timing. The telephonic records of D and his cousins were also examined and allegedly the contacts and its timings supported the view that there were contacts between them during the time of these trades. The financial transactions between D and his cousins were also examined and similar supporting evidence was allegedly found supporting the view that D helped facilitate such transactions. It was also stated that the cousin of D who carried out such trades consistently made profits on such trades which SEBI said was rare and unbelievable in the present facts. And thus, such trades pointed out to illegitimate and illegal use of information to profit, at the cost of the employer FII.

The Adjudicating Officer thus held that these transactions were in violation of Regulation 3(a) to 3(d) of the PFUTP Regulations. Penalties aggregating to Rs. 11 crores were levied on D and his cousins. On appeal, the SAT reversed the order of the AO on two grounds.

Firstly, it took a view that front running was made a specific violation of the PFUTP Regulations and it referred to front running by intermediaries only. It compared the present Regulations with the PFUTP Regulations of 1995 which, according to SAT, covered front running by “any person”. Since D and his cousins were not intermediaries, SAT held that this clause could not apply to them.

In the words of SAT, “In the absence of any specific provision in the Act, rules or regulations prohibiting front running by a person other than an intermediary, we are of the view that the appellants cannot be held guilty of the charges levelled against them.”.

Secondly, it held that front running at best amounted to a fraud by D on his employers. It was found that the employer FII had indeed carried out an internal investigation report. Certain findings of this report were referred to by SAT. It was also noted that the employer had punished him by, effectively, making him resign. However, it did not, SAT held, amount to a manipulative practice or a fraud on the market. Hence, first, the provisions of Regulations 3(a) to 3(d) which were held to be violated by D as per the order of the Adjudicating Officer, could not apply to the present facts. What is even more interesting is that, the SAT held that in the absence of any specific provision in law, the acts could not be punishable under any other provision either.

As the SAT observed, “The alleged fraud on the part of Dipak may be a fraud against its employer for which the employer has taken necessary action. In the absence of any specific provision in law, it cannot be said that a fraud has been played on the market or market has been manipulated by the appellants when all transactions were screen based at the prevalent market price.”

The decision raises several concerns and questions. There is surely a valid point in SAT’s view that unless there is a manipulation in or fraud on the market, a purely private wrong cannot be punished by SEBI unless there is a specific provision prohibiting it. However, the question still remains that when such a wrong is carried out in the market, how private does it indeed remain? And if it remains unpunished, whether it will affect the credibility of the market?

The question also arises whether the decision was arrived at because the charges were framed too narrowly, limiting it to specific clauses in the PFUTP Regulations. Or whether the decision has a broader scope and that such decision would apply generally leaving SEBI with no powers – either under the other clauses of the PFUTP Regulations or under the Act – to deal with such acts.

There is another point that the SAT made which with due respect does not seem to be correct. It held that the 2003 PFUTP Regulations made a departure from the 1995 PFUTP Regulations. The 1995 PFUTP Regulations, as per SAT, prohibited front running by any person. The 2003 PFUTP Regulations, however, prohibited front running by intermediaries only.

SAT observed, “We are inclined to agree with learned counsel for the appellants that the 1995 Regulations prohibited front running by any person dealing in the securities market and a departure has been made in the Regulations of 2003 whereby front running has been prohibited only by intermediaries.” (emphasis supplied)

The relevant Regulation 6 of 1995 PFUTP Regulations does start with the phrase “No person shall…”. However, clause (b), which seems to be the relevant clause to which SAT refers to reads as follows:-

“(No person shall) on his own behalf or on behalf of any person, knowingly buy, sell or otherwise deal in securities, pending the execution of any order of his client relating to the same security for purchase, sale or other dealings in respect of securities.

Nothing contained in this clause shall apply where according to the client’s instruction, the transaction for the client is to be effected only under specified conditions or in specified circumstances;” (emphasis supplied)

Thus, while the prohibition is on any person, the prohibition applies provided such dealing is “pending the execution of any order of his client ”. In other words, even in the present facts where D did not apparently deal “pending the execution of any order of his client”, the 1995 PFUTP Regulations could not have applied.

Having said that, it is also clear that the present facts and decision was not with reference to 1995 Regulations but the 2003 Regulations and they do refer specifically to intermediaries. Still, this distinction sought to be made appears to be erroneous.

It seems certain that, considering the nature of the transaction, and the amounts involved and the other cases of a similar nature, SEBI will appeal this case before the Supreme Court. Perhaps, SEBI may also take an initiative and amend its Regulations, to introduce specific provisions prohibiting such transactions.

Nirav Shah

Maharashtra Housing (Regulation and Development) Act, 2012

Conveyance

Provisions relating to conveyance are dramatis personae in the Bill. The maximum upheaval has taken place in this area and hence, one needs to study these provisions in depth.

S.10(1) of the Maharashtra Ownership Flats (Regulation of the Promotion of Construction, Sale, Management and Transfer) Act, 1963 (“MOFA”) currently provides that as soon as the minimum number of persons required to form a co-operative society have taken flats, the promoter has a duty to submit an application to the Co-operative Society Registrar for the registration of the society. The minimum number is 60% of the total flats. This application as per the Rules is to be made within 4 months from the date on which the minimum number is met. The promoter can also form a company instead of a society.

The Bill has modified this provision by extending the time available for forming a society or a company. A promoter must now make an application within 4 months from the earliest of the following dates:

(a) the date on which the OC is received for the building; or

(b) the date on which a minimum 60% of the flat purchases have taken possession; or

Two other new features also find a place in MHRD which are not to be found under MOFA. In the case of a layout which consists of more than one building or wings of a building, the promoter must constitute a separate co-operative society or a company in respect of each such wing or building. The abovementioned timelines for formation of the entity would be separate qua each building or wing. This is a good amendment so that the conveyance of all buildings is not delayed till the completion of the layout. In the case of Jayantilal Investments v Madhuvihar Co-op. Hsg. Society,(2007) 9 SCC 220, the Supreme Court had an occasion to consider the timing when a conveyance needed to be executed in the case of a layout. Can conveyance be delayed till all the buildings in the layout are developed was the issue? In this respect, the Solicitor General made the following arguments, which in a way are the reasons for the new provision in the Bill: “ ..

It is submitted that, it is not open to the builders to insert clauses in the agreement with the flat takers stating that conveyances will be executed only after the entire property is developed. Learned amicus curiae submitted that the contention of the promoter in the present case is that its obligation to form society and execute a conveyance only after completion of the scheme is misconceived because u/s. 10 and 11 when the builder enters into an agreement with the flat takers he is required to form a cooperative society as soon as the minimum number of flat takers is reached and, thereafter, the conveyance has to be executed in favour of the society within four months after the formation thereof in terms of Section 11. He submitted that MOFA has been enacted to regulate the activities of the builders and not to confer benefits on them…”

The Supreme Court in this case remanded the matter back to the High Court for a fresh consideration. A Bombay High Court judgment in the case of Padmavati Constructions v State of Maharashtra, 2007 (1) Bom. CR 609 had held that conveyance of buildings in a layout need not be held up till the entire layout is completed.
Further, the promoter must take steps for forming an Apex Body or Federation consisting of all co-operative societies/companies within the layout.

The Apex Body would be the nodal authority for administering and maintaining the common areas and facilities within the layout while the individual societies would retain control of the internal affairs of their own respective buildings or wings as the case may be. Thus, the Apex Body would function like an Advanced Locality Management for the layout, but it is a more structured and formal concept. There are no timelines for the formation of the Apex Body. Probably, the Rules would deal with the same.

In cases where the promoter fails to execute a conveyance, the members of the society can make an application for execution of an unilateral deemed conveyance. An appeal can be made to the Housing Appellate Tribunal against an Order in respect of an unilateral deemed conveyance.

In respect of a layout, conveyance of title from the Promoter to the Society till such time as the entire development of the layout is completed, it shall be only in respect of the structures of the buildings in which a minimum number of 60% of total flats are sold along with FSI consumed in such building. Moreover, the conveyance shall be subject to the common right to use, the internal access roads and recreation areas developed or to be developed in the layout and with the right to use of the open spaces allocated to such building in terms of the agreement for sale executed by the Promoter with each flat purchaser.

There is an important non-obstante clause which provides that irrespective of anything contained in the MHRD/other Law/any agreement/any judgment/ Court order, the Promoter is entitled to develop and continue to develop the remaining layout and to construct any additional structures thereon by consuming the balance FSI, balance TDR and any future increase in FSI or TDR.

If the FSI of the plot in a layout is increased subsequent to the conveyance of any building in the layout to flat purchasers, then a part of the increase in the FSI shall belong to the flat purchasers of the conveyed structure or structures. The part belonging to the society is computed as a proportion of the FSI utilised or consumed by the conveyed structure to the total FSI of the layout. The promoter would have a right over the balance FSI or TDR remaining after what belongs to the society and it shall not be necessary for him to obtain any consent or permission from the flat purchasers for the purpose of utilising the balance FSI or TDR rights. These are indeed interesting amendments to the existing provisions under MOFA.

In cases where the promoter’s title to be conveyed is qua the entire undivided land appurtenant to all buildings in a layout, and if no period for executing such conveyance is agreed upon, then such conveyance shall be executed by the promoter in favour of the Apex Body within such time as may be prescribed after the formation of the Apex Body. It is likely that the Rules which would be framed under MHRD would prescribe the time limit.

The Bill provides that upon execution of the conveyance in its favour, the Society/ Company shall be entitled to the FSI or TDR rights relating to the building which has been conveyed and the proportionate share in the FSI increase explained above. If, after the conveyance of the layout land to the Apex Body, there is any increase in FSI or TDR or any benefits available on a layout plan due to changes in Government policies, then such increased FSI or TDR shall be apportioned among the respective legal entities in proportion to the TDR or FSI used for the purpose of construction of the buildings managed by them.

Additions and Alterations

U/s. 7(1) of the MOFA, once the approved plans of a building have been disclosed to any flat buyer, the promoter cannot make any alteration in the structures described there, in respect of the flats which are agreed to be taken without the previous consent of the purchaser. Further, he cannot make any alterations or additions in the building’s structure without the previous consent of all persons who have agreed to take flats in that building. For instance, in Khatri Builders v Mohd. Farid Khan, 1992 (1) Bom. C.R. 305 it was held that trying to construct an additional flat on the terrace by acquiring additional FSI falls within the mischief of section 7(1) of MOFA. What constitutes a consent was the subject-matter of discussion in this case where the Court held as under:

“46. Thus, there is consistent view of this court, that the blanket consent or authority obtained by the promoter, at the time of entering into agreement of sale or at the time of handing over possession of the flat, is not consent within the meaning of Section 7(1) of the MOFA, inasmuch as, such a consent would have effect of nullifying the benevolent purpose of beneficial legislation.

47. It is, thus, clear that it is a consistent view of this court, that the consent as contemplated u/s. 7(1) of the MOFA has to be an informed consent which is to be obtained upon a full disclosure by the developer of the entire project and that a blanket consent or authority obtained by the promoter at the time of entering into agreement of sale would not be a consent contemplated under the provisions of the MOFA…”

Even in Bajranglal Eriwal v. Sagarmal Chunilal, (2008) 6 Bom.C.R. 887, it was held that it is not open to a developer/promoter to rely upon a general consent. To allow such generalised consents to operate would defeat the public policy which underlies the provisions of section 7(1).

The Bombay High Court’s decision in the case of Jitendra Shantilal Shah v Zenal Construction P Ltd, Appeal from Order No.884 of 2008 is interesting. A plot was proposed to be amalgamated with an adjoining plot on which a building was already constructed. The Court held that the proposed construction violated section 7(1), since it touched the old building and entire open space of the occupants of the old building would be blocked. An SLP has been filed (SLP(C)No.10335/2009) before the Supreme Court against this Order of the High Court. However, in Jamuna Darshan Co-op. Hsg. Society v JMC & Meghani Builders, 2011(4) BCR 185, where a separate building was to be constructed as per the plan sanctioned by the Municipal Corporation, it was held that flat purchasers’ further consent was not required to be obtained since it must be deemed to have been obtained when their agreement itself was entered into and when they were shown the sanctioned plans.

The MHRD Bill contains a similar provision as section 7(1) of MOFA albeit with a twist. In case any alterations or additions are:
(a)    required by any Government Authority;
(b)    required due to changes in law; or
(c)    disclosed in the Agreement for Sale
then the same shall not require the prior consent of the flat purchasers. Thus, the flat buyers should carefully read the contents of the Agreement. The old legal maxim of caveat emptor or buyer beware of what you buy would squarely apply.

A second new entrant in the Bill is a provision which permits the promoter to amend the layout, including the garden, recreational area, park, playground, etc., which had been disclosed in the building plans. These can be amended without prior consent of the flat purchasers, if the same is amended in accordance with the Development Control Regulations and for utilisation of the full development potential which is available from time to time.

A third scenario has been provided where a promoter can make changes without prior approval of purchasers. In case of development under a layout or a township, the promoter can construct any new building after obtaining the local authority’s permission in accordance with the Development Control Regulations, the only caveat being that the promoter shall not reduce the aggregate area of recreation garden, park, playground without the prior consent of all flat purchasers.

The fallout of this provision probably lies in the Supreme Court’s decision in the case of Jayantilal Investments v Madhuvihar Co-op. Hsg. Society,(2007) 9 SCC 220 which held that once the original plans of the building are approved by the local authority and the flats are sold on that basis, promoter/developer is prohibited from making any additions or alterations without the consent of the flat purchasers. A comprehensive project scheme has to be disclosed on such plot of land where the builder is going to construct the flats. Builders cannot construct additional structures which is not in the original layout plan without the consent of flat purchasers. The following extract from the Supreme Court’s decision are relevant:

“……he is also obliged to make full and true disclosure of the development potentiality of the plot which is the subject matter of the agreement. ….he is also required at the stage of lay out plan to declare whether the plot in question in future is capable of being loaded with additional FSI/ floating FSI/TDR. In other words, at the time of execution of the agreement with the flat takers the promoter is obliged statutorily to place before the flat takers the entire project/ scheme, be it a one building scheme or multiple number of buildings scheme. …….the above condition of true and full disclosure flows from the obligation of the promoter under MOFA …..This obligation remains unfettered because the concept of developability has to be harmoniously read with the concept of registration of society and conveyance of title. Once the entire project is placed before the flat takers at the time of the agreement, then the promoter is not required to obtain prior consent of the flat takers as long as the builder put up additional construction in accordance with the lay out plan, building rules and Development Control Regulations etc..”

Consequent to the Supreme Court remanding the case back to the Bombay High Court, the High court in Madhuvihar Cooperative Housing vs M/s. Jayantilal Investments, First Appeal No. 786 of 2004, Order dated 7th October, 2010 has passed the following Order:

“40. It can, thus, be seen that it is settled position of law, as laid down by the Apex Court, that a prior consent of the flat owner would not be required if the entire project is placed before the flat taker at the time of agreement and that the builder puts an additional construction in accordance with the layout plan, building rules and Development Control Regulations. It is, thus, manifest that if the promoter wants to make additional construction, which is not a part of the layout which was placed before flat taker at the time of agreement, the consent, as required u/s. 7 of the MOFA, would be necessary.”

Does this new provision mean that if there is a relaxation in the FSI Policy then the promoter can amend the layout to take full advantage of the available development potential? This is one area which is likely to attract maximum attention.

Penalties

Under MOFA, the promoters, on conviction of certain offences, are punishable with imprisonment of a term upto 3 years and/or with a fine. Further, when a promoter is convicted of any offence, he is debarred from undertaking construction of flats for 5 years. Any promoter who commits a criminal breach of trust of any amount advanced for a specific purpose is liable to an imprisonment of upto 5 years and/or fine.

The Bill has converted all offences into civil offences since all imprisonment provisions have been done away with. Interestingly, the Central RERA yet retains prosecution. Failure to refund the sum received with interest in case of non-possession or the act of creating a mortgage without consent of the flat purchaser attracts a penalty of Rs. 10,000 per day or of Rs. 50 lakhs, whichever is lower. Certain offences attract a penalty of up to Rs. 1 crore. Any person who fails to comply with the orders of the HRA or the Tribunal is liable to a penalty of upto Rs. 10 lakhs. The earlier draft of the Bill provided for imprisonment in certain cases which has now been dropped.

A new penalty has been introduced on the flat purchaser/allottee in case he does not pay the sums/ charges payable under the Agreement for Sale. On an order by the HRA, the purchaser is liable to a penalty of up to Rs. 10,000 or 1% of the Agreement value, whichever is higher.

Auditor’s duty

CAs have been given an important role under the MHRD since the Bill provides that the accounts of a promoter must be audited. For this purpose, a CA would have to be conversant with the requirements of Schedule II to understand the various Heads of Accounts which the promoter is required to maintain.

Conclusion

The intent behind the Act is noble, but what one needs to see is whether the implementation of the Act would also be noble. As would be evident from the above analysis, that like a mystery novel, there are several twists and turns in this Bill. The true impact of many provisions would come out once Rules are framed and actual cases become testing waters.

One must always remember that, in Law, and more so when it comes to property law, there is often a slip between the cup and the lip. There have been several innovative concepts such as deemed conveyance which have remained ‘pie in the sky’ concepts. One can only hope that the MHRD will lead to the constitution of an effective and efficient regulator and not lead to more corruption, bureaucracy and red tape.

Nirav Shah

Succession Certificate – Application by widow for waiver in payment of court fees – Bombay Court fees Act 1959, section 379.

Shehala Pramod Desai vs. Nil, AIR 2012 Bombay 168 (High Court)

The petition has been filed for issue of succession certificate in respect of the securities left by the deceased husband of the petitioner. The petitioner has not stated or substantiated that the petitioner, as the widow, is not able to otherwise maintain herself.

The securities mentioned in the petition are the moveable property left by the deceased. The petitioner, as also her two married daughters, are entitled to have an equal share in the estate of the deceased. The petitioner would be entitled to the securities upon the death of the deceased and upon administration of his estate.

The Hon’ble Court observed that it is a settled position in law that a woman is entitled to waiver/ exemption of Court fee only in respect of applications for maintenance in matrimonial disputes or with regard to divorce and family law matters and not for property disputes.

Since the petition is in respect of only the securities, the petitioner has not applied for Probate or Letters of Administration of the deceased, but only for the issue of Succession Certificate u/s. 370 of the Indian Succession Act. Upon the certificate being issued in the form specified in the schedule VIII, the petitioner would be empowered to receive interest and dividends thereon u/s. 374(a) of the Indian Succession Act (ISA). The petitioner would, therefore, be liable to deposit the sum equal to fee payable under the Court fees act 1870 (and later Bombay Court Fees Act, 1957) as applicable u/s. 379(1) of the ISA. The fact of the succession certificate being issued would be conclusive against the companies in which the deceased held the shares and securities u/s. 381 of the ISA.

Any party aggrieved by the issue of the certificate would be entitled to apply for revocation of the certificate u/s. 383 of the ISA. The order passed herein would be liable to appeal u/s. 384 of the ISA. Thus, the petition for issue of succession certificate is no different from the provisions under which the probate or Letters of Administration are granted. The petition for Succession Certificate may be filed only because the probate or Letter of Administration would not be applied for, since it is not in respect of immoveable property left by the deceased. The petitioner is also liable to pay the court fees.

Consequently, merely because the petitioner is the widow or child of the deceased, the petitioner would not be entitled to any remission, exemption or waiver of the Court fee statutorily required to be payable u/s. 379 of the ISA for securities or other debts of the deceased.

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Nirav Shah

Sale of property of Minor – Court permission – Hindu Minority and Guardianship Act 1956, section 8(4):

Ku Kamna Satyanarayan Handibag vs. Satyanarayan Chatrabhuj Handibag & Anr AIR 2012 Bombay 163 (High Court)

The applicant is maternal uncle of Ku. Kamna Satyanarayan Handibag. An application was filed by the respondent No.1 for sale of land in the name of Ku. Kamna, which had been allowed by the trial court. The said order was challenged on the ground that while allowing the said application, the trial court had not taken into consideration the interest of the minor child. It was also submitted that it was an admitted position that the said land was purchased by the respondent for Rs.4.00 lakh and the approximate value of the said land, in the application filed before the trial Court, was shown Rs.2.00 lakh. The applicant submitted that the fact that the said land was purchased for Rs.4.00 lakh and the respondent No.1 wants to sell it for just Rs.2.00 lakh, itself, shows that the respondent No.1 is not interested in protecting the interest of the minor and the Court had also not considered the interest of the minor. It was also submitted that, even the Court should have considered the provision of Sections 29 and 31 of the Guardians and Wards Act, 1890.

The Hon’ble High Court observed that in view of sub-section (4) of Section 8 of the Hindu Minority and Guardianship Act, it was incumbent upon the trial court to find out and make enquiry in depth on how the sale of the land standing in the name of the minor is going to be beneficial or advantageous to the child in future. The very fact that the land standing in the name of the minor was purchased at Rs.4.00 lakh and its approximate price is shown in the application as Rs.2.00 lakh itself is indicative of the fact that the respondent i.e. original applicant has not approached the Court with clean hands. That apart, a copy of notice received by the revision applicant in Misc. Application No. 18 of 2012 clearly indicated that, the custody of the minor is with the revision applicant i.e. maternal uncle of Kum. Kamna. In the said proceedings, there was a prayer by the applicant to declare him as a natural guardian. Therefore, in Misc. Civil Application No. 18 of 2012, a formal declaration is sought by the respondent in the said application to declare him as a natural guardian. Therefore, it follows from the said prayer that the application filed by the respondent for the sale of land standing in the name of Ku. Kamna (minor) was premature.

Apart from the above fact, the trial court was duty bound to find the truth whether the application seeking permission for the sale of land, standing in the name of the minor, would be for the benefit of the minor. However, the trial court had not made an in-depth endeavour to do such an exercise and by cryptic reasons had allowed the application filed by the respondent granting him permission to sell the land standing in the name of minor Ku. Kamna. In the application for sale of the land, the averments were general in nature and there were no specifications given by the applicant, in which he expressed his desire to protect the interest of the minor and by which mode and manner, he intends to deposit the amount after sale of land standing in the name of minor. Further, the trial court had not adverted to the provisions of Sections 29 and 31 of the Guardians and Wards Act, 1890.

The Hon’ble Court set aside the order of trial court and remitted the matter back to trial court to decide alongwith the Misc. Civil Application No.18/2012, which was kept pending for hearing.

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Nirav Shah

Recovery of debts –– Limitation – Property mortgage with Bank – SRFAESI Act, 2002 section 13(2) & 36.

Somnath Manocha vs. Punjab & Sind Bank & Ors AIR 2012 Delhi 168 (High Court).

The respondent Bank had given certain loans to one M/s. General Tyre House, a partnership firm in the year 1981. For securing the loan, the appellant was one of the guarantors. He also gave the security in the form of equitable mortgage in respect of house property

The loan could not be paid by M/s. General Tyre House, which forced the Bank to file suit for recovery of Rs. 7,75,283.60 against that firm as well as the appellant and other guarantors. The aforesaid proceedings are still pending adjudication and the suit had not been decided so far. The Parliament enacted SARFAESI Act which came into effect from 18-12-2002. Though no immediate action was taken, however fresh notice dated 20- 11-2004 u/s. 13(2) was served on similar lines calling upon the appellant to pay the entire outstanding liability amounting to Rs. 3,84,59,807/- together with interest with effect from 21-11-2004. The appellant replied on 07-1-2005 questioning the validity of this notice on the ground that the action was time barred in view of the provisions of Section 36 of SARFAESI Act read with Article 62 of the Schedule to the Limitation Act. The Bank, however, took the stand that notice was not time barred.

The appellant filed a petition against the aforesaid action of the Bank taking the same plea, viz., the claim of the respondent Bank was impermissible as the action was time barred.

The Hon’ble Court held that it could not be disputed that under ordinary law, the respondent Bank had lost the remedy of enforcing the aforesaid security by way of mortgage as limitation of 12 years as provided in Article 62 of the Schedule to the Limitation Act, 1963 had expired. The Bank chose to file only a suit for recovery of money and, it did not file any suit under Order XXXIV of the CPC. In terms of order XXXIV Rule 14, the Bank was entitled to bring the mortgaged property to sale by instituting a suit for sale in enforcement of the mortgage where after obtaining a decree for payment of money, in satisfaction of the claim under mortgage. However, such a suit could be filed within the period of limitation prescribed under Article 62 in the Schedule to the Limitation Act. Thus, under the ordinary law, the Bank was precluded from filing a mortgage suit in respect of the aforesaid property.

Thus, on the date of notice issued u/s. 13(2) of SARFAESI Act, there was no such existing or subsisting right qua mortgage. In the present case, since right to file a suit or proceedings stood extinguished, the SARFAESI Act would not revive this extinguished claim. Position would have been different if the Bank had filed mortgage suit and such a suit was pending. If the period of 12 years had not expired under Article 62 in the Schedule to the Limitation Act and there was still time to file the proceedings of mortgage suit, even that would have saved the right of the Bank to enforce the provision of SARFAESI. But even that action has become time barred. It was therefore held that the claim is barred u/s. 36 of SARFAESI Act and therefore, it was not open to the Bank to proceed under this Act. The impugned notice u/s. 13(2) and 13(4) of SARFAESI Act issued by the Bank was quashed.

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Nirav Shah

Professional Misconduct – Charges of preparing and signing two sets of balance sheets reflecting different entries pertaining to sale. Chartered Accountants Act, 1949, section 20(2):

Institute of Chartered Accountants of India vs. Rajesh Chadha FCA & Anr. AIR 2012 P & H 170 (High Court)

The disciplinary proceedings against the respondent- Rajesh Chadda, Chartered Accountant was initiated on the basis of a complaint u/s. 21 of the Act, received from Commissioner, Central Excise Chandigarh-II Chandigarh against the respondent. Considering the aforesaid complaint, the Council of the Institute of Chartered Accountants of India under the Act referred the case to the Disciplinary Committee for inquiry.

The complaint was that, during the audit of M/s. Ashwin Fabrics (P) Ltd., Amritsar by Central Excise Commissioner from 14.6.1999 to 16.6.1999, the Central Excise Officers came across two sets of balance sheets prepared and signed by the same Chartered Accountant i.e. the respondent herein. One set of balance sheet was prepared for Income Tax Department and another for Central Bank of India. In the two balance sheets, there was a difference of Rs. 3 crore in the entry pertaining to sale of stocks. It was mentioned in the complaint that the respondent was summoned u/s. 14 of the Central Excise Act, 1944. He accepted that both these balance sheets were prepared and signed by him.

It was therefore, requested that appropriate action may be initiated against Rajesh Chadha, of M/s. Rajesh Chadha & Associated Chartered Accountant, for professional misconduct.

In the reply filed to the complaint before the Council, the respondent admitted having made statement before the Central Excise Authorities but asserted that he ought to have taken due caution while tendering statement before the Central Excise Department.

The Disciplinary Committee also noticed that on the basis of the balance sheet, submitted by the Company, duly authenticated by the Chartered Accountant, loan was sanctioned by the Bank and that the respondent had neither to put in appearance nor the witnesses cited have been examined. He has failed to bring in evidence to prove his bona fide conduct in the entire matter. The Council also decided to recommend to the High Court that the name of the Respondent be removed from the Register of Members for a period of three years.

The Hon’ble Court in pursuance of such recommendation of the Council examined the matter and observed that the respondent had not examined any defence witnesses in support of his assertion that his signatures on the balance sheets do not tally. He had admitted before the Central Excise Authorities that both the sets of balance sheets were signed by him. Copy of the said statement was supplied to the respondent on the same date, as is apparent from the endorsement recorded at the end of the statement. It is not even asserted by the respondent that he disputed the recording of the statement at any time by submitting any objection at any time or by submitting any protest petition to the Central Excise Department. In the absence of any oral or documentary evidence, the stand in the written statement that the signatures on the two balance sheets are not genuine, cannot be believed. The nature of the print out and the other figures are exactly the same as in the other balance sheet of which Manufacturing & Trading & Profit and Loss Account for the year ending 31.3.1998, which is available in the paper book.

It was for the respondent to explain as to how for the same period, two different Manufacturing & Trading & Profit and Loss Account statements came into existence duly signed by him, giving discrepant purchase and sale figures. Having failed to give any plausible explanation, the disciplinary proceedings have rightly been concluded as to misconduct on the part of the respondent. The recommendation and order removal of respondent- Shri Rajesh Chadha as the member of the institute for the period of three years was accepted.

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Nirav Shah

Gift – Acceptance of gift – Between father and daughter Transfer of property Act 1882, section 54 & 122:

Chaudhary Ramesar vs. Smt. Prabhawati Phool Chand AIR 2012 Allahabad 173 (High Court)

The plaintiff was the brother of one Mohan. Mohan neither had a son nor a daughter and that during his lifetime his wife Smt. Tirthi had died. It was alleged that the defendant got a gift-deed executed through an imposter of Mohan, which was liable to be cancelled on the grounds: that Mohan did not at all execute the gift-deed; that the statement in the gift-deed that the defendant was daughter of Mohan was incorrect; that the gift-deed was executed without a mental act of the donor; that there was no valid acceptance of the gift; that the defendant did not enter into possession of the property.

The defendant contested the suit by denying the allegations and claiming that she was the only daughter of Mohan and that Mohan had no son or other issue. It was claimed that the gift was voluntarily executed by Mohan, which was duly attested by the witnesses and registered in accordance with the law of registration; and that the gift was duly accepted by her and that her name was duly recorded in the revenue records pursuant to the gift-deed. It was also claimed that the suit was barred by limitation as also by principles of estoppel and acquiescence.

The Trial Court came to the conclusion that the gift-deed was validly executed, the execution of which was proved by its attesting witness – that the defendant was the daughter of Mohan, that the death certificate produced by the plaintiff to the effect that Mohan died on 25.5.1991, that is prior to the execution of the gift-deed, was not reliable, whereas from the evidence led by the defendant it was clear that Mohan had died on 10.8.1991; and that the name of the defendant was also mutated in the revenue records. With the aforesaid findings the suit was dismissed. The finding recorded by the Courts below that Dr. K. Shivaram Ajay R. Singh Advocates Allied laws Prabhawati (defendant) was the daughter of Mohan had not been subjected to challenge.

The Hon’ble Court observed that from a perusal of the photocopy version of the gift-deed, it appeared that bhumidhari land was gifted whereas Rs. 40,000/- has been mentioned as the valuation of the property donated and not as consideration. The valuation has been mentioned, obviously, for the purpose of payment of stamp duty. Accordingly, the first contention was not acceptable. Thus, a composite reading of the deed clearly disclosed that it was a gift of immovable property and not a sale.

On the question of valid acceptance of the gift, the learned counsel for the appellant contended that the defendant was a minor on the date of the execution of the gift-deed, therefore, in absence of any proof of valid acceptance by a guardian or next friend on her behalf, the gift would not be complete.

The Court observed that the age of Smt. Prabhawati has been disclosed as 28 years, which translates to 21 years on the date of execution of the gift-deed. In the plaint, however, it has been mentioned that from the impugned deed, acceptance is not established. In the gift-deed, there is a clear recital that the donor was transferring his possession over his bhumidhari land and that the gift has been accepted by the donee i.e. Prabhawati and that she was entitled to get her name mutated in the revenue records. This recital in the gift-deed raises a presumption about the acceptance of the gift by the donee. The trial Court while deciding issue No. 1 has taken note of the statement of Prabhawati, wherein she had stated that on the same day she entered into possession of the land and continues to remain in possession. Thus, it cannot be said that there was no acceptance of the gift. Even otherwise, assuming that actual physical possession remained with the father, then also, the gift could not have been invalidated considering the relationship of father and daughter. In the case of Kamakshi Ammal vs. Rajalaksmi and others, AIR 1995 Mad 415 (para 21) it was held that where a father made a gift to his daughter and on its acceptance by her, she allowed her father to enjoy the income from the properties settled in view of the relationship of father and daughter between the donor and donee, it could not be said that there was no acceptance of gift by the donee, even assuming that the donor continued to be in possession and enjoyment of the property gifted.

Further, even if it is assumed that the defendant was minor on the date of execution of the giftdeed, the gift would not be invalidated for lack of acceptance by another guardian or next friend, as acceptance can be implied by the conduct of the donee.

The appeal was dismissed.

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Nirav Shah

Greedonomics

It is said that there is no end to Greed. The Free Dictionary defines “Greed’ as an excessive or rapacious desire, especially for wealth or possessions”.

Though, I am not an Economist but a sceptical man, I see the current economic growth driven by first spending to create demand and then instigating people to spend. This instigation, is from various mediums, such as advertising, social status, etc. This gradually becomes a habit, which will lead to the need for money. To earn money, a person will do various types of jobs and then spend the money earned on his habits. People slowly get into the trap of spending and increasing demand, which then leads to inflation.

“Our economy is based on spending billions to persuade people that happiness is buying things, and then insisting that the only way to have a viable economy is to make things for people to buy so they’ll have jobs and get enough money to buy things.” ? Philip Elliot Slater

Management Gurus and Economists may explain this phenomenon as growth. For economies, money is the root for growth, more the money circulation more is the growth. But what is the limit of growth or is there any ideal growth rate?

As a thought, if people in economies that are growing at less than 1% can live a good life, then why should we increase at 8% or even higher!! It is like we all are in a race to grow fast. But wait, is it growth or are we going towards depletion of resource at a fast pace. If the existing resources would say last for next 100 years, why do we want to deplete them in 50 years?

“Worldwide, compared to all other fossil fuels, coal is the most abundant and is widely distributed across the continents. The estimate for the world’s total recoverable reserves of coal as of January 1, 2009 was 948 billion short tons. The resulting ratio of coal reserves to consumption is approximately 129 years, meaning that at current rates of consumption, current coal reserves could last that long.” – US Energy Information Administration (www.eia.gov)

There is a law of Diminishing Marginal Utility (DMU). The law of DMU states that other things being equal, the marginal utility derived from successive units of a given item goes on decreasing. Hence, the more we have of a thing; the less we want of it, because every successive unit gives less and less satisfaction. However, there is an exception to this law for a particular thing i.e. money.

For example, when a person is hungry, the first bite of food will give the most satisfaction, then the second. Thus, the hunger is satisfied by the last bite. However, it is reverse in case of money, with every increase in earnings, the greed to have more, increases.

This concept of DMU is used in business, to increase the sale of products by fixing a lower price. Since consumers tend to buy more to equate their utility (i.e. value for money) with price, the manufacturer can expect a rise in sale and thus, increase its margin by increase in volume. Indian mythology carries many examples around Greed and Deed. Lord Krishna said, “Karma kar, phal ki chinta mat kar” meaning “perform your duty with generosity without expecting any outcome from it. However, in reality, the way the businesses are run, is purely based on profit i.e. outcome. Kenneth Allard, a former army colonel and an adjunct professor in the National Security Studies Program at Georgetown University, holding a PhD from the Fletcher School of Law and Diplomacy and an MPA from Harvard University, has written a book named “Business is War”. He was dean of students of the National War College from 1993 to 1994.

He writes “A 21st-century business strategy for succeeding in a tough global economy. To succeed in today’s turbulent business environment operating in a ‘business as usual’ mode will no longer work. Conflict and competition can come from anywhere. In tough economic times, survival is a matter of waging war, and people are looking for proven strategies to solve all types of problems..”

Thus, it can be seen that the modern philosophy of business is changing. I would quote Mahatma Gandhi which sounds paradoxical to the latest business strategies, “Earth provides enough to satisfy every man’s needs, but not every man’s greed.”

How businesses are affected by Greed:
Take an example of Satyam Computers, who in their greed to grow over its competitors and derive higher valuations, constantly showed better results and increase in earnings per share. The fact was that, there were no real customers, the invoices raised were not realised in real and the money in fixed deposits was no more than paper. There is an increasing tendency of businesses competing with each other in the race to have higher valuations, which in turn depends on higher earnings. The thing to bear in mind is that “greed is good.” That is, it’s good for a business, but perhaps not for the society in which the business survives. Unrestrained greed in the business can lead to cruelty and malpractices. A business dominated by greed will often ignore the harm their actions can cause to others. Child labour, sweat shops, unsafe working conditions and destruction of livelihoods are all consequences of businesses whose personal greed overcame their social consciences.

Greed and Society
From a macro point of view, a society that bans individual greed may suffer. It is greed that makes people want to do things, since they will be rewarded for their efforts. It is a carrot and stick approach that can yield better results. Remove the reward and it may lead to reduction in incentive to work.

“The former Soviet Union provides an example of this: the collective farms provided no individual incentive to strive, and thus produced an insufficient supply of food. The individually owned and run truck farms, however, with the possibility of selling the produce and keeping the proceeds, grew a far greater harvest per acre than the collective farms. The “greed” of American farmers has allowed them to grow food for the world, since the more they produce the more money they make.”

Nonetheless, however you regard it, unrestrained greed is detrimental to the society; unrestrained disapproval of greed is detrimental to the society. People attempt to find a balance between personal and social necessity.

“If it weren’t for greed, intolerance, hate, passion and murder, you would have no works of art, no great buildings, no medical science, no Mozart, no Van Gough, no Muppets and no Louis Armstrong.” ? Jasper Forde, The Big Over Easy

To conclude, the strange fact as understood is that, once a person generates earnings, earnings originate greed. Then slowly, the earnings that gave birth to greed, gets to the back seat and greed governs the level of earnings. Thus, there is no limit to the desire to grow earnings, because, there is no end to Greed. Here, I remember a quote from the twenty-first verse in the Sixteenth Chapter of the Bhagavad-Gita, where Lord Krishna says:

“tri-vidham narakasyedam dvaram nasanam atmanah kamah krodhas tatha lobhas tasmad etat trayam tyajet” “Give up kama, krodha, lobha i.e. lust, anger, and greed. If you become influenced or affected by them, then you will open your door to hell.”

In this Contemporary World, it is very difficult to completely give up Greed, so this New Year, let us resolve one thing, Let us Rationalise our Greed…

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Nirav Shah

Investment Allowance – Whenever the assessee claims investment allowance u/s. 32A of the Act, it has to lead evidence to show that the process undertaken by it constitutes “production”.

Vijay Granites Pvt. Ltd. v. CIT (2012) 349 ITR 350(SC)

The assessee, a company engaged in the business of raising granites from mines, polishing them and exporting them outside India as also in purchasing granite blocks and after subjecting granite blocks to further processing, exporting them outside India, claimed investment allowance in respect of cranes for assessment year 1986-87 and 1987-88 and allowance u/s. 32A for the assessment year 1988-89.

The Assessing Officer disallowed the claim, firstly on the ground that cranes were transport vehicles and further on the ground that no manufacturing process was involved in cutting the granites and polishing them. On appeal, the appellate authority accepted the contention of the assessee to the effect that the machinery was not a transport vehicle and the assessee was engaged in the manufacture or production of articles and therefore entitled to deduction. On appeal by the Department, the Tribunal confirmed the aforesaid conclusion. On the basis of application filed u/s. 256(1) the Tribunal referred the questions of law to the High Court. The High Court held that the act of cutting and polishing granite slabs before exporting them, did not involve any process of manufacture or production and the assessee was not entitled to the deduction u/s. 32A.

On appeal by the assessee to the Supreme Court, the Supreme Court found that the assessee had not led evidence before the Assessing Officer as to the exact nature of activities undertaken by it in the course of mining, polishing and export of granites. The Supreme Court observed that it has repeatedly held that, whenever the assessee claims investment allowance u/s. 32A, it has to lead evidence to show that the process undertaken by it constistutes “production”. The Supreme Court remitted the case to the Assessing Officer for fresh determination within three months from the date of receipt of the record, after giving opportunity to the assessee to produce relevant evidence.

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Nirav Shah

Rectification of mistakes – Issue involving moot question of law at the relevant time – Rectification not permissible.

Dinosaur Steels Ltd. v. Jt. CIT (2012) 349 ITR 360 (SC)

The assessee, an industrial undertaking engaged in the manufacturing of steel products, filed its return of income for assessment year 1999-98 disclosing an income of Rs.3,31,188 as under:

Gross Total Income Rs. 34,92,097
Less: Deduction u/s. 80IA @ 30% Rs. 10,47,629
————————
Rs. 24,44,468

Less: Brought forward losses
   of earlier assessment year             Rs. 21,13,280
                                                 ————————-
Total Income                                   Rs. 3,31,188
                                                    ============
The return was processed u/s. 143(1)(a).

Subsequently, the Assessing Officer issued a notice u/s. 154 of the Act, calling for objections on the ground that there was a mistake in the assessment order, namely, the claim of deduction u/s. 80-IA had been allowed inadvertently before setting off the earlier years’ losses from the profits and gains of the industrial undertaking. The assessee objected to the proposal of restricting its claim u/s. 80-IA, by placing reliance on the judgment of the Madhya Pradesh High Court in the case of CIT v. K. N. Oil Industries reported in [1997] 226 ITR 547 (MP), in which the High Court held that losses of earlier years were not deductible from the total income for purposes of computation of special deduction u/s. 80HH and 80-I (predecessors of section 80-I). Further, according to the assessee, in any event, section 154 of the Act was not applicable as there was no patent error in the order passed by the Department u/s. 143(1)(a). In this connection, reliance was placed by the assessee on the judgment of this case of T.S. Balaram, ITO v. Volkart Brothers reported in (1971) 82 ITR 50 (SC). These contentions were rejected by the Assessing Officer. Aggrieved by the order passed by the Assessing Officer u/s. 154, the assessee filed an appeal to the Commissioner of Incometax (Appeals). The Commissioner of Income-tax (Appeals) dismissed the appeal by following the judgment of the Supreme Court in the case of CIT v. Kotagiri Industrial Co-operative Tea Factory Ltd. reported in (1997) 224 ITR 604(SC). Aggrieved by the said order, the assessee filed an appeal to the Income-tax Appellate Tribunal which was also dismissed, saying that deduction u/s. 80-IA can be allowed only after setting off the carry forward losses of the earlier years in accordance with section 72 of the Act, particularly when the only source of income of the assessee during the previous year relevant to the initial assessment year and to every subsequent assessment year was only from the industrial undertaking. According to the Tribunal, this was the law which was well settled by the judgment of the Supreme Court in the case of Kotagiri Industrial Co-operative Tea Factory Ltd. (supra). Therefore, according to the Tribunal, there was a patent mistake in the assessment order passed u/s. 143(1)(a) and consequently the Assessing Officer was right in invoking section 154 of the Act. This decision of the Tribunal has been upheld by the Court.

On an appeal by the assessee to the Supreme Court, the Supreme Court observed that the provisions of Chapter VI-A, particularly those dealing with quantification of deduction have been amended at least eleven times. Moreover, even section 80-IA, was earlier preceded by section 80HH and 80-I, which resulted in a plethora of cases. The Supreme Court noted that some of the amendments have been enacted even after the judgment of the Supreme Court in the case of Kotagiri Industrial Co-operative Tea Factory Ltd. (supra) delivered on 5th March, 1997. In the circumstances, the Supreme Court was of the view that one cannot say that this was a case of a patent mistake. The assessee had followed the judgment of the Madhya Pradesh High Court in K.N. Oil Industries (supra). Hence, the assessee was right in submitting that the issue involved a moot question of law, particularly at the relevant time (assessment year 1997-98).

For the above reasons, the Supreme Court held that section 154 of the Act was not applicable.

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Nirav Shah

Bad Debt – Prior to 1-4-1989 – Allowable as deduction even in cases in which the assessee(s) made only a provision in its accounts for bad debts and interest thereon and even though the amount is not actually written off by debiting the profit and loss account of the assessee and crediting the amount to the account of the debtor.

Kerala State Industrial Development Corporation v. CIT (2012) 349 ITR 365 (SC)

The assessee, the Kerala State Industrial Development Corporation Ltd., a limited company wholly owned by the Government of Kerala, had advanced large amounts to Vanchinad Leather Ltd., a joint sector company promoted by the assessee in the year 1974 for processing hides and skins. The company started commercial production in 1977. However, it was closed down in 1980. Later it was reopened in September, 1982 and again closed down in January, 1983.

During the assessment year 1988-89, the assessee claimed deduction of Rs.55,70,949 as a provision for bad debts as in February, 1988 a declaration was made by BIFR that Vanchinad Leather Ltd. had become a sick company. The claim was disallowed on the ground that no reasonable steps had been taken for recovery of the debts and further, no part of the outstanding amount had been assessed as the income of earlier years. Also, the amount was not written off in the assessee’s accounts in claiming bad debts. The Commissioner of Income Tax (Appeals) confirmed the disallowance. The Tribunal dismissed the appeal, taking the view that the assessee could not prove that the debt had become irrevocable during the previous year and that the condition for claiming deduction u/s. 36(2)(i)(b) were not satisfied.

The following question of law was referred to the High Court u/s. 256(1) of the Act:
“Whether, on the facts and in the circumstances of the case, the Tribunal is justified in holding that the claim of bad debts in respect of Vanchinad Leather Ltd. was not legally sustainable and allowable?”

The High Court answered the question in favour of the revenue and against the assessee, holding that in the profit and loss account the assessee had made only a provision for bad and doubtful debt and the debt had not been written off as bad debts.

On an appeal to the Supreme Court by the assessee, the Supreme Court noted that till the end, the company could not be revived and it had been wound up. In the circumstances, applying the commercial test and business exigency test, the Supreme Court held that both the conditions u/s. 36(1)(vii) read with section 36(2)(i)(b) of the Act were satisfied observing that in Southern Technologies Ltd. v. CIT (320 ITR 577) it had held that prior to 1-4-1989 even in cases in which the assessee(s) made only a provision in its accounts for bad debts and interest thereon and even though the amount is not actually written off by debiting the profit and loss account of the assessee and crediting the amount to the account of the debtor, the assessee was still entitled to deduction u/s. 36(1) (vii). According to the Supreme Court, there was no reason to deny to the assessee the claim for deduction of bad debt.

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Nirav Shah

Deemed income: section 41(1): A.Y. 1995-96: Cheques not presented by creditors within validity period: No remission of liability: Amount not assessable u/s.41(1).

For the A.Y. 1995-96, the assessee credited to its profit and loss account a sum of Rs.5,02,646 as liabilities no longer required to be written back since the cheques for the amounts issued to the creditors were not presented within the validity period. The assessee claimed that the sum is liable to be excluded from the profit and could not be taxed u/s.41(1) of the Income-tax Act, 1961. The Assessing Officer treated the amount as the assessee’s income u/s.41(1) of the Act. The Commissioner (Appeals) and the Tribunal upheld the addition.

On appeal by the assessee the Calcutta High Court reversed the decision of the Tribunal and held as under:

“(i) The words ‘obtained, whether in cash or in any other manner, whatsoever, any amount in respect of such loss or expenditure’ incurred in any previous year in section 41(1)(a) of the Income-tax Act, 1961, refers to the actual receiving of cash of that amount. The amount may be actually received or it may be adjusted by way of any adjustment entry or a credit note or in any other form when the cash or the equivalent of the cash can be said to have been received by the assessee. But it must be the obtaining of the actual amount which is contemplated by the Legislature when it used the words ‘has obtained, whether in cash or in any other manner, whatsoever, any amount in respect of such loss or expenditure in the past’.

(ii) The question whether the liability is actually barred by limitation is not a matter which can be decided by considering the assessee’s case alone, but has to be decided only if the creditor is before the concerned authority. In the absence of the creditor, it is not possible for the authority to come to a conclusion that the debt is barred and has become unenforceable. There may be circumstances which may enable the creditor to come with a proceeding for enforcement of debt even after expiry of the normal period of limitation as provided in the limitation Act.

(iii) It has not been established that due to nonencashment of cheques in question, the money involved had become the money of the assessee because of limitation or by any other statutory or contractual right. The amount was not assessable u/s.41(1).”

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Nirav Shah

Receipt — Whether sales tax incentive is a capital receipt is a substantial question of law which ought to have been considered by the High Court.

The assessee-company derived income from the manufacture of yarn, synthetic fabrics, etc. In the earlier assessment year, it had also commenced manufacture of polyester staple fibre in its unit in Patalganga. In the return of income filed by the assessee for the A.Y. 1986-87 in computing the total income a sum of Rs.14,70,40,220 was reduced from the net profit of Rs.71,33,74,748 being subsidy (notional sales tax liability) in the nature of capital receipt. According to the assessee, to encourage setting of new industrial units in backward areas of Maharashtra, the State Government instead of giving cash subsidy, allowed the assessee to retain sales tax payable to the State Government. The Assessing Officer disallowed the claim for the reasons given in the assessment order and first Appellate order for A.Y. 1984-85, in which it was held that the assessee had already got remission by way of exemption of sales tax and there was no ground for taking notional sales tax liability as notional receipt. On appeal, the Commissioner (Appeals) following his earlier order rejected the ground of appeal on the above issue. The Tribunal referred the matter to the Special Bench, since the Tribunal in the earlier orders in the assessee’s own case for the A.Ys. 1984-85 and 1985-86 had held that the sales tax incentive was a capital receipt, but thereafter after considering the above judgments, the Bombay Bench of the Tribunal, in the case of Bajaj Auto Ltd. (ITA Nos. 49 and 1101 of 1991, dated 31-12-2002) had rejected the assessee’s claim that the incentive was a capital receipt on various grounds. The Special Bench of the Tribunal held as under:

“The Scheme framed by the Government of Maharashtra in 1979 and formulated by its Resolution dated 5-1-1980 has been analysed in detail by the Tribunal in its order in RIL for the A.Y. 1985-86 which we have already referred to the extenso. On an analysis of the Scheme, The Tribunal has come to the conclusion that the thrust of the Scheme is that the assessee would become entitled for the sales tax incentive even before the commencement of the production, which implies that the object of the incentive is to fund a part of the cost of the setting up of the factory in the notified backward area. The Tribunal has at more than one place, stated that the thrust of the Maharashtra Scheme was the industrial development of the backward districts as well as generation of employment, thus establishing a direct nexus with the investment in fixed capital assets. It has been found that the entitlement of the industrial unit to claim eligibility for the incentive arose even while the industry was in the process of being set up. According to the Tribunal, the Scheme was oriented towards and was subservient to the investment in fixed capital assets. The sale tax incentive was envisaged only as an alternative to the cash disbursement and by its very nature was to be available only after production commenced. Thus, in effect, it was held by the Tribunal that the subsidy in the form of sales tax incentive was not given to the assessee for assisting it in carrying out the business operations. The object of the subsidy was to encourage the setting up of industries in the backward area.”

On appeal, the High Court noting the above held that a finding has been recorded that the object of the subsidy was to encourage the setting up of industries in the backward area by generating employment therein. In our opinion, in answering the issue, the test as laid down by the Supreme Court in Commissioner of Income-tax v. Ponni Sugars and Chemicals Ltd., (2008) 306 ITR 392 (SC) will have to be considered. The Supreme Court has held that the test of the character of the receipt of a subsidy in the hands of the assessee under a scheme has to be determined with respect of the purpose for which the subsidy is granted. The Supreme Court further observed that in such cases, what has to be applied is the purpose test. The point of time at which the subsidy is paid is not relevant. The source is immaterial. Form of subsidy is material. The Supreme Court then proceeded to observe as under:

“The main eligibility condition in the Scheme with which we are concerned in this case is that the incentive must be utilised for repayment of loans taken by the assessee to set up new units or for substantial expansion of existing units. On these aspects there is no dispute. If the object of the subsidy Scheme was to enable the assessee to run the business more profitably than the receipt is on revenue account. On the other hand, if the object of the assistance under the subsidy Scheme was to enable the assessee to set up a new unit or to expand the existing unit than the receipt of the subsidy was on capital account.”

The High Court applying the purpose test based on the findings recorded by the Special Bench observed that the object of the subsidy was to set up a new unit in a backward area to generate employment. The High Court therefore held that the subsidy was clearly on capital account.

On an appeal by the Revenue, the Supreme Court held that the High Court ought not to have dismissed the appeal without inter alia considering the following question, which did arise for consideration:

“Whether on the facts and in the circumstances of the case and in law the Hon’ble Tribunal was right in holding that sales tax incentive is a capital receipt?”

The Supreme Court allowed the civil appeals and set aside the impugned order of the High Court and remitted the matter back to the High Court to decide the question, formulated above, in accordance with the law.

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Nirav Shah

Set-off of Brought Forward Busines Losses against Capital Gains u/s.50

Issue for consideration

Under the provisions relating to set-off of brought forward business losses u/.s72, a brought forward business loss can be set off only against business profits of the current year, and not against income from any other source, including capital gains of the current year. Gains arising on sale of depreciable business assets forming part of a block of assets, though arising in the course of business, is taxable under the head ‘Capital Gains’ as a deemed shortterm capital gains on account of the specific provisions of section 50.

Section 50 reads as under:

“50. Notwithstanding anything contained in clause (42A) of section 2, where the capital asset is an asset forming part of a block of assets in respect of which depreciation has been allowed under this Act or under the Indian Income-tax Act, 1922 (11 of 1922), the provisions of sections 48 and 49 shall be subject to the following modifications:

(1) where the full value of the consideration received or accruing as a result of the transfer of the asset together with the full value of such consideration received or accruing as a result of the transfer of any other capital asset falling within the block of the assets during the previous year, exceeds the aggregate of the following amounts, namely:

(i) expenditure incurred wholly and exclusively in connection with such transfer or transfers;

(ii) the written down value of the block of assets at the beginning of the previous year; and

(iii) the actual cost of any asset falling within the block of assets acquired during the previous year,

such excess shall be deemed to be the capital gains arising from the transfer of short-term capital assets;

(2) where any block of assets ceases to exist as such, for the reason that all the assets in that block are transferred during the previous year, the cost of acquisition of the block of assets shall be the written-down value of the block of assets at the beginning of the previous year, as increased by the actual cost of any asset falling within that block of assets, acquired by the assessee during the previous year and the income received or accruing as a result of such transfer or transfers shall be deemed to be the capital gains arising from the transfer of short-term capital assets.”

The issue has arisen as to whether brought forward business losses can be set off against deemed shortterm capital gains, arising on transfer of depreciable assets, taxable u/s.50, since such gain is really a type of business income. While the Bangalore and Rajkot Benches of the Tribunal have held that unabsorbed business loss cannot be set off against the gains arising u/s.50, the Mumbai Bench of the Tribunal has held that the business loss brought forward from earlier years can be set off against such capital gains chargeable u/s.50.

Kampli Co-operative Sugar Factory’s case

The issue had come up before the Bangalore Bench of the Tribunal in the case of Kampli Co-operative Sugar Factory Ltd. v. Jt. CIT, 83 ITD 460. In this case relating to A.Y. 1997-98, the assessee sold the assets of its sugar factory, including the depreciable assets but excluding investments and deposits and the liabilities. The assessee claimed that the sale was a slump sale and the gains thereon was not taxable, since section 50B introduced with effect from A.Y. 2000-01 was not applicable to the year under consideration.

The Assessing Officer broke up the consideration into two parts — one for the land, which was held taxable as a long-term capital gains after deducting the indexed cost of the land, and the other for the depreciable assets, which was held taxable as deemed short-term capital gains after deducting the written-down value of the block of assets. He also did not set off the brought forward business losses against such capital gains.

The Commissioner (Appeals), upheld the order of the Assessing Officer and denied the set-off of the unabsorbed business losses against the capital gains.

The Tribunal confirmed that the sale was not a slump sale and bifurcation of the consideration was justified but proceeded to further examine the issue as to whether the unabsorbed business loss could be set off against the short-term capital gains arising u/s.50. The Tribunal held that the business assets were also capital assets as defined u/s.2(14), giving rise to capital gains on their sale chargeable u/s.45. The Tribunal observed that prior to 1st April, 1988, a component of capital gains arising from the sale of business assets was treated as a business profit by the legal fiction of the then prevailing section 41(2) while section 50 charged the whole amount under the head ‘capital gains’. The Tribunal further noted that the deeming capital gains u/s.50 of the Act is restricted to the capital gains being short-term capital gains and did not deem a business income to be the capital gains u/s.50 of the Act. The Tribunal therefore held that the unabsorbed business losses could not be set off against the capital gains.

A similar view was taken by the Rajkot Bench of the Tribunal in the case of Master Silk Mills (P.) Ltd. v. Dy. CIT, 77 ITD 530, where the Tribunal held that unabsorbed business losses could not be set off against sales proceeds of scrap of building that was taxable u/s.50 as a short-term capital gains. In that case the business had been closed and the income could not be said to have arisen in the course of business.

Digital Electronics’ case

The issue recently came up before the Mumbai Bench of the Tribunal in the case of Digital Electronics’ Ltd. v. Addl. CIT, 135 TTJ (Mum.) 419.

In this case, the assessee sold the factory building and plant and machinery, and claimed set-off of unabsorbed depreciation and brought forward business loss against such short-term capital gains taxable u/s.50. It was claimed that though the income was taxable as capital gains, its character remained that of business income inasmuch as the gains arose on transfer of a business asset on which depreciation was allowed. Reliance was placed on the decision of the Mumbai Bench of the Tribunal in the case of J. K. Chemicals Ltd. v. ACIT, 33 BCAJ (April 2001) page 36 [ITA No. 3206/Bom./89 dated 1st November 1993], where the Tribunal had held on similar facts [though in the context of section 41(2) and capital gains] that the character of such income that arose on transfer of depreciable assets remained that of business income, though it was taxed as capital gains under a deeming fiction.

The Assessing Officer however disallowed such setoff. The Commissioner (Appeals) upheld the stand of the Assessing Officer, taking the view that there was no ambiguity in section 72, and that reliance could not be placed on erstwhile provisions of section 41(2).

The Tribunal, analysing the provisions of section 72, observed that the said section 72 stated that the losses incurred under the head ‘Profits and Gains of Business or Profession’ which could not be set off against income from any other head of income, had to be carried forward to the following assessment year and was allowable for being set off “against the profits, if any, of that business or profession carried on by him and assessable for that assessment year.” In other words, according to the Tribunal, there was no requirement of the gains being taxable under the head ‘Profits and gains of business or profession’ and thus, as long as gains were ‘of any business or profession carried on by the assessee and assessable to tax for that assessment year’, the same could be set off against loss under the head profits and gains of business or profession carried forward from earlier years. According to the Tribunal, the gains arising on sale of the business assets was in the nature of business income, though it was taxed under the head ‘Capital Gains’.

The Tribunal therefore held that the unabsorbed business losses could be set off against the capital gains charged to tax u/s.50.

Observations

The income from transfer of a depreciable asset, used for business, has its origin in business and is primarily characterised as a business income. This position in law was acknowledged specifically by old section 41(2) that is deleted w.e.f. 1-4-1988. Even the new section 41(2) provides for the similar treatment for taxing income on sale of depreciable assets used for generation and distribution of power under the head ‘profits and gains of business’.

The Income-tax Act contains provisions, for example, sections 8 and 22, which provide for an income to be taxed under a specific head of income though the same otherwise may have a different character. These provisions contain a deeming fiction and it is understood that they have a limited application.

The Supreme Court following its decisions in the cases of United Commercial Bank Ltd., 32 ITR 688 and Chhugandass & Co., 55 ITR 17, in the case of CIT v. Radhaswami Cocanada Bank Ltd., 57 ITR 306, had established this principle in the context of set-off of business losses against dividend income, which was then taxable under the head ‘Income from Other Sources’. It was noted by the Supreme Court that while one set of provisions, i.e., the nature of loss incurred by the assessee, classified the same on the basis of income being taxable under a particular head for the purpose of computation of the net income, the other set of provisions was concerned only with the nature of gains being from business and not with the head of tax. Their Lordships held that as long as the profits and gains were in the nature of business profits and gains, and even if these profits were liable to be taxed under a head other than income from business and profession, the loss carried forward could be set off against such profits of the assessee. The ratio of these decisions was again confirmed by the Supreme Court in the case of Western States Trading Co. Pvt. Ltd., 80 ITR 21.

Even in the context of section 50 gains, the Courts have consistently held that such gains, though taxed under a deeming fiction as short-term capital gains, are eligible for the benefit of exemption from taxation u/s.54E, 54EC, 54F, etc. on its reinvestment in the specified assets [see Assam Petroleum Industries Ltd., 262 ITR 587 (Gau.) Rajiv Shukla, 334 ITR 138 (Del.) and Ace Builders Pvt. Ltd., 281 ITR 210 (Bom.)]. The SLP against the last decision has been dismissed by the Supreme Court.

It is accordingly a fairly settled position in law that a benefit otherwise allowed in law under one provision shall not be denied by extending a fiction contained in any other provision of law unless specifically provided for. No such provision is found to be contained in the provisions of sections 70, 71 and 72 of the Act.

On a closer reading of section 72 one finds that it does not mandate that the income that is sought to be adjusted against the brought forward loss should be the one that is taxable under the head ‘profits and gains of business’. This precisely is brought out by the Mumbai Bench of the Tribunal by explaining that there is a distinct difference in the language employed in section 72 in the context of the loss that is to be carried forward, where the loss under the particular head of income is referred to, as against the context of the loss which it can be set off against, where the nature of income is referred to.

Looked at it from one more angle, the income that is sought to be taxed u/s.50 is to a large extent nothing but recoupment of depreciation that has been allowed as a deduction in computing the income under the head ‘profits and gains of business or profession’ and to the extent of the amount representing the recoupment should be considered as the business income.

The Mumbai Tribunal in the above-referred decision in J. K. Chemicals’ case was also impressed by the fact pointed out to the Tribunal that even the form of the Return of Income for the relevant year under consideration in that case provided for a set-off of brought forward business losses against the deemed short-term capital gains.

It is thus clear that in the case of capital assets of a business, the source of the income is really the business itself. It is by virtue of the fact that a business had been carried on that gains arises on sale of assets of that business. The character of the income is therefore that of business income, though there are specific provisions for taxing such gains as capital gains. Even a businessman would regard the character of such income as arising from his business.

Therefore, the view taken by the Mumbai Bench of the Tribunal in Digital Electronics case seems to be the better view of the matter.

Nirav Shah

The Year Gone By

Finally, the Lok Sabha has passed the Lokpal Bill, albeit with many deficiencies. This would not have been possible but for the continuous pressure exerted by Shri Anna Hazare and his team on the political class in general and the government in particular.

It is a general perception that the institution of the Lokpal under the Bill that has been passed by the Lok Sabha will not be sufficiently strong and independent. The appointment and the removal of the Lokpal are indirectly controlled by the Government. Doubts have been expressed about the constitutional validity of certain provisions. Apart from this, on the major objection to the Bill is that the government has retained control over the Central Bureau of Investigation (CBI). This is a legitimate objection. Every government has influenced the working of the CBI to suit its purposes. Without independence to investigate and prosecute, the CBI has lost its credibility as well as effectiveness. These views have been expressed by more than one retired Directors of CBI. They have, in no uncertain terms, stated that the CBI has to follow the orders of its political masters even in the matters of investigation, prosecution and filing appeals etc.

It is disappointing that the proposal of the government to give constitutional status to the Lokpal could not muster the requisite support.

In the Rajya Sabha where the government did not enjoy even simple majority the Bill could not be passed. The Government possibly deliberately avoided voting on the Bill. More than one MP stated that Parliamentarians were not ‘public servants’ and they should not be covered by Lokpal. Some of the MPs created ruckus, criticised Anna Hazare, tore the copy of the Bill and threw it on the floor of the House. Parliamentarians tell the citizens that the Parliament is supreme. But when MPs themselves create pandemonium and lower the prestige of the Parliament one is left wondering. We are back to square one without a Lokpal institution in place.

Disappointed Anna Hazare has ended his fast and also called off his proposed protest by masses courting arrest. Partly this retreat is on account of lack of expected crowd at the venue of the fast. This is not to say that there is no public support to the movement against corruption. However, it is difficult to sustain the kind of public participation that one saw in last April and in August. Also, there are many who feel that the approach of Team Anna in insisting that only the draft of the Bill prepared by them is acceptable is rather extreme and unacceptable.

There are lessons to be learnt by all from the events relating to the issue of Lokpal. Citizens have realised that if they strongly feel about something and voice that opinion through various forums the government cannot ignore it. The government and the ruling party should accept the fact that after all it is the citizens who are supreme and the Parliament is expected to reflect the opinion of the public. The educated urban middle class and youth are becoming aware and active; that constituency cannot be taken for granted. The opposition on the other hand should learn that they need to take a stand and make it public rather than sit on the fence and try to take advantage of the predicament of the government. The Civil Society should understand that in a functioning democracy one cannot expect or insist that only one view is right and that alone should be accepted. Let us hope that the movement against corruption continues and sooner than later we have a strong, independent and effective Lokpal.

The year 2011 is coming to a close. It is time to look back and ponder over the events of the year. The world saw change of guard in Egypt, the uprising in Syria. Dictator Gaddafi was killed in Libya with support from NATO, Kim Jong II another dictator died in North Korea while terrorist Osama bin Laden was killed in Pakistan by US forces. Economies of European countries as well as US are not in the best shape. Closer home, Indian economy has not been doing as well as one would like it to be. Interest rates have been consistently rising, the rupee has lost value in the recent months, and inflation has been only going up so also the trade deficit. The growth rate is lower than what was planned or expected at the beginning of the year. Industrialists attribute this lower growth in the Indian economy at least partially to ‘policy paralysis’, while the Prime Minister and Finance Minister blame the business heads for spreading the atmosphere of despondency. Huge scams rocked the nation and Tihar jail became a VIP hostel.

The year 2011 also saw audit reports of Comptroller and Auditor General making news. One must complement Mr Vinod Rai, the Comptroller and Auditor General for the excellent work done by him. He exposed major scams, inefficiencies, favouritism and faulty decision making. In spite of tremendous pressure and criticism, he went about doing his duty. He makes the profession of auditors proud. Recently, he has been appointed by the United Nations as the chairman of the panel of external auditors that audits and reports on the accounts and management operations of the United Nations and its agencies. The CAG has also shown how person occupying an office can make that office strong and effective. One experienced similar phenomena when T. N. Seshan became the Election Commissioner and Mr. N. Vittal became the Chief Vigilance Commissioner. Each of these individuals made an impact by their performance, courage and conviction while discharging their duties without getting perturbed by the limitations, criticism or pressure.

The year also saw the death of Pandit Bhimsen Joshi, Jagjit Singh and Bhupen Hazarika from the world of music, celebrated artist and painter M. F. Husain, Mario Miranda who brought smile to many faces with his cartoons, Dev Anand and Shammi Kapoor the two evergreen doyens of Bollywood, Satyadev Dubey from the field of theatre, Mansur Ali Khan Pataudi, the cricketer. Each of these individuals directly or indirectly touched the life of many Indians.

In the ensuing leap year 2012 may India progress in leaps and bound.

Wishing you all a very Happy 2012.

Corruption is nature’s way of restoring our faith in democracy —Peter Ustinov

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Nirav Shah

Clarifications w.r.t. goods specified in registration certificate vis-à-vis in declaration/ certificate under CST Act, 1956: Trade Cir. No.22T of 2012. Dated 26.11.2012

It is clarified that the application for declaration under CST Act should not to be rejected only because nomenclature of the goods stated in such application does not exactly match with nomenclature of the goods mentioned in the registration record. If the goods mentioned in such application match with the class or classes of goods as mentioned in the certificate of registration, then declaration can be issued without any need to carry out the amendments to CST registration certificate.

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Nirav Shah

Cancellation of assessment order u/s. 23(11): Trade Circular No.21T of 2012 dated 26.11.2012

It has been clarified that the application u/s. 23 (11) for cancellation of assessment order cannot be rejected if the order has been passed u/ss. (3A) of section 23, because even though the order has been passed within the extended time period, it is required to be made u/ss. (2) and (3).

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Nirav Shah

Refund through Electronic Clearance Service (ECS) Trade Cir.No.-20T of 2012 dated 19.11.2012

It is clarified that ECS facility for remittance of refund will be optional for dealers in Greater Mumbai & that to avail the benefits of ECS, it would be mandatory to submit the mandate form physically.

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Nirav Shah

Clarification w.r.t. occurrence of due date on Sunday or public holiday: Trade Circular No.19T of 2012 dated 9.11.2012

It is clarified that, if the due date for any payments or submissions falls on Sunday or a public holiday, then such payments or submissions can be done on the next working day immediately following the due date and the same will be considered as within due date and consequently no penal actions would be taken and no interest would be levied.

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Nirav Shah

Restoration of old service specific accounting codes for service tax payment: Circular No.165/16/2012 –ST dtd. 20.11.2012

To avoid practical difficulties and for the purpose of Statistical Analysis, CBEC has restored Service Specific Accounting codes for payment of service tax and for obtaining service tax registration. Accordingly, a list of 120 descriptions of services for the purpose of registration and accounting codes corresponding to each description of service for payment of tax is provided in the annexure to this Circular. A specific sub-head has been created for payment of “penalty” under various descriptions of services and the sub-head “other receipts” is meant only for payment of interest payable on delayed payment of service tax.

It is also provided that where registrations have already been obtained under the description ‘All Taxable Services’, the taxpayer is required to file amendment application online in ACES and opt for relevant description/s from the list of 120 descriptions of services given in the Annexure.

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Nirav Shah

State of Jharkhand And Others v. Shivam Coke Industries, [2011] 43 VST 279 (SC)

Revision – Suo Motu Revision by Joint Commissioner – By forming his own opinion and satisfaction – On the basis of material on record- Does not become invalid merely because it was exercised pursuant to a letter by another Deputy Commissioner,

Limitation – No provision prescribing time limit – Provision of limitation act prescribing period of three years – Not applicable – However, such power to be exercised within reasonable period of time – Exercise of such power within period of three years or soon thereafter – On facts – Reasonable, Section 46 (2), (3), and (4) of The Bihar Finance Act, 1981 and Art. 137 of The Limitation Act, 1963.

Facts

The Deputy Commissioner of Commercial Taxes, Dhanbad Circle, on the basis of guidelines issued by Joint Commissioner (appeals) passed a revised assessment order. The dealer filed writ petition before the High Court of Jharkhand praying for a direction to quash the order passed by the Joint Commissioner by which he had set aside the revised assessment order. The High Court allowed the writ petition filed by the dealer against which the department filed appeal before the Supreme Court.

Held

In all these appeals the Joint Commissioner has exercised the Suo Motu power vested in him under the Act within a period of three years in some cases and in some cases soon thereafter. The revision order was passed by him by forming his own opinion and satisfaction on the basis of the material on the record. Therefore, the revision order by him is valid. When the language of the legislature is clear and unambiguous, nothing could be read or added to the language, the High Court wrongly read application of section 137 of the Limitation Act to section 46 (4 ) of the BFT Act. In absence of any specific provision in the act, the provision of the Limitation Act cannot apply to section 46(4) of the Act. However, such a power cannot be exercised by the authority indefinitely. Such power has to be exercised within a reasonable period of time and what is a reasonable period of time would depend on the facts and circumstances of each case. When such powers have been exercised within three years of time in some cases and in some cases soon after the expiry of three years period it cannot be said to be unreasonable.

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Nirav Shah

Penalty vis-à-vis Mens Rea in relation to CST Act, 1956

VAT

Introduction :

Normally all fiscal laws
contain penalty provisions. The intention of such provisions is to have
deterrent effect on the defaulting dealers. However, in what circumstances
penalty can be levied is an issue to be appreciated by authority empowered to
levy the penalty. There are number of judgments where it is held that for levy
of penalty mens rea is a condition precedent. There are also judgments where it
is observed that mens rea may not be necessary to be proved for levy of penalty
under fiscal laws. Normally in relation to fiscal laws reference is made to the
landmark judgment of the Supreme Court in case of Hindustan Steel Ltd. (25 STC
211) (SC) wherein the Supreme Court has observed about nature and incidence of
penalty under fiscal laws. The relevant para is reproduced below:

“Under the Act penalty may
be imposed for failure to register as a dealer : S. 9(1) r/w S. 25(1)(a) of the
Act. But the liability to pay penalty does not arise merely upon proof of
default in registering as a dealer. An order imposing penalty for failure to
carry out a statutory obligation is the result of a quasi-criminal proceeding,
and penalty will not ordinarily be imposed unless the party obliged either acted
deliberately in defiance of law or was guilty of conduct contumacious or
dishonest, or acted in conscious disregard of its obligation. Penalty will not
also be imposed merely because it is lawful to do so. Whether penalty should be
imposed for failure to perform a statutory obligation is a matter of discretion
of the authority to be exercised judicially and on a consideration of all the
relevant circumstances. Even if a minimum penalty is prescribed, the authority
competent to impose the penalty will be justified in refusing to impose penalty,
when there is a technical or venial breach of the provisions of the Act or where
the breach flows from a bona fide belief that the offender is not liable
to the act in the manner prescribed by the statute. Those in charge of the
affairs of the company in failing to register the company as a dealer acted in
the honest and genuine belief that the company was not a dealer. Granting that
they erred, no case for imposing penalty was made out.”

Recently, the Supreme Court
had an occasion to decide one such penalty matter under the CST Act, 1956 in
case of M/s. Commissioner of Sales Tax, U.P. v. Sanjiv Fabrics, (35 VST 1) (SC).

The facts are that, as per
Registration Certificate under the CST Act, 1956 the dealer was authorised to
purchase cotton/cotton yarn on C Form. However the dealer had purchased cotton
waste, polythene, sutli and tat against C Form. The lower authority considered
the said purchases as unauthorised and levied penalty u/s.10(b) read with S. 10A
of the CST Act, 1956.

The further fact is that
when the issue of penalty came up, the dealer applied for amendment of
registration certificate. Against the penalty order an appeal was filed but the
dealer failed. The Tribunal also upheld the penalty on the ground that cotton
and cotton wastes are two different commodities, hence, there was sufficient
cause for penalty. The argument of the dealer was that he has acted under
bona fide belief that cotton includes cotton waste. The matter was carried
further to the High Court by the dealer. The Allahabad High Court allowed the
appeal by observing as under :

‘Cotton’ and ‘Cotton Waste’
are two different commodities known to Sales Tax Laws. However, there is not
much distinction from the point of view of ordinary people. The applicant is a
registered dealer since the A.Y. 1977-78 and has been making purchases of
‘Cotton waste’ and issuing Form C thereof since then. The department earlier
than October 15, 1985 raised no objection. This as was submitted by the learned
counsel for the applicant is very relevant
circumstance for determination of the question ‘false representation’ occurring
in S. 10(b) of the Act . . . . When Tax Laws are so complex the administration
should proceed specially in the penalty matter from the view of ordinary citizen
who is always willing to comply with the conditions of law. The assessee as soon
as it came to know about its (sic) fault filed application for amendment of
registration certificate. Some fault was on the part of the Department also for
maintaining silence over the period of about eight years.”

The Sales Tax Department
preferred SLP before the Supreme Court contending that mens rea is not an
essential ingredient of the offence u/s.10(b) of the CST Act, 1956 and it is in
the nature of civil liability. It was further argued that if prosecution is
launched, only then mens rea assumes importance.

The argument of the dealer
was that the penalty u/s.10(b) is in lieu of prosecution and mens rea would be
sine qua non for attracting the said penalty.

The Supreme Court referred
to relevant provisions of the CST Act, 1956 i.e., S. 10(b) and S. 10A which are
reproduced below :

“10. Penalties

If any person —

“(b) being a registered
dealer, falsely represents when purchasing any class of goods that goods of
such a class are covered by his certificate of registration, or . . . .”

“10A.
Imposition of penalty in lieu of prosecution

(1) If any person purchasing goods is guilty of an offence under clause (b) or clause (c) or clause
(d) of S. 10, the authority who granted to him or, as the case may be, is competent to grant to him a certificate of registration under this Act may, after giving him a reasonable opportunity of being heard, by order in writing, impose upon him by way of penalty a sum not exceeding one and a half times the tax which would have been levied under Ss.(2) of S. 8 in respect of the sale to him of the goods, if the sale had been a sale falling within that sub-section. Provided that no prosecution for an offence u/s.10 shall be instituted in respect of the same facts on which a penalty has been imposed under this Section.”

The Supreme Court observed that the real issue is to see what is the significance of using the words ‘falsely represents’. In light of the above, the Supreme Court wanted to find out whether the above term contemplates concept of mens rea. Supreme Court referred to earlier judgment in the case of Nathulal v. State of Madhya Pradesh, (AIR 1966 SC 43) and referred to the following observations:

“Mens rea is an essential ingredient of a criminal offence. Doubtless a statute may exclude the element of mens rea, but it is a sound rule of con-struction adopted in England and also accepted in India to construe a statutory provision creating an offence in conformity with the common law rather than against it unless the statute expressly or by necessary implication excluded mens rea. The mere fact that the object of the statute is to promote welfare activities or to eradicate a grave social evil is by itself not decisive of the question whether the element of guilty mind is excluded from the ingredients of an offence. Mens rea by necessary implication may be excluded from a statute only where it is absolutely clear that the implementation of the object of the statute would otherwise be defeated. The nature of the mens rea that would be implied in a statute creating an offence depends on the object of the Act and the provisions thereof ….”

The Supreme Court referred to the judgment in the case of Union of India v. Dharamendra Textile Processors, (2008) 13 SCC 369 and simultaneously also referred to the judgment in the case of Union of India v. Rajasthan Spinning & Weaving Mills, (2009) (13 SCC 448) and observed that “in examining whether mens rea is an essential element of an offence created under a taxing statute, regard must be had to the following factors:

(i)   the object and scheme of the statute;
(ii)   the language of the Section; and
(iii)   the nature of penalty.”

On overall appreciation of S. 10(b) and legal position about mens rea, the Supreme Court held as under:

“In view of the above, we are of the considered opinion that the use of the expression ‘falsely represents’ is indicative of the fact that the offence u/s.10(b) of the Act comes into existence only where a dealer acts deliberately in defiance of law or is guilty of contumacious or dishon-est conduct. Therefore, in proceedings for levy of penalty u/s.10A of the Act, burden would be on the Revenue to prove the existence of circumstances constituting the said offence. Furthermore, it is evident from the heading of S. 10A of the Act that for breach of any provision of the Act, constituting an offence u/s.10 of the Act, ordinary remedy is prosecution which may entail a sentence of imprisonment and the penalty u/s.10A of the Act is only in lieu of prosecution. In light of the language employed in the Section and the nature of penalty con-templated therein, we find it difficult to hold that all types of omissions or commissions in the use of Form ‘C’ will be embraced in the expression ‘false representation’. In our opinion, therefore, a finding of mens rea is a condition precedent for levying penalty u/s.10(b) read with S. 10A of the Act.”

Accordingly the Supreme Court held that mens rea was required to be satisfied before levy of penalty. The Supreme Court remitted the matters back to the adjudicating authority for fresh consideration of the issue, in light of the findings of the mens rea on part of the dealer.

Nirav Shah

Road map to GST

In view of the announcement made by the Union Finance Minister, in his budget speech, to introduce Goods and Services Tax (GST), from 1st April 2010, in place of existing indirect taxes all over India, the Empowered Committee of State Finance Ministers has released its First Discussion Paper on 10th November 2009. And it has invited views and suggestions from all stake-holders.

Although only a broad outline of the proposed GST has been presented through this Discussion Paper, the detailed aspects thereof are yet to be revealed. It is now up to the trade, industry, professionals and people in general to come forward and give their views and suggestions, so the same can be considered by the Government before making a final draft of the proposed Law.

The views presented by the Empowered Committee, through its First Discussion Paper on GST, may be summarised as follows :

1. It would be dual GST i.e., Central GST and State GST.

2. This dual GST model would be implemented through multiple statutes (one for CGST and SGST statute separate for each State).

3. Central GST shall be administered by the Central Government and State GST by respective State Government.

4. The Central GST and State GST are to be paid to the accounts of the Centre and the States separately.

5. Since the Central GST and State GST are to be treated separately, taxes paid against the Central GST shall be allowed to be taken as input tax credit (ITC) for the Central GST and could be utilised only against the payment of Central GST. The same principle will be applicable for the State GST. A taxpayer or exporter would have to maintain separate details in books of account for utilisation or refund of credit.

6. Cross-utilisation of ITC between the Central GST and the State GST would not be allowed except in the case of inter-State supply of goods and services, which shall be liable for IGST.

7. The inter-State transactions of goods as well as services shall be liable for IGST (i.e., CGST plus SGST) with full credit in the State of destination.

8. Although CGST and SGST would be applicable to all transactions of goods and services made for a consideration, except on exempted goods and services, there would also be a list of items which shall remain out of the purview of GST.

9. The State Governments shall continue to levy excise duty and sales tax (VAT) on production/sale/purchase of goods, which are outside the purview of GST.

10. The imports shall be liable for CGST as well as SGST to be levied by Central and State Governments, respectively.

11. The Empowered Committee has recommended that certain taxes and levies, presently levied by the Central Government and the States, should be subsumed in GST, however whether to include or not certain other taxes and levies, the matter is still under consideration.

12. Although, rates of tax are yet to be decided, the Discussion Paper indicates that there may be more than two rates of tax. The rate of CGST and the rate of SGST on various goods and services may be different. The rate of tax on goods and the rate of tax on services may also differ.

13. While the threshold limit of gross annual turnover for SGST is proposed to be Rupees 10 lacs (both for goods as well as services), the threshold for CGST may be Rupees 150 lacs and a separate threshold of CGST may be worked out in respect of annual turnover of services.

14. The exemptions, remissions, etc. in relation to Special Industrial Area Schemes are proposed to be continued till legitimate expiry time both for the Centre and the States.

15. Each taxpayer would be allotted a PAN-linked taxpayer identification number with a total of 13/15 digits. This would bring the GST PAN-linked system in line with the prevailing PAN-based system for income-tax, facilitating data exchange and taxpayer compliance.

16. The taxpayer would need to submit periodical returns, in common format as far as possible, to both the Central GST authority and to the concerned State GST authorities.

The Empowered Committee has recommended that, to begin with, the following taxes and levies may be subsumed in the proposed Goods and Services Tax :

A. Central Taxes :

(i) Central Excise Duty

(ii) Additional Excise Duties

(iii) Excise Duty levied under the Medicinal and Toiletries Preparation Act

(iv) Service Tax

(v) Additional Customs Duty, commonly known as Countervailing Duty (CVD)

(vi) Special Additional Duty of Customs — 4% (SAD)

(vii) Surcharges, and

(viii) Cesses

B. State Taxes :

(i) VAT/Sales tax.

(ii) Entertainment tax (unless it is levied by the local bodies).

(iii) Luxury tax.

(iv) Taxes on lottery, betting and gambling.

(v) State Cesses and Surcharges insofar as they relate to supply of goods and services.

(vi) Entry tax not in lieu of Octroi.

There are several other taxes and levies on which a consensus is yet to be arrived.

Nirav Shah

Deemed dividend: Section 2(22)(e): A.Y. 1999-00: Gratuitous loan deemed to be dividend: Shareholder permitting his immovable property to be mortgaged to bank enabling company to obtain loan: Loan by company to shareholder not deemed dividend.

The assessee holding substantial shareholding in a private company permitted his immovable property to be mortgaged to the bank for enabling the company to take the benefit of loan. In spite of request of the assessee, the company was unable to release the property from mortgage. Consequently, the board of directors of the company passed a resolution authoring the assessee to obtain from the company interest-free deposit up to Rs.50,00,000 as and when required. In the A.Y. 1999-00, the assessee obtained from the company a sum of Rs.20,75,000 by way of security deposit. A sum of Rs.20,00,000 was subsequently returned by the assessee to the company. For the A.Y. 1999-00, the Assessing Officer added the sum of Rs.20,75,000 as deemed dividend u/s.2(22)(e) of the Income-tax Act, 1961. The Tribunal upheld the addition.

On appeal by the assessee, the Calcutta High Court reversed the decision of the Tribunal and held as under:

“(i) The phrase ‘by way of advance or loan’ appearing in sub-clause (e) of section 2(22) of the Incometax Act, 1961, must be construed to mean those advances or loans which a shareholder enjoys simply on account of being a person who is the beneficial owner of shares . . . . . ; but if such loan or advance is given to such shareholder as a consequence of any further consideration which is beneficial to the company received from such shareholder, in such case, such advance or loan cannot be said to be deemed dividend within the meaning of the Act.

(ii) Thus gratuitous loans or advance given by a company to those class of shareholders would come within the purview of section 2(22), but not cases where the loan or advance is given in return to an advantage conferred upon the company by such shareholder.

(iii) For retaining the benefit of loan availed from the bank if decision was taken to give advance to the assessee, such decision was not to give gratuitous advance to its shareholder, but to protect the business interest of the company. The sum of Rs.20,75,000 could not be treated as deemed dividend.”

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Nirav Shah

Capital gain: Sections 10B and 50(2): A.Y. 1993- 94: Assessee eligible for exemption u/s.10B sold assets to sister concern after expiry of period of exemption. Purchase of assets of same rate of depreciation: Assessee entitled to benefit u/s.50(2).

The assessee had an export-oriented unit. After expiry of the term of benefit u/s.10B, in the A.Y. 1993-94, the assessee transferred the unit to a closely held company. There was a difference of Rs.71,42,904 between the value of the assets, as shown in the balance sheet as on date of transfer and the value of the assets adopted by the company. The Assessing Officer treated the difference as short term capital gains without allowing the benefit u/s.50(2). The Tribunal confirmed the order of the Assessing Officer.

On appeal by the assessee, the Madras High Court reversed the decision of the Tribunal and held as under:

“(i) The assessee carried on the same line of business, both as an export undertaking as well as in domestic trade. The assessee made an addition of 25% in the block of assets, viz., plant and machinery, during the previous year. Given the fact that the depreciation in respect of the assets transferred and purchased carried the same rate of depreciation and, hence, fell under ‘block of assets’, the assessee was justified in his claim on capital gains, that with the cost of the machinery added to the written down value of the machinery and the sale of the machinery during the relevant previous year, he was entitled to relief u/s.50(2).

(ii) Going by the provisions u/s.10B, the Revenue would not be justified in treating the assets of an export-oriented unit in isolation on the expiry of the tax holiday period, particularly when section 10B(4)(iv) recognises deemed grant of the depreciation allowance during the currency of the tax holiday, which means that at the expiry of the period of five years, the written down value of the plant and machinery continues to be available for the business of the assessee, which goes for normal assessment under various provisions of the Act.”

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Nirav Shah

Business expenditure: Section 43B: In A.Y. 1996- 97 the assessee paid a sum of Rs.322.46 lakh on account of excise duty being the liability for the A.Y. 1997-98: Assessee is entitled to the deduction in the A.Y. 1996-97 in view of section 43B(a) r/w. Expl. 2.

During the previous year relevant to the A.Y. 1996-97, the assessee paid a sum of Rs.322.46 lakh on account of excise duty, the liability for payment of which was incurred in the previous year relevant to the A.Y. 1997-98. Relying on the provisions of section 43B of the Income-tax Act, 1961, the assessee claimed the deduction of the said amount in the A.Y. 1996-97. The Assessing Officer disallowed the claim. The Tribunal upheld the disallowance.

On appeal by the assessee, the Calcutta High Court reversed the decision of the Tribunal and held as under:

“The assessee cannot be deprived of the benefit of deduction of excise duty actually paid during the previous year, although in advance, according to the method of accounting followed by him. Section 43B(a) r/w. Expln. 2 allows deduction in such cases.”

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Nirav Shah

Interest u/s.220(2): A.Y. 1994-95: Original assessment order set aside by Tribunal: Interest u/s.220(2) to commence after thirty days from the date of service of demand notice pursuant to fresh assessment order.

For the A.Y. 1994-95, the assessment was completed u/s.143(3) of the Income-tax Act, 1961 on 28-2-1997 determining the total income at Rs.2.05 crores. By a demand notice dated 28-2-1997 a demand of Rs.1.76 crore was raised. The assessment order was set aside by the Tribunal. Fresh assessment order was passed on 24-12-2006 computing the income at Rs.44.88 lakhs and raising a demand of Rs.22.02 lakhs. The Assessing Officer held that the assessee was liable to pay interest u/s.220(2) of the Act commencing from the day after thirty days from the date of service of the original demand notice dated 28-2-1997. The CIT(A) and the Tribunal accepted the claim of the assessee that the liability to pay interest u/s.220(2) commences from the day after thirty days from the date of service of the demand notice dated 24-12-2006 pursuant to the fresh assessment order.

On appeal by the Revenue, the Bombay High Court upheld the decision of the Tribunal and held as under:

“(i) The argument of the Revenue is that even though the original assessment order dated 28-2-1997 was set aside by the ITAT, once the fresh assessment order is passed, the demands arising therefrom would relate back to the date of service of the original demand notice dated 28-2-1997.

(ii) We see no merit in the above contention. U/s.156 of the Act, service of the demand notice is mandatory. Section 220(2) of the Act provides that if the amount specified in any notice of demand u/s.156 is not paid within the period prescribed u/ss.(1) of section 220, then, the assessee shall be liable to pay simple interest at the rate prescribed therein.

(iii) As per section 220(1) of the Act, the assessee was liable to pay the demand within thirty days from the service of the demand notice dated 24-12-2006. It is only if the assessee fails to pay the amount demanded, within thirty days of service of the demand notice dated 24-12-2006, the assessee was liable to pay interest u/s.220(2) of the Act. If the liability to pay interest u/s.220(2) arises after thirty days of service of the demand notice dated 24-12-2006, the question of demanding interest for the period prior to 24-12-2006 does not arise at all.

(iv) From the facts of the present case, the decision of the ITAT in holding that the assessee is liable to pay interest u/s.220(2) of the Act, from the end of thirty days after the service of notice of demand dated 24-12-2006 till the date on which the amount demanded was paid cannot be faulted.”

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Nirav Shah

Capital gains: Exemption u/s.54F: Purchase of two adjacent flats, interconnected and used as one residential house: Assessee entitled to exemption u/s.54F

“It has been shown to us that investment was made by the assessee himself from his bank account in respect of both the flats i.e., flat Nos. 301 and 302 at Cozy Dwell Apartments at Bandra, Mumbai. However, this needs verification by the Assessing Officer. Further the fact whether these two apartments are being used as one residential house or not is also to be verified. Accordingly, the order of the CIT(A) is set aside and the matter is restored to the file of the Assessing Officer to — (1) verify the fact whether investment in flat Nos. 301 and 302 was made by the assessee from his own funds, and (2) whether such flats are adjacent to each other having common passage and are being used as one residential house. After ascertaining these facts the Assessing Officer shall allow the exemption in respect of both the flats if it is found that both the flats are being used as one residential house and the investment was made by the assessee himself.”

The Bombay High Court upheld the decision of the Tribunal and dismissed the appeal filed by the Revenue.

Note: The Supreme Court has dismissed the SLP No. 12607 of 2009 filed by the Revenue, by order dated 7-9-2009.

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Nirav Shah

Capital gains: Exemption u/s.54F: Purchase of two adjacent flats, interconnected and used as one residential house: Assessee entitled to exemption u/s.54F.

The assessee had purchased two adjacent flats which were interconnected and used as one residential house. On the assesee’s claim for exemption u/s.54F of the Income-tax Act, 1961 the Tribunal passed the order as under: “It has been shown to us that investment was made by the assessee himself from his bank account in respect of both the flats i.e., flat Nos. 301 and 302 at Cozy Dwell Apartments at Bandra, Mumbai. However, this needs verification by the Assessing Officer. Further the fact whether these two apartments are being used as one residential house or not is also to be verified. Accordingly, the order of the CIT(A) is set aside and the matter is restored to the file of the Assessing Officer to — (1) verify the fact whether investment in flat Nos. 301 and 302 was made by the assessee from his own funds, and (2) whether such flats are adjacent to each other having common passage and are being used as one residential house. After ascertaining these facts the Assessing Officer shall allow the exemption in respect of both the flats if it is found that both the flats are being used as one residential house and the investment was made by the assessee himself.” The Bombay High Court upheld the decision of the Tribunal and dismissed the appeal filed by the Revenue. Note: The Supreme Court has dismissed the SLP No. 12607 of 2009 filed by the Revenue, by order dated 7-9-2009.

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Nirav Shah

(2011) 39 VST 529 (AP) Asian Peroxide Limited and Another v. State of Andhra Pradesh

VAT — Constitutional validity — Power to prescribe rule not eligible for input tax credit — Valid — Retrospective effect — Invalid — Sections 2(19), 4(3) 13(4), and 78 of the Andhra Pradesh Value Added Tax Act, (5 of 2005) and Rule 20(2) (h) of the Andhra Pradesh Value Added Tax Rules, 2005.

Facts
The dealers filed writ petition before the AP High Court challenging constitutional validity of section 13(4) of the APVAT Act and Rule 20(2)(h) of the APVAT Rules. The effect of this rule is that all petitioners availing input tax credit in respect of coal, naphtha or natural gas u/s.13(1) of the APVAT Act is denied from retrospective effect.

Held
(1) The replacement of sales tax by VAT is mainly intended to improve revenue collections and to prevent cascading effect on sale price, besides plugging gaps in tax collection. It also becomes clear that though the Legislature permits the dealers to avail input tax credit (ITC) in respect of most items of common consumption, it was never intended that all taxable goods and business should invariables be allowed ITC.

(2) Under the Act, the tax payable by the VAT dealer shall be X-Y, where X is the total of VAT payable in respect all taxable sales made by a dealer and Y is the total ITC, which he is eligible to claim set-off. The ITC is allowed in respect of purchases of taxable goods except tax paid on purchase of goods specified in the sixth Schedule, subject to conditions that may be prescribed by the VAT Rules. S.s (4) of section 13 of the Act bars a VAT dealer claiming ITC in respect of the purchase of taxable goods as may be prescribed by the rule-making authority to that extent position is not denied. The petitioners urged that under the Act, ITC can be denied only in respect of those goods which are exempt from tax or attracts special rate of tax as provided in the sixth Schedule.

(3) The Government can prescribe any or all purchase of taxable goods in respect of which ITC should not be allowed, whether or not those taxable goods are included in the first or sixth Schedule. Section 13(4) r.w.s. 78(1) of the Act confers widest power on the State to prescribe the taxable goods in respect of which ITC cannot be allowed.

(4) The Legislature has retained prior legislative control on the rule-making authority. The VAT Rules, so laid before the legislative assembly for a period of 14 days can be modified or annulled and they shall be enforced only subject to such modification or annulment. Therefore section 13(4) of the VAT Act does not suffer from excessive delegation.

(5) The Rule 20(2)(h) which disqualifies natural gas, naphtha and coal from claiming ITC is valid and does not suffer from any defect of being ultra vires and is also not unreasonable. Since under Rule 20(2) when goods mentioned in negative list are sold subsequently without availing ITC, no tax shall be levied or recoverable from a dealer on sale of such goods. This brings out the rationale in classifying the traders and non-traders. Traders and non-traders do not stand on the same footing when it comes to use of such goods. The purpose or the use to which goods are put to use can be basis for a valid classification. The impugned rule is not discriminatory.

(6) In absence of any reasons, the retrospective effect given to rule is inequitable and arbitrary. Accordingly, it shall apply prospectively from notified date i.e., 31-12-2005.

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Nirav Shah

Vasanthi Automobiles v. Commercial Tax Officer II, Puducherry, [2011] 43 VST 142 (Mad)

Sales Tax- Inter-State Stock Transfer-Time – Limit Prescribed for Furnishing “F” Form – Forms obtained after time-limit – Can be accepted- Section 16 of The Pondicherry General Sales Tax Act, 1967 and The Central Sales Tax ( Registration and Turnover) Rules,1957.

Facts

The Pondicherry General Sales Tax Rules provides that if the assesse claimed any concessional rate of tax based on any declaration in form C or D, as the case may be and fails to furnish the declaration with returns then the dealer shall be assessed at the higher rate of tax on the turnover declared in the returns filed by him. However, if the dealer filed required declaration within a period of 90 days from the date of receipt of the assessment order, the assessment order stands suitably modified under the Act to the extent of the declaration filed. Since in the case of a dealer, necessary declaration in F form was not filed at the time of filing of the return, the assessment was made at higher rate of tax. The dealer filed application u/s. 16 of the Act with the production of necessary F form which was rejected on the ground that the application was not made within the prescribed period of 90 days. The dealer filed writ petition before the High Court against the order.

Held

It may be noted that the furnishing of the statutory forms is not within the control of the petitioner and is dependent on the other State dealer’s co-operation. If on a sufficient cause the petitioner satisfies the requirements of law, the claim cannot be rejected unjustifiably merely on the score of time limit prescribed under the Act. The High Court accordingly allowed the writ petition filed by the dealer with a direction to the department to accept Form F filed by the dealer and grant necessary relief.

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Nirav Shah

2012 TIOL 993 (Tri.-Mumbai) Life Care Medical System vs. CST, Mumbai – II

Promotion/marketing of goods for a foreign principal in India, can it be termed as export of services as the user of the service is located outside India? Held, it is not export of services.

Facts:

The appellants were engaged in promoting, marketing and distributing (installation and warranty) of various medical equipments for M/s. Viasys International Corporation, Pennsylvania, USA. The appellants discharged the service tax liability in respect of the installation and warranty services but did not pay service tax on advertising, promoting and marketing services under the category of business auxiliary as it was export of services. The appellants submitted that all the conditions as stipulated from time to time in relation to export of services were satisfied. The appellants relied on the CBEC Circular No. 111/5/2009-ST dated 24th February, 2009 which stated that in respect of service recipient based services, the relevant factor is the location of the service recipient and not the place of performance. The appellants also relied on a) Em Jay Engineers vs. CCE, Mumbai 2010 (20) STR 821 (Tri – Mum), (b) Lenovo (India) Pvt. Ltd. vs. CCE, Bangalore 2010 (20) STR 66 (Tri – Bang) and (c) SGS India Pvt. Ltd. vs. CST, Mumbai 2011 (24) STR 60 (Tri – Mumbai).

Held:

The Tribunal held that the appellants satisfied the conditions laid down for export of services for the period 1st July, 2003 to 19th November, 2003 as service tax is a destination based tax and the service recipient being located outside India, no service tax was leviable. For the period 15th March, 2005 till 18th April 2006, the Export of Services Rules, 2005 inserted the conditions that (a) service should be delivered outside India and (b) there should be receipt in foreign exchange. The condition of delivery outside India was not satisfied as the services were rendered in India and thus consumed in India. For the period from 19th April, 2006 to 5th December, 2007, the condition in relation to export of services was amended stating that (a) the services should be provided from India and used outside India; and (b) there should be receipt in foreign exchange. During the said period also, the services were not used outside India as the sales took place in India and thus, the services were provided and consumed without reverting to foreign principals for consumption abroad meant to have exhausted in India and hence not exported. The Tribunal also observed that since the appellants discharged the liability on installation and warranty services, they were aware of the levy of service tax. Moreover, the relevant clause of the agreement also stipulated the condition of reimbursement of tax from the foreign principal. Hence, plea of limitation was also disallowed and pre-deposit of Rs. 25 lakh was ordered.

Note: in the above case, the Tribunal distinguished the following cases:

• Em Jay Engineers vs. CCE, Mumbai 2010 (20) STR 821 (Tri – Mum)
• Lenovo (India) Pvt. Ltd. vs. CCE, Bangalore 2010 (20) STR 66 (Tri – Bang)
• SGS India Pvt. Ltd. vs. CST, Mumbai 2011 (24) STR 60 (Tri – Mumbai) and relied on:
• Microsoft Corporation (India) Pvt. Ltd. vs. CST, Delhi 2009-TIOL-601-HC-DEL-ST
• All India Federation of Tax practitioners 2007-TIOL-149-SC-ST

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Nirav Shah

2012 (28) STR 391 (Tri.-Mumbai) Skoda Auto India Pvt. Ltd. vs. Commissioner of C. Ex., Aurangabad

If CENVAT Credit is claimed for service tax paid under reverse charge mechanism, it implies that the service tax liability was accepted.

Facts:

The appellants, a manufacturer of motor vehicles also rendered technical assistance, training with respect to supply, assembly, manufacture, testing and quality assurance of products and to use their trademark, to Skoda Auto A. S. The appellants paid service tax with interest during the pendency of SCN. In view of decision of Indian National Ship Owners Association vs. Union of India 2009 (13) STR 235 (Bom.), the appellants filed refund claim of interest for delayed payment of Service tax paid in pursuance of the SCN. The authorities rejected the refund claim on the grounds of limitation and that the order-in-original was not challenged. However, the appellants contested that the issue was well settled in view of judgment of Indian National Ship Owners Association (Supra) which was confirmed by the Supreme Court that import of services were not taxable prior to 18/04/2006 and therefore they were eligible for refund of service tax with interest from 11/12/2008 when the Hon’ble High Court decided the issue. Further, since the appellants took CENVAT credit of service tax paid, the refund claim was with respect to interest paid which was filed within 1 year from the date of decision of the Hon’ble High Court.

Held:

The appellants paid service tax with interest in the year 2006 which was appropriated by way of adjudication and the appellants took CENVAT Credit of Service tax paid and filed refund claim of interest paid. Though in view of the decision in the case of Indian National Ship Owners Association (Supra) Service tax was not leviable, the appellants did not claim refund of Service tax which implied that the appellants had admitted their Service tax liability. Since the liability was admitted, it should be paid with interest as held by Hon’ble Supreme Court in case of CCE vs. SKF India Ltd. 2009 (239) ELT 385 (SC) and therefore, the appeal was rejected.

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Nirav Shah

2012 (28) STR 380 (Tri.-Mumbai) Jyoti Structures Ltd. vs. Commissioner of Central Excise, Nasik

One to one co-relation not required for utilisation of CENVAT credit for payment of excise duty or service tax.

Facts:

The appellants, a manufacturer of transmission towers also provides erection, commissioning and installation, management, maintenance or repairs, testing, inspection of these towers services. For discharging Central Excise Duty and Service tax liability, the appellants utilised CENVAT Credit. The department denied utilisation of CENVAT Credit for payment of Central Excise Duty on the dutiable final product and output services on the grounds that the appellants did not maintain separate books of accounts for inputs and input services utilised in the manufacture of final products and used in providing output services.

Held:

Following Tribunal’s decision in case of Forbes Marshall Pvt. Ltd. vs. Commissioner of Central Excise, Pune 2010 (258) ELT 571 (Tri.), the Tribunal held that there was no provision under CENVAT Credit Rules, 2004 for segregation of CENVAT Credit for payment of Central Excise Duty and Service tax liability.

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Nirav Shah

2012 (28) STR 364 (Tri.-Del.) C.C.E., Chandigarh vs. Amar Nath Aggarwal Builders Pvt. Ltd.

The builders constructing residential complexes on their own land and selling to prospective customers, were not leviable to service tax prior to 01/07/2010.

Facts:

The respondents constructed residential complexes on their land and made agreements for sale of flats and received advance from prospective buyers. As per CBEC Circular, the builders provided no service to any prospective buyers. The activity was covered only after introduction of Explanation to section 65 (105) (zzzh) of the Finance Act, 1994 i.e. with effect from 01/07/2010. The said explanation was prospective and such activity was not chargeable to service tax prior to 01/07/2010 as depicted in the case of Skynet Builders Developers Colonizers and others 2012 (27) STR 388 (Tri.-Del.) The revenue relying on Punjab & Haryana High Court in case of G. S. Promoters vs. UOI 2011 (21) STR 100 (P & H) contended the activities as chargeable to service tax even prior to 01/07/2010 and considered the explanation to be clarificatory.

Held:

The G. S. Promoter’s case (Supra) dealt with the issue of constitutional validity of the Explanation inserted u/s. 65(105)(zzzh) of the Finance Act, 1994 with effect from 01/07/2010 and the case did not examine whether the explanation could have retrospective effect. Following the decision of Skynet Builders (Supra), revenue’s appeal was dismissed.

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Nirav Shah

2012 (28) STR 362 (Tri.-Del.) Ashok Agarwal vs. Commissioner Of Central Excise, Jaipur – I

If the assessee did tax planning, extended period of limitation cannot be invoked.

Facts:

The appellant, a clearing and forwarding agent for M/s. Chambal Fertilisers & Chemicals Ltd. (‘CFCL’) also had separate contract with CFCL for giving their godown on rent for the goods for which they acted as clearing and forwarding agent. Service tax was demanded on godown rent under “storage and warehousing services”. According to the appellant, the godown rent was in the form of reimbursements and as per CBEC clarification, it was not leviable to service tax. Further, the nature of services of the appellants was “clearing and forwarding agent” as against “storage and warehousing services” and that the department issued SCN under the category of storage and warehousing services and the demand was confirmed under “clearing and forwarding agent” and therefore, the order travelled beyond the scope of SCN. According to revenue, the services of clearing and forwarding could not have been performed without storage space and the cost of storage space was integral part of value of services provided. Further, the separate contract for rent was for the purpose of reduction of tax incidence. Since the contract was hidden, there was suppression of facts and therefore, extended period was invoked.

Held:

There was a legal infirmity that tax was demanded under a different category from the one mentioned in SCN. Viewing the case as one of tax planning rather than tax evasion, extended period of limitation was held not justified and appeal was dismissed.

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Nirav Shah

2012 (28) STR 291 (Tri.-Mumbai) Commissioner of C. Ex. & Service Tax (LTU) vs. Lupin Ltd.

Definition of “input services” is very wide and covers not only services which are directly or indirectly used in or in relation to the manufacture of final product but also after manufacturing of the final product

Facts:

The department denied CENVAT Credit on input services; viz. tour operator’s services, garden maintenance services, waste management services and repair of fan services on the grounds that these services were not integrally connected to the manufacture of final product and therefore, these were not eligible input services under Rule 2(l) of the CENVAT Credit Rules, 2004.

The respondents contended these to be eligible for the manufacturing process as the tour operator’s services were used for transporting their staff from residence to factory and back. Waste management services were a statutory requirement. So also garden maintenance was essential to keep the factory premises neat and clean and fans were installed in the factory and therefore, their maintenance was integral to manufacturing. Further, CENVAT Credit on waste management services and tour operator services was allowed by Tribunal in their own case.

Held

Relying on Ultratech Cement Ltd. 2010 (20) STR 577 (Bom.) and various other relevant decisions, CENVAT credit in respect of above services as well as in respect of services of photography, dry cleaning of uniforms of staff, construction for premises of manufacture, brokerage paid for selling products were held as input services eligible for credit.

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Nirav Shah

2012 (28) STR 270 (Tri.-Del.) Commissioner of S. T., New Delhi vs. Fankaar Interiors Pvt. Ltd.

Completion and finishing services are taxable with effect from 16/06/2005 under commercial or industrial construction services and the same were not covered under earlier definition of construction services.

Facts:

The respondents were engaged in the execution of interior, civil, electrical and various other miscellaneous work. The Commissioner (Appeals) passed an order in favour of the respondents stating that the definition of construction services was provided u/s. 65(30a) of the Finance Act, 1994 till 15/06/2005 and thereafter, the definition of commercial or industrial construction services was introduced u/s. 65(25b) of the Finance Act, 1994 which expanded the scope of the services to include completion and finishing services. Further, even renovation services were inserted under service tax levy with effect from 16/06/2005. The revenue contested that the amendment with effect from 16/06/2005 was only to define the scope of services specifically and that the completion and finishing services were taxable even prior to 16/06/2005.

Held:

Relying on the Tribunal’s judgment in the case of Spandrel vs. CCE, Hyderabad 2010 (20) STR 129 (Tri.-Bang.), it was held that the completion and finishing services were taxable only with effect from 16/06/2005.

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Nirav Shah

2012 (28) STR 268 (Tri.-Del.) Bhawana Motors vs. Commissioner of Central Excise, Jaipur – II

Extended period of limitation cannot be invoked in a case where the department had issued a SCN on the same grounds for previous period.

Facts:

The appellants engaged in providing vehicles on hire were not paying service tax and were not filing service tax returns. Therefore, the department issued a Show Cause Notice (SCN) considering the said services to be “rent-a-cab services” for the period from February, 2004 to March 2005 demanding service tax with interest and penalty u/s. 76, 77 and 78 of the Finance Act, 1994. Relying on the Hon’ble Apex Court’s decision in case of Nizam Sugar Factory vs. CCE, A.P. 2008 (9) STR 314 (SC), the appellants argued that the SCN was time barred since on the same grounds, the department had issued SCN previously for the period from 01/04/2002 to 31/12/2003.

Therefore, the department was aware of the facts and accordingly, there cannot be any allegation with respect to suppression of facts from the department and thereby, invoking extended period of limitation was not justified. Further, relying on Tribunal’s decision in the case of P. Sugumar vs. CCE, Pondicherry 2010 (17) STR 524 (Tri.-Chennai), the activity of the appellants, being transportation of employees at a pre-determined rate, were not covered under “rent-a-cab services”. The department argued that the said activity was taxable in view of Punjab & Harayana High Court’s decision in the case of CCE, Chandigarh vs. Kuldeep Singh Gill 2010 (18) STR 708 (P & H). Further, since the appellants did not submit ST-3 returns, it amounted to suppression of facts and therefore, invoking of extended period was justified.

Held:

Though the appellants wilfully ignored the payment of service tax and submission of returns even after issuance of SCN for the previous period, the activities of the appellants were fully known to the department. The department could have further searched the premises of the appellants in such a case to obtain any requisite information. Accordingly, following the ratio laid down by the Hon’ble Apex Court in case of Nizam Sugar Factory vs. CCE, A. P. (Supra), the demand was not sustainable on the grounds of limitation and therefore, the issue was not discussed with respect to its merits.

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Nirav Shah

2012 (28) STR 264 (Tri.-Mumbai) Commissioner of Service Tax, Mumbai vs. P. N. Writer & Co. Ltd.

Condition of saleability should be satisfied to consider something as ‘goods’.

Facts:

The respondents were engaged in storage and retrieval of records of banks and corporate houses and the records consisted of discharged cheques, vouchers, agreements, books of accounts etc. not intended for sale, but to comply with a statutory requirement. The department contended that the services were classifiable under storage and warehousing and therefore, leviable to service tax. The respondents contested that storage and warehousing of goods were leviable to service tax. As per Finance Act, 1994, the definition of ‘goods’ is adopted from the Sale of Goods Act, 1930. In case of R. D. Saxena vs. Balram Prasad Sharma (AIR 2000 SC 912), the Hon’ble Supreme Court has held that to constitute goods, the same should be marketable. Since files, records etc. were not saleable, it could not be considered as goods. However, the adepartment pleaded that in view of express definition of “goods” under Sale of Goods Act, 1930, every movable property is considered to be goods. Since files, records etc. were movable property, the same should essentially be considered as ‘goods’ and condition of sale was not necessary for levy of service tax.

Held:

As per section 2(7) of the Sale of Goods Act, 1930, to constitute goods, saleability was an essential criteria. If the intention was not to consider the saleability, the service tax laws would not have referred to the definition of goods under the Sale of Goods Act, 1930. Further, the Hon’ble Supreme Court has passed numerous judgments holding that the goods are something which can come into the market for being bought and sold. Therefore, following the judgment delivered in case of R. D. Saxena vs. Balram Prasad Sharma (Supra), it was held that the files, records etc. cannot be considered as goods in the absence of its feature of saleability and therefore, the activity cannot be covered under the storage and warehousing services leviable to service tax.

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Nirav Shah

2012 (28) STR 248 (Tri.-Del.) Max India Ltd. vs. Commissioner of Central Excise, Chandigarh.

Liberal interpretation to be given to notification no. 41/2007-ST dated 06/10/2007 which grants refund of CENVAT Credit on input services used while exporting goods. The revenue authorities cannot be allowed to approbate and reprobate on the same issue with reference to different assessees.

Facts:

The department rejected refund claim of CENVAT credit in respect of input services; viz. inland haulage charges, terminal handling charges, bill of lading charges, processing fee, terminal services, movement charges in port etc. used for export of goods vide Notification No.41/2007-ST dated 06/10/2007. The appellants contended that the service recipient cannot change the classification of the service provided by the service provider. Further, as long as the description of service is covered within the said notification, refund should be available. Further, the appellants referred to the Larger Bench decision in case of Western Agencies 2011 (22) STR 305 (Tri.-LB) and contended that all services rendered within the port area would be considered as port services. The department contested that though the opening paragraph expressly did not mention about classification under the Finance Act, 1994, it is obvious that the description should match with classification of service and that in the present case, the services were not port services since prior to amendment made by the Finance Act, 2010, only services which were performed in the port area by a person authorised by port authorities, were classifiable as port services. Further, the decision of the Larger Bench in case of Western Agencies (supra) is stayed by the Madras High Court and therefore, the judgment could not be relied upon.

Held:

The classification of services cannot be changed by service recipient. There is a serious lacuna in the said notification and missing words cannot be supplied by anyone interpreting the provisions.

The expression “port services”, though was available, the draftman did not insert such expression in the notification and therefore, the expression actually used should be interpreted. The Government intended to include all services rendered in port area as “port services” as is evident from amendment through the Finance Act, 2010. Though the amendment was prospective, the Notification No.41/2007-ST dated 06/10/2007 being beneficial notification for granting refund of tax when the goods are exported, liberal interpretation should be given. Revenue advanced arguments with respect to interpretation of “port services” prior to the introduction of the Finance Act, 2010, which were exactly opposite to the arguments canvassed in case of Western Agencies Pvt. Ltd. which cannot be allowed and therefore, the appeals were allowed.

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Nirav Shah

Commissioner of Central Excise, Raipur (C.G) vs. Simplex Casting Ltd. 2012 (285) ELT 365 (Tri.-Del)

Wrong classification not challenged when approved by the department does not attain finality.

Facts:

Wrong classification was made by department which the assessee did not challenge. The department issued Show Cause Notice demanding tax under wrong classification. The assessee contested such classification in the reply to the Show Cause Notice. The Commissioner (Appeals) held in favour of assessee. The revenue’s contention revolved only around non-challenge at the time of approval by the Assistant Commissioner.

Held:

The Tribunal dismissed the appeal stating that, only because the jurisdictional Assistant Commissioner classified and approved some goods under wrong heading without any challenge by the assessee, it would not mean that for future also, wrong classification shall continue in respect of such goods. Also, on the receipt of demand of duty vide Show Cause Notice, the assessee challenged the erroneous classification. Therefore, it cannot be said that the assessee had accepted the classification and that the approval attained finality.

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Nirav Shah

2012 (28) STR 426 (Mad.) Commissioner of C. Ex., Coimbatore vs. GTN Engineering (I) Ltd./2012 (281) ELT 185 (Mad)

Refund of CENVAT Credit under Rule 5 of the CENVAT Credit Rules, 2004 read with Notification No.5/2006-CE (NT) dated 14/03/2006, should be filed within 1 year from the date when the goods were cleared for export.

Facts:

The respondents filed refund claims for unutilised CENVAT credit of duty paid on inputs and capital goods used in the manufacture of export goods vide Notification No.5/2006-CE (NT) dated 14/03/2006 read with Rule 5 of the CENVAT Credit Rules, 2004. The claims were rejected as timebarred.

The revenue contended that though section 11B of the Central Excise Act, 1944 was applicable only in respect of duty and interest and not in respect of CENVAT credit, section 11B of the Central Excise Act, 1944 was made applicable to refund of CENVAT credit through clause 6 of the Notification No.5/2006-CE (NT) dated 14/03/2006 read with Rule 5 of the CENVAT Credit Rules, 2004 providing for refund of CENVAT credit. However, CESTAT passed the order in favour of the respondents and held that as per Rule 5 of the CENVAT Credit Rules, 2004, no notification was issued with respect to “relevant date” as defined u/s. 11B(5)(B) of the Central Excise Act, 1944 and therefore, no period of limitation was prescribed.

Held:

It was undisputed fact that section 11B of the Central Excise Act, 1944 was applicable only in case of duty and not with respect to CENVAT credit. However, on analysing the relevant provisions, specifically, Rule 5 of the CENVAT Credit Rules, 2004, it was observed that though there is no specific “relevant date” prescribed in the notification, the relevant date should be the date on which final products were cleared for exports. The Hon’ble High Court distinguished the decision of Hon’ble Gujarat High Court’s in case of Commissioner of Central Excise and Customs vs. Swagat Synthetics 2008 (232) ELT 413 (Guj.) and departed from Madhya Pradesh High Court’s decision in case of STI India Ltd. vs. Commissioner of Customs and Central Excise, Indore 2009 (236) ELT 248 (MP) and held that the refund claims filed by respondents were time-barred. Note: In 2012 (281) ELT 227 (Mad.) Dorcas Market Makers P. Ltd. vs. CCE, Single Member Bench decided that rebate cannot be rejected on the ground of limitation. However, the said decision was considered inapplicable by the Bombay High Court in Everest Flavours Ltd. vs. UOI 2012 (282) ELT 481 (Bom.) which also ruled that limitation prescribed in section 11B applied to rebate claim as well.

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Nirav Shah

Negative List and its Implications in tht Context of Cenvat Credit Rules

“The law must be stable, but it must not stand still.” Roscoe Pound – US Jurist

Introduction

Contrary to the expectation of the trade and industry that it might get delayed, the regime of ‘Negative List-based levy of Service Tax’ has kicked in from 1st July, 2012. The new regime replaces the 18-year old regime of ‘Positive List-based levy of Service Tax’. As is well known, the Government had, while introducing the levy in 1994, opted for ‘Selective Approach’, confining the levy initially only to three services. The Government, thereafter, continued with this approach for the next 18 years, expanding the coverage of levy by bringing in new services under the tax net, year after year. However, the Government has finally jettisoned this ‘Selective Approach’ and embraced the ‘Comprehensive Approach’ for the taxation of services. This marks a paradigm shift in the manner in which service tax is levied. In the new system of levy, all services, other than those covered by the Negative List (Section 66D) or exempted under a Notification, will be (or are intended to be) subjected to tax. A set of new and substantial provisions in the form of section 65B and sections 66B to 66E governing the new system has been inserted in the Finance Act, 1994 (‘the Act’) by the Finance Act, 2012 and the same has come into force on 01.07.2012. Simultaneously and effective from this date, the provisions of section 65, 65A, 66 and 66A have ceased to apply.

Section 66D – Negative List of Services:

Section 66B is the new charging provision governing the levy under the new system of taxation of services. The Section reads as under:

“66B. There shall be levied a tax (hereinafter referred to as the service tax) at the rate of twelve per cent on the value of all services, other than those services specified in the negative list, provided or agreed to be provided in the taxable territory by one person to another and collected in such manner as may be prescribed”.

(Emphasis Provided) It will, therefore, be observed that the services specified in the ‘Negative List’ are excluded from the scope of levy through the charging provision of section 66B itself. The term ‘Negative List’ is defined vide clause (34) of section 65B of the Act as under:

“65B(34) “negative list” means the services which are listed in section 66D”.

Thus, the list of services specified u/s. 66D constitutes the ‘Negative List’ and remains outside the purview of levy of service tax. Section 66D contains 17 entries covering a gamut of services which have been kept outside the tax net. Further, most of the entries have in-built sub-entries which significantly expand the number of services that remain outside the scope of levy. The services specified by 17 Clauses of the Section are briefly outlined below:

• Services by Government or local authority excluding specified services [Clause (a)];

• Services by the Reserve Bank of India [Clause (b)];

• Services by a foreign diplomatic mission located in India [Clause (c)];

• Specified services relating to agriculture or agriculture produce [Clause (d)];

• Trading of goods [Clause (e)];

• Any process amounting to manufacture or production of goods [Clause (f)];

• Selling of space or time slots for advertisements other than advertisements broadcast by radio or television [Clause (g)];

• Access to a road or a bridge on payment of toll charges [Clause (h)];

• Betting, gambling or lottery [Clause (i)];

• Admission to entertainment events or access to amusement facilities [Clause (j)];

• Transmission or distribution of electricity by an electricity transmission or distribution utility [Clause (k)];

• Specified Education related services [Clause (l)];

• Renting for residential purpose [Clause (m)];

• Extending loans, advances or deposits on interest or discount [Clause (n)];

• Sale/ Purchase of foreign currency amongst banks or authorised dealers [Clause (n)];

• Specified services of transportation of passengers [Clause (o)];

• Services of transportation of goods by road other than those excluded [Clause (p)];

• Services of funeral, burial, etc. [Clause (q)].

Conceptual Difference Between ‘Non-Taxable Services’ Covered By ‘Negative List’ & ‘Exempted Services’:

It is essential to understand the conceptual difference between ‘non-taxability’ of services covered by the ‘Negative List’ and ‘non-taxability’ arising in respect of ‘exempted services’. At first glance, whether the service is covered by the ‘Negative List‘ or by an exemption notification, both appear to be sitting at par in as much as service tax is not payable in either case. However, dig deeper, and the distinction becomes clear. The services specified in the ‘Negative List’ (section 66D) are excluded from the scope of levy through charging section 66B itself. Hence, such services are ‘non-taxable’ per se. This ‘nontaxability’ is akin to ‘non-excisability’ that arises in the context of Central Excise when, in a given case, the twin-tests of ‘manufacture’ and ‘marketability’ are not satisfied. On the other hand, a service which is exempted by an exemption notification does not become ‘non-taxable’, that is, it does not go outside the purview of levy of tax. It remains ‘taxable’ (just like an ‘excisable but exempted product’) but is freed from the burden of service tax for the time being in view of the exemption notification. It may be remembered that ‘exemption follows the levy but it does not determine nor precede the levy’. Whereas an exemption notification can be withdrawn or amended by the Central Government under its delegated powers at any time so as to subject the exempted service to the payment of service tax, the amendment to ‘Negative List’ would require legislative sanction which generally happens only through the Finance Act.

Here, it would be advantageous to refer to a few judicial pronouncements in the context of Central Excise and the principles of law laid down therein which apply equally in the context of Service Tax.

• Hico Products vs. CCE – 1994 (71) ELT 339 (SC) – It was held that exemption by a notification does not take away the levy or has the effect of erasing the levy of duty. The object of exemption notification is to forgo the duty and confer certain benefits upon the manufacturer or buyer or consumer through manufacturer, as the case may be.

• Peekay Re-Rolling Mills vs. Assistant Commissioner – 2007 (219) ELT 3 (SC) – In this case, the court observed:

“In our opinion, exemption can only operate when there has been a valid levy, for if there is no levy at all, there would be nothing to exempt. exemption does not negate a levy of tax altogether.”

“Despite an exemption, the liability to tax remains unaffected, only the subsequent requirement of payment of tax to fulfill the liability is done away with.”
(para 35 & 39 of the judgment) The Hon’ble Apex Court quoted with approval the following observations of the Hon’ble Court in ACC Ltd. vs. State of Bihar – (2004) 7 SCC 642 rendered in the context of an exemption notification issued by the State Government reducing the liability of tax under the Bihar Finance Act to the extent of tax paid under an earlier Ordinance in respect of entry of goods:

“Crucial question, therefore, is whether the appellant had any “liability” under the Act…. The question of exemption arises only when there is a liability. Exigibility to tax is not the same as liability to pay tax.

The former depends on charge created by the Statute and latter on computation in accordance with the provisions of the Statute and rules framed thereunder if any. It is to be noted that liability to pay tax chargeable under Section 3 of the Act is different from quantification of tax payable on assessment. Liability to pay tax and actual payment of tax are conceptually different. But for the exemption the dealer would be required to pay tax in terms of Section 3. In other words, exemption presupposes a liability. Unless there is liability question of exemption does not arise. Liability arises in term of Section 3 and tax becomes payable at the rate as provided in Section 12. Section 11 deals with the point of levy and rate and concessional rate.”

• Kiran Spinning Mills vs. CCE – 1984 (17) ELT 396 (Tribunal) – It was observed as under:

“Such a notification issued under Rule 8(1) can only grant exemption — full or partial — vis-a-vis the duty leviable under the Tariff. An exemption notification clearly is not a charging provision and it cannot be interpreted so as to create a duty liability where none existed under the Tariff entry.”

• The judgment in Kiran Spinning Mills’ case (supra) was followed by the Larger Bench of the Hon’ble Tribunal in New Shorock Mills vs. CCE – 2006 (202) ELT 192 (Tri-LB), wherein it was held that mention of an item in an exemption Notification is not determinative of its excisability.

• Golden Paper Udyog vs. CCE – 1983 (13) ELT 1123 (Tribunal) In this case it was held:

“Exemption Notification No. 184/76 in respect of bituminised water-proof paper or paper board cannot be construed to imply a levy under Tariff Item 17(2). Where there is no levy, an exemption from levy is meaningless nor can a levy be interred from an exemption from such levy when in fact, there was none.”

• State of Haryana vs. Mahabir Vegetable Oils P. Ltd. – (2011) 3 SCC 778 SC. It was held that exemption is a concession. It can be withdrawn under the very power in exercise of which exemption was granted.

‘Negative List’, ‘Exempted Services’ & 13th Finance Commission’s Report:

As stated above, the coverage of ‘Negative List of Services’ by section 66D is substantially wide. Here, one may also refer to the Mega Exemption Notification No. 25/2012-ST dated 20.06.2012 (effective from 1st July, 2012) as well as other independent service-specific exemption Notifications granting exemption from payment of service tax in respect of various taxable services.

If the services covered by the ‘Negative List’ and the existing exemption Notifications are taken into account, then it can easily be said that a fairly large number of services are presently not facing the ‘axe of tax’. It will be interesting to note that the 13th Finance Commission headed by Dr. Vijay Kelkar has, in its Report presented on 25th February, 2010 recommended that only a handful of activities/sectors be kept outside the purview of ‘Goods & Service Tax’. The relevant abstract from para 5.29 of the Report is reproduced below:

“No exemptions should be allowed other than a common list applicable to all states as well as the Centre, which should only comprise: (i) unprocessed food items; (ii) public services provided by all governments excluding railways, communications and public sector enterprises and (iii) service transactions between an employer and employee (iv) health and education services.”

It will, however, be seen that the number of activities or sectors kept outside the tax net is quite large. This does not augur well for the impending GST regime. Though the introduction of GST may not materialise any time soon (in the author’s view, at least, not before F.Y. 2016-17), keeping such a large number of services outside the tax net during the intervening period will only create hurdles and roadblocks in the path of a smooth introduction of GST.

After all, the GST (or VAT), operating through ‘tax credit or invoice method’ (i.e. the subtractive/indirect method) is expected or ought to be an all encompassing, comprehensive system of taxation of goods and services. Under this system, the sectors or activities kept outside the levy (through exemption or otherwise) should ideally be bare minimum, keeping socio-economic or practical considerations in mind. There is no gain-saying that exemption creates distortions in the tax system; breaks the input-stage tax credit chain and hinders the smooth flow of credit across the supply chain of goods or services. In hindsight, one may even say that instead of solving or mitigating the problem of cascading effect of ‘tax on tax’, exemption indirectly aggravates the problem.

This idiosyncrasy of GST is best captured in the following words of a distinguished author on the subject:

“The VAT is a paradox: (using the credit method) the VAT is a tax in which those who believe themselves exempt are taxed, and those who believe themselves taxed, are generally exempt. This is not valid at the retail level; a retailer who is believed exempt is nevertheless taxed, and indeed taxed, when subject to taxation. Whoever grasps the meaning of this, will not have any trouble under-standing VAT”.

[J. Reugebrink/M.E. van Hilten, Omzetbelasting, Deventer 1997, p.40]

‘Negative List of Services’ & its implications under the Cenvat Credit Rules, 2004:

In the preceding paragraphs, we have seen that there is a significant conceptual difference between the services covered by the Negative List and the ‘exempted services’. We have also seen that the policy of keeping large number of services outside the tax net may render the task of smooth and comprehensive introduction of GST extremely difficult. Not only this, if persisted, this policy may create distortions in the system and disturb the uninterrupted flow of credit across the supply chain.

But then, one may not be required to wait till GST is introduced to understand these implications of ‘non-taxability of services’, whether through Negative List or Exemption Notifications. The implications are quite evident in the context of the existing Cenvat Credit Rules, 2004 (the CCR) as explained below.

Rule 2 (e) of the CCR defines the term ‘exempted service’ as under:

“R.2(e )- ‘exempted service’ means a –

(1)   taxable service which is exempt from the whole of the service tax leviable thereon; or
(2)   service, on which no service tax is leviable under Section 66B of the Finance Act; or
(3)   taxable service whose part of value is exempted on the condition that no credit of inputs and input services, used for providing such taxable service, shall be taken;

but shall not include a service which is exported in terms of Rule 6A of the Service Tax Rules, 1994.”

The moot question here is whether the ‘non-taxable services’ i.e. the services covered by the ‘Negative List’ prescribed vide section 66D can be considered as ‘exempted services’ within the meaning of the term as defined vide Rule 2(e) of the CCR?. The answer is an unequivocal ‘yes’. As explained above, the services specified in the ‘Negative List’ are excluded from the purview of service tax vide the charging section 66B and hence, no service tax is leviable thereon at all. As a consequence, these services would be covered by clause (2) of Rule 2(e) of the CCR and considered as ‘exempted services’ as defined in the said Rule.

It may be noticed that there is a stark difference between the definition of ‘exempted goods’ given vide Rule 2(d) of the CCR and that of ‘exempted service’ given vide Rule 2(e) ibid. The definition of ‘exempted goods’ does not include ‘non-excisable goods’ i.e. the goods which are outside the purview of levy of the excise duty. The definition of ‘exempted service’, on the other hand, is quite expansive and includes even ‘non-taxable services’ i.e. the services which are outside the scope of levy of service tax.

Therefore, a manufacturer of excisable and dutiable goods or a service provider engaged in providing a taxable service, if, also simultaneously carries on any activity which is covered by the Negative List u/s. 66D, then he would be considered as being engaged in both, dutiable/taxable activity and provision of ‘exempted service’. Consequently, the provisions of Rule 6 of the CCR would stand attracted in case of such an assessee if he uses common inputs or input services for carrying on both the types of activities i.e. dutiable/taxable activity and the non-taxable activity i.e. activity covered by the Negative List and considered as ‘exempted service’. The assessee, in such a situation, will have to comply with the rigours of Rule 6 of the CCR. The course of action available to the assessee can be briefly explained below:

(a) The assessee can avail full Cenvat Credit on the inputs or input services exclusively used for carrying on the manufacture of dutiable product or for provision of taxable service [Rule 3 (1)];

(b) In respect of inputs or input services exclusively used for providing the ‘exempted service’ i.e. the activity covered by the Negative List, the Assessee will have to forgo the entire Cenvat Credit attribut-able to such input or input services [Rule 6 (1)];

(c) So far as the common inputs or input services used for carrying on the dutiable/taxable activity and the exempted activity are concerned, the assessee can:

(i) Maintain separate records and avail the Cenvat credit only on inputs or input services attributable to dutiable/taxable activity [Rule 6 (2) ]; or

(ii) pay an amount equal to 6% of the value of the exempted goods or exempted services [Rule 6 (3)(i)]; or

(iii) pay an amount i.e. equal to proportionate credit as determined under sub-rule (3A) of Rule 6 [Rule 6 (3)(ii)]; or

(iv) maintain separate accounts for inputs and avail Cenvat credit on inputs attributable to dutiable/taxable activity and pay an amount i.e. proportionate credit as determined under sub-rule (3A) in respect of input services [Rule 6 (3)(iii) refers].

Thus, even though there is a conceptual and legal difference between the ‘non-taxable service’ (i.e. service covered by the Negative List and outside the purview of the tax) and ‘exempted service’, for the purposes of Cenvat Credit, the two have been treated at par by the legislature. Needless to say, this is a highly dangerous provision and the implications for the Assessees can be quite severe if they are engaged in both types of activities i.e. dutiable/taxable activity and activity covered by the Negative List and are availing the benefit of Cenvat Credit on input/input services. Such assessees may be caught unaware and are well advised to be on their guard. If Rule 6 is found attracted in a given case, then the assessee will have to carefully select from the options available to him under sub-rule (2) or (3) of Rule 6. It shall be noted that it is not uncommon for the department to raise huge demand in terms of Rule 6 (3)(i) i.e. demand of an amount equal to specified percentage of the value of exempted goods or exempted service even if a negligible credit is availed on the common input or input services used for both the types of activities.

Placing the ‘non-taxable services’ on the equal footing as ‘exempted services’ is rather unfortunate. The only justification can be that the Board might be apprehensive of the assessee availing the Cenvat Credit on all inputs or input services, regardless of whether the same are exclusively used or are common for the dutiable/taxable activity and exempted activity. However, whatever may be the reason or logic behind this provision, the fact remains that it will only lead to ‘compliance nightmare’ and more seriously, the cascading effect of tax inasmuch as non-admissibility of Cenvat Credit on input or input services may result in the increased cost of the final activity. Whether the assessee opts to maintain separate records in terms of Rule 6 (2) or to pay an amount equal to proportionate credit in terms of Rule 6 (3)(ii) or 6(3) (iii), the task of maintaining the separate records and/or determining the quantum of proportionate credit is not an easy one. On the other hand, with the bar on availing of input-stage credit due to the final activity covered by the Negative List not attracting the service tax, the cascading effect of tax will only be aggravated.

Conclusion:

The shift to ‘comprehensive approach’ or ‘Negative List-based levy of Service Tax’ was inevitable considering the fact that the GST regime is knocking at the door of the Indian economy. Besides this, the ‘selective approach’, though, served its purpose well in the initial years, with the passage of time, it was turning out to be a burden, both, for the departmental authorities and the tax payers. The advantage of ‘definitiveness’ or ‘certainty of taxation’ associated with ‘selective approach’ disappeared once more and more services were brought under the tax net. With the overlapping of services, the spectre of classification disputes had started raising its ugly head and the interpretation- related issues were arising more as a rule, than as an exception. Under these circumstances, the shift to ‘comprehensive approach’ is only to be welcomed. No doubt, the coverage of the activities vide the Negative List as also the Mega Exemption Notification No. 25/2012-ST is sufficiently large which may create complications at the time of introduction of GST. Moreover, the implications of the ‘Negative List’ in the context of Cenvat Credit Rules are also quite serious as discussed above. One can only hope that the steps would be taken to ensure, on one hand, the comprehensive coverage of services under the tax net, barring a bare minimum exceptions and on the other hand uninterrupted and unrestricted availment of input-stage Cenvat Credit to the assessees.

“Death and taxes and childbirth – There’s never any convenient time for any of them!” (Margaret Mitchell)

Nirav Shah

Works Contract vis-à-vis Service Contract – Recent Position

Recently, Hon. Bombay High Court has decided issue about nature of Works Contract vis-à-vis Service Contract. The issue pertained to 1989-90 wherein the transaction about plate making was held as not amounting to works contract by Tribunal. From Tribunal judgment, the matter was referred to Bombay High Court by way of Reference in case of Comm. of Sales Tax, Maharashtra vs. M/s.Ramdas Sobhraj (STR No.9 of 2003 dt. 25.10.2012).

The facts are that the appellant was engaged in plate making activity. Hon’ble High Court recorded facts as under:

“c) In the job work of plate making the customers of the respondent-assessees supplies to the respondent-assessees duly grained zinc or aluminum plates. On receipt, plates are coated by dipping in water wherein gun bio chromate is dissolved. Thereafter positives are exposed on the treated plates by halogen lamps. The image is formed by the positives on the plates and the same is developed in the solution of calcium, lactic acid ferric chloride, cupric chloride and hydrochloride. The plates are thereafter washed in industrial solvent, as a result of which all the chemicals are washed out and only the images remain on the plates. Thereafter, lacquer and ink are applied on the plates. On a specific query, we were informed that lacquer and ink are applied on the plates so as to ensure that the images on the plates do not get disturbed/smudged by constant use. After the above process, the plates are dried and again washed with water and returned to the customers.”

On above facts, the arguments of Department were as under:

(i) there is a deemed sale by way of transfer of property in ink and lacquer as contemplated u/s. 2(l) of the Works Contract Act;

(ii) this is particularly so as the lacquer and ink are used by the respondent-assessee in the process of plate making, so as to ensure that images formed on the plates are not disturbed/smudged due to constant use. The lacquer and ink in plate so used get settled on the plate so as to become a part of the plate;

(iii) the Tribunal applied an incorrect test to hold that there is no transfer of property of lacquer and ink viz. the thickness of the plates continue to remain the same both before and after the process; and

(iv) in any case the issued raised in this reference stands concluded in favour of the applicant-revenue by the decision of this court in the matter of Commissioner of Sales Tax v. Matushree Textiles Limited reported in 132 Sales Tax Cases Page 539.

The arguments on behalf of dealer were as under:

(i) there has been no deemed sale by way of transfer of property in ink & lacquer while executing the job of plate making as held by the Tribunal.

(ii) the decision of this court in the matter of Matushree Textiles Ltd (Supra) will not apply in view of the subsequent decision of the Apex Court in the matter of Bharat Sanchar Nigam Ltd. v. UOI reported in 145 STC 19 which holds that there must be a transfer of goods as goods for the work Contract Act to be applicable. Similarly, the dominant intention of the transfer viz. whether to provide services or transfer of goods will be determinative of there being transfer of goods or not as held by the Apex Court in the matter of Idea Mobile Communication Ltd. v. Commissioner of Central Excise reported in 43 VST. Page 1. In this case, there is no transfer of goods as goods nor was there any intent to transfer the ink and lacquer to its customers; and

(iii) the order of the Tribunal is unexceptionable and the Court should affirm the view of the Tribunal.

The High Court, in relation to argument about dominant object, held that the understanding on the part of the dealer is not correct. The High Court referred to following part in the judgment in the case of Bharat Sanchar Nigam Ltd. (145 STC 19)(SC).

“47. In Rainbow Colour Lab v. State of M.P. (2000) 2 SCC 385, the question involved was whether the job rendered by the photographer in taking photographs, developing and printing films would amount to a “work contract” as contemplated under article 366 (29A)(b) of the Constitution read with section 2(n) of the M.P. General Sales Tax Act for the purpose of levy of sales tax on the business turnover of the photographers.

48. The court answered the questions in the negative because, according to the court:

“Prior to the amendment of article 366, in view of the judgment of this Court in State of Madras v. Gannon Dunerley & Co. (Madras) ltd. (1958) 9 STC 353; AIR 1958 SC 560, the states could not levy sales tax on sale of goods involved in a works contract because the contract was indivisible. All that has happened in law after the 46th Amendment and the judgment of this Court in Builders’ case (1989) 2 SCC 645 is that it is now open to the States to divide the works contract into two separate contracts by a legal fiction: i) contract for sale of goods involved in the said works contract, and (ii) for supply of labour and service. This division of contract under the amended law can be made only if the works contract involved a dominant intention to transfer the property in goods and not in contracts where the transfer in property takes place as an incident of contract of service. What is pertinent to ascertain in this connection is what was the dominant intention of the contract. On facts as we have noticed that the work done by the photographer which, as held by this Court in Assistant Sales Tax officer v. B.C.Kame (1977) 1 SCC 634 is only in the nature of a service contract not involving any sale of goods, we are of the opinion that the stand taken by the respondent-State cannot be sustained.”

49. This conclusion was doubted in Associated Cement Companies Ltd. v. Commissioner of Customs (2001) 4 SCC 593 saying :

“The conclusion arrived at in Rainbow Colour Lab case (2000) 2 SCC 385, in our opinion, runs counter to the express provision contained in article 366(29A) as also of the Constitution Bench decision of this Court in Builders’ Association of India v. Union of India (1989) 2 SCC 645.

50. We agree. After the 46th Amendment, the sale elements of those contracts which are covered by the six sub-clauses of clause (29A) of article 366 are separable and may be subjected to sales tax by the States under entry 54 of List II and there is no question of the dominant nature test applying. Therefore when in 2005, C.K. Jidheesh v. Union of India (2005) 8 Scale 784 held that the aforesaid observations in Associated Cement were merely obiter and that Rainbow Colour Lab (2000) 2 SCC 385 was still good law, it was not correct. It is necessary to note that Associated Cement (2001) 4 SCC 593 did not say that in all cases of composite transaction the 46th Amendment would apply.”

Dealer also referred to the judgment of Idea Mobile Communication (43 VST 1)(SC), to substantiate its point of service nature of transaction. The High court rejected the same on the ground that it is under Service Tax and not relevant to works contract.

In relation to other argument about transfer of property in goods as goods, the High Court relied extensively upon the judgment in case of Matushree Textiles Ltd. (132 STC 539)(Bom) and reversed the judgment of the Tribunal and held the transaction as liable to tax.

Implications

The above judgment decides one of the important aspects about works contract vis-à-vis service transaction. In Bharat Sanchar Nigam Ltd. (145 STC 91). Hon. Supreme Court amongst others, in para 44, 45 has observed as under:

“44.. Gannon Dunkerley survived the 46th Constitutional Amendment in two respects. First with regard to the definition of “sale” for the purposes of the Constitution in general and for the purposes of entry 54 of List II in particular except to the extent that the clauses in article 366(29A) operate. By introducing separate categories of “deemed sales”, the meaning of the word “goods” was not altered. Thus the definitions of the composite elements of a sale such as intention of the parties, goods, delivery, etc., would continue to be defined according to known legal connotations. This does not mean that the content of the concepts remain static. Courts must move with the times. But the 46th Amendment does not give a licence, for example, to assume that a transaction is a sale and then to look around for what could be the goods. The word “goods” has not been altered by the 46th Amendment. That ingredient of a sale continues to have the same definition. The second respect in which Gannon Dunkerley has survived is with reference to the dominant nature test to be applied to a composite transaction not covered by article 366(29A). Transactions which are mutant sales are limited to the clauses of article 366(29A). All other transactions would have to qualify as sales within the meaning of the Sales of Goods Act, 1930 for the purpose of levy of sales tax.

45. Of all the different kinds of composite transactions, the drafters of the 46th Amendment chose three specific situations, a works contract, a hire-purchase contract and a catering contract to bring within the fiction of a deemed sale. Of these three, the first and third involve a kind of service and sale at the same time. Apart from these two cases where splitting of the service and supply has been constitutionally permitted in clauses (b) and (f) of clause (29A) of article 366, there is no other service which has been permitted to be so split. For example, the clauses of article 366(29A) do not cover hospital services. Therefore, if during the treatment of a patient in a hospital, he or she is given a pill, can the sales tax authorities tax the transaction as a sale? Doctors, lawyers and other professionals render service in the course of which it can be said that there is a sale of goods when a doctor writes out and hands over a prescription or a lawyer drafts a document and delivers it to his/her client? Strictly speaking with the payment of fees, consideration does pass from the patient or client to the doctor or lawyer for the documents in both cases.”

Therefore, once again, a controversy was arising as to dominant intention. In case of transaction involving very small value of goods and where skill was more important, there was a feeling that the transaction should not be a works contract but a service contract. However, the above judgment of Hon. Bombay High Court has dispelled any doubt about the nature of transaction and it appears that the ratio of Matushree Textiles Ltd. (132 STC 539)(Bom) will prevail for all purposes for interpretation of nature of works contract transaction.

Nirav Shah

Valuation of Taxable Services – Rule for Taxing Reimbursements Held ultra vires

Preliminary:

Subsequent to the introduction of Negative List based Taxation of Services wef 1/7/12, no amendments were made in Section 67 of the Finance Act, 1994 (Act) and Rule 5 of Service Tax (Determination of Value) Rules, 2006 [Valuation Rules] framed thereunder relating to the taxability of reimbursements. However, significant amendments were made, in regard to valuation relating to Works Contract Services (Rule 2A) and Valuation relating to Supply of Food/Outdoor Catering Services (Rule 2C).

In the meantime, in a significant recent judicial development, Rule 5 of Valuation Rules has been held to be ultra vires. Hence, considering its significant repercussions, the same is analysed and discussed in detail here. Provisions of Rules 2A and 2C of the Valuation Rules will be discussed in this feature in due course.

Delhi high court ruling in Inter Continental Consultants and Technocrats Pvt Ltd. (2012 TIOL – 966 HC – Del – ST)

In this case, the Delhi High Court was concerned with the question of law wherein it was decisively ruled that Rule 5(1) of the Valuation Rules providing inclusion of the expenditure or costs incurred by the service provider during the course of providing taxable service, to be part of the value for the purpose of charging Service tax is ultra vires Sections 66 and 67 of the Act, as the said rule travels beyond the scope and mandate of the said section 67.

Background:

In the case of Intercontinental Consultants and Technocrats Pvt. Ltd. (2012-TIOL-966-HC-DEL-ST), writ petition was filed. The petitioner company was providing consulting engineering services to National Highway Authority of India (NHAI) and charged service tax thereon and paid the same. However, during the course of providing the said service, the petitioner had incurred certain out of pocket expense like traveling, boarding and lodging, office rent, office supplies and utilities testing charges etc. These expenses were separately indicated in the invoice for recovering the same. This according to the revenue were essential expenses for providing taxable services of consulting engineers and therefore they directed the company to pay service tax on the same. While proposing the demand of service tax, the Show Cause Notice made Rule 5(1) of the Valuation Rules as its basis. Challenging the Show Cause Notice and the said Rule 5(1) of the Valuation Rules, the petitioner filed writ petition in 2008 with three prayers viz.

• quashing Rule 5 of Valuation Rules to the extent that it included reimbursable expenses in the taxable value for charging service tax;

• declaring the said rule to be unconstitutional and ultra vires section 66 and 67 of the Act;

• quashing the Show cause Notice holding it illegal, without jurisdiction and unconstitutional. In the interim order, the High Court had directed not to take coercive steps against the petitioner [reported at 2008 (12) STR 689 (Del)]. The final order dated 30th November, 2012 is reported at the above citation.

Discussion: Provisions of law:

Section 94 of the Act empowers the Central Government to make rules by issuing notifications. The rules are framed to carry out the provisions of Chapter V of the Act providing for the levy and collection of service tax. Valuation Rules were accordingly notified to come into effect from 19th April, 2006. Almost simultaneously, i.e. w.e.f. 18th April, 2006 section 67 dealing with ‘valuation’ of any taxable service also was amended to read as follows:

Section 67 (as introduced from 18/04/2006):

1. Subject to the provisions of this Chapter, where service tax is chargeable on any taxable service with reference to its value, then such value shall, –

(i) in a case where the provision of service is for a consideration in money, be the gross amount charged by the service provider for such service provided or to be provided by him;

(ii) in a case where the provision of service is for a consideration not wholly or partly consisting of money, be such amount in money, with the addition of service tax charged, is equivalent to the consideration;

(iii) in a case where the provision of service is for a consideration which is not ascertainable, be the amount as may be determined in the prescribed manner.

2 Where the gross amount charged by a service provider, for the service provided or to be provided is inclusive of service tax payable, the value of such taxable service shall be such amount as, with the addition of tax payable, is equal to the gross amount charged.

3 The gross amount charged for the taxable service shall include any amount received towards the taxable service before, during or after provision of such service.

4 Subject to the provisions of sub-sections (1), (2) and (3), the value shall be determined in such manner as may be prescribed.

Explanation – For the purposes of this section, –
(a) “consideration” includes any amount that is payable for the taxable services provided or to be provided;
(b) “money” includes any currency, cheque, promissory note, letter of credit, draft, pay order, travelers cheque, money order, postal remittance and other similar instruments but does not include currency that is held for its numismatic value;
(c) gross amount charged” includes payment by cheque, credit card, deduction from account and any form of payment by issue of credit notes or debit notes and book adjustment.

It is interesting to note that the above section 67 as amended and as it stood prior to 18/04/2006 authorised determination of the value of taxable service as, the gross amount charged by the service provider for such service provided or to be provided by him in a case where the consideration is in money. The highlighted words, “for such service” are key words in the above section read with the charging section 66 which reads as “there shall be levied a tax (hereinafter referred to as the service tax) @ 12% of the value of taxable services referred to in sub-clauses …………. of section 65 and collected in such manner as may be prescribed”. Thus, the charge of the service tax as per section 66 is on the value of taxable services. In turn, the taxable services are listed in section 65(105) and the relevant sub-clause under which the consulting engineering service is covered is sub-clause (g). Therefore, the only value which can be subjected to service tax is the value of the service provided by the petitioner to NHAI which is that of consulting engineer and nothing more. In other words, the quantified value can never exceed the gross amount charged by the service provider for such service provided by him. The petitioner thus contended that though section 94 of the Act enables the Central Government to prescribe rules, such rules can only be made to carry out the provisions of Chapter V of the Act. The power conferred cannot exceed or go beyond the section providing for them the charge or collection of the levy.

In the scenario, it is necessary to understand the subject matter of the controversy i.e. what does the said Rule 5 intend to include in the value of any taxable service. Rule 5 of the Valuation Rules reads as follows:

“(1) Where any expenditure or costs are incurred by the service provider in the course of providing taxable service, all such expenditure or costs shall be treated as consideration for the taxable service provided or to be provided and shall be included in the value for the purpose of charging service tax on the said service.”

Sub-clause (2) of the said section contains an exception to the above rule, that the expenditure or costs incurred shall be excluded from the value of taxable value when the service provider acts as a pure agent of the recipient of service subject to the conditions contained in the said sub-section. These conditions are required to be satisfied cumulatively and it is extremely hard to do so.

Further, Explanation 2 to the said Rule 5 reads as follows, followed by four illustrations:

“Explanation 2. – For the removal of doubts, it is clarified that the value of the taxable service is the total amount of consideration consisting of all components of the taxable service and it is immaterial that the details of individual components of the total consideration is indicated separately in the invoice.

Illustration 1. – X contracts with Y, a real estate agent to sell his house and thereupon Y gives an advertisement in television. Y billed X including charges for Television advertisement and paid service tax on the total consideration billed. In such a case, consideration for the service provided is what X pays to Y. Y does not act as an agent on behalf of X when obtaining the television advertisement, even if the cost of television advertisement is mentioned separately in the invoice issued by X. Advertising service is an input service for the estate agent in order to enable or facilitate him to perform his services as an estate agent.

Illustration 2. – In the course of providing a taxable service, a service provider incurs costs such as traveling expenses, postage, telephone, etc., and may indicate these items separately on the invoice issued to the recipient of service. In such a case, the service provider is not acting as an agent of the recipient of service, but procures such inputs or input service on his own account for providing the taxable service. Such expenses do not become reimbursable expenditure merely because they are indicated separately in the invoice issued by the service provider to the recipient of service.

Illustration 3. – A contracts with B, an architect for building a house. During the course of providing the taxable service, B incurs expenses such as telephone charges, air travel tickets, hotel accommodation, etc., to enable him to effectively perform the provision of services to A. In such a case, in whatever form B recovers such expenditure from A, whether as a separately itemised expense or as part of an inclusive overall fee, service tax is payable on the total amount charged by B. Value of the taxable service for charging service tax is what A pays to B.

Illustration 4. – Company X provides a taxable service of rent-a-cab by providing chauffeur-driven cars for overseas visitors. The chauffeur is given a lump sum amount to cover his food and overnight accommodation and any other incidental expenses such as park-ing fees by the Company X during the tour. At the end of the tour, the chauffeur returns the balance of the amount with a statement of his expenses and the relevant bills. Company X charges these amounts from the recipients of service. The cost incurred by the chauffeur and billed to the recipient of service constitutes part of gross amount charged for the provision of services by the Company X.”

Perusing the above, the Court observed that the above illustration 3 amplifies what is meant by sub-rule
(1). In the illustration given, the architect who renders the service incurs expenses such as telephone charges, air travel tickets, hotel accommodation etc. to enable him to effectively perform his services. Through the illustration, the Rule clearly breaches the boundaries of section 67. In addition to traveling beyond the mandate and the scope of the section, it may also result in double taxation. For instance, air travel attracts service tax and by including it in the value of the invoice and to charge service tax thereon would be certainly paying tax twice. In this frame of reference, the Court recognised that there could be double taxation provided it is clearly intended and cannot be enforced by implication. Citing Supreme Court in Jain Brothers vs. UOI (1970) 77 ITR 107, a part of the extract of the Court’s observation reads as follows:

“It is not disputed that there can be double taxation if the legislature has distinctly enacted it. It is only when there are general words of taxation and they have to be interpreted, they cannot be so interpreted as to tax the subject twice over to the same tax (vide Channell J. in Stevens v. Durban-Roodepoort Gold Mining Co. Ltd.). The Constitution does not contain any prohibition against double taxation even if it be assumed that such a taxation is involved in the case of a firm and its partners after the amendment of section 23(5) by the Act of 1956. Nor is there any other enactment which interdicts such taxation. If any double taxation is involved the legislature itself has, in express words, sanctioned it. It is not open to any one thereafter to invoke the general principles that the subject cannot be taxed twice over.”

While the Hon. Court found adequate authority for the contention that the rules cannot overreach the provisions of the main enactment, it cited the following:

“In Central Bank of India vs. Their Workmen, AIR 1960 SC 12 the observation was, “We do not say that a statutory rule can enlarge the meaning of Section 10; if a rule goes beyond what the Section contemplates, the rule must yield to the statute. We have, however, pointed out earlier that Section 10 itself uses the word “remuneration” in the widest sense, and R.5 and Form-I are to that extent in consonance with the Section.”

Similarly, In Babaji Kondaji Garad vs. Nasik Merchants Co-operative Bank Ltd., (1984) 2 SCC 50, the Supreme Court observed “Now if there is any conflict between a statute and the subordinate legislation, it does not require elaborate reasoning to firmly state that the statute prevails over subordinate legislation and the bye-law, if not in conformity with the statute in order to give effect to the statutory provision, the Rule or bye-law has to be ignored. The statutory provision has precedence and must be complied with.”

In the light of the above observations, the Court found that the expressions “consideration in money” or “the gross amount charged” used in section 67 in widest sense are not suggestive of including the amount collected for travel, hotel stay, transportation and other out of pocket expenses, but these words are defined in the Explanation below the section. Significantly, out of pocket expenses such as travel, hotel stay, transportation etc. are not included in those expressions.

The Court also relied on the observation in Devi Datt vs. Union of India, AIR 1985 Delhi 195 “but obviously the said rule has to be construed in the light of the parent section and it cannot be construed as enlarging the scope of Section 19 itself. It is a well settled canon of construction that the Rules made under a statute must be treated exactly as if they were in the Act and are of the same effect as if contained in the Act. There is another principle equally fundamental to the rules of construction, namely, that the Rules shall be consistent with the provisions of the Act. Hence, Rule 102 has to be construed in conformity with the scope and ambit of Section 19 and it must be ignored to the extent it appears to be inconsistent with provisions of Section 19”. Similarly in CIT vs. S. Chenniappa Mudaliar, (1969) 74 ITR 41 it was held that “if a rule clearly comes into conflict with the main enactment or if there is any repugnancy between the substantive provisions of the Act and the Rules made therein, it is the rule which must give way to the provisions of the Act.” Also in Bimal Chandra Banerjee vs. State of M.P. and Ors. (1971) 81 ITR 105, the Court observed:

“No tax can be imposed by any bye-law or rule or regulation unless the statute under which the sub-ordinate legislation is made specially authorises the imposition even if it is assumed that the power to tax can be delegated to the executive. The basis of the statutory power conferred by the statute cannot be transgressed by the rule making authority. A rule making authority has no plenary power. It has to act within the limits of the power granted to it”.

The Court further relied on CIT, Andhra Pradesh vs. Taj Mahal Hotel, (1971) 82 ITR 44 and Commissioners of Customs and Excise vs. Cure and Deeley Ltd., (1961) 3 WLR 788 (QB) and made similar observation as to the canon that a rule has to be framed remaining within the scope and ambit of the Act.

For the case under examination, the Court observed that reading section 66 and section 67(I)(i) of the Act together and harmoniously, it seems clear that while valuing a taxable service, nothing more and nothing less than the consideration paid as quid pro quo for the service can be brought to charge. Sub-section (4) of the said section 67 enabling the determination of value of taxable service “in such manner as may be prescribed” is expressly made subject to the provisions of sub-section (1). The Court decisively ruled that sections 66, 67 and 94, which empower the Central Government to prescribe rules to carry out the provisions of Chapter V of the Act mean that only the service actually provided by the service provider can be valued and assessed to service tax and Rule 5(1) of the Valuation Rules runs counter and is repugnant to sections 66 and 67 of the Act and to that extent it is ultra vires. By including the expenditure and costs, it goes far beyond the charging provisions and cannot be upheld. Citing Hukam Chand vs. Union of India, AIR 1972 SC 2427, the Court concluded that simply because every rule framed by the Central Government is laid before both the Houses of the Parliament, does not confer validity on a rule if it is not made in conformity with the Act as it is a specie of a subordinate legislation.

Whether all reimbursable expenses would not attract service tax any more?

While the ruling of the Delhi High Court indeed is extremely welcome, little can be commented about its finality at this stage. A lot will depend whether the revenue chooses to file appeal against the above ruling in the Supreme Court and this is most likely to happen. The possibility of the Government bringing about retrospective amendment in section 67 itself cannot also be ruled out, considering the fact that a large number of assessees have already paid service tax on the reimbursable expenses and again a large number of them may have paid after recovering the same and of which, CENVAT credit is availed by the recipients of such services. Precedents of retrospective amendment have already been experienced in the service tax administration itself in case of renting of immovable property service and broadcasting service, besides the fact that Supreme Court struck down provisions relating to reverse charge made via subordinate legislation as ultra vires vis-à-vis services of clearing and forwarding agents and goods transport agencies. (Refer Laghu Udyog Bharti Anr. vs. UOI 1999 (112) ELT 365 (SC) and subsequent retrospective amendment made in section 68 of the Act by the Central Government to overcome the directives of the Court in the said case). Therefore, the relief or even the sense of ‘fairness’ felt on account of the above judgment may remain short-lived and plan of action on the basis of the above ruling may not be an act of prudence, as felt by many at this point in time. However, and not withstanding the outcome or the finality in the above context, it is relevant to analyse the rationale laid down by the Larger Bench of the Bangalore Tribunal in Shri Bhagawathy Traders vs. CCE, Cochin 2011 (24) STR 290 (Tri.-LB) which dealt with the issue of taxability of reimbursable expenses under the service tax law in the scenario when Rule 5(1) did not exist. In this case, issues relating to reimbursement of various expenses incurred by C. & F. Agents were discussed in detail, by the Larger Bench including various conflicting judicial views in the matter. Relevant extracts of the observations made by the Larger Bench are under.

Having analysed the various decisions cited on behalf of the assessee and on behalf of the department, it would be appropriate to consider the scope of the term “reimbursements” in the context of money realised by a service provider. ……The concept of reimbursement will arise only when the person actually paying was under no obligation to pay the amount and he pays the amount on behalf of the buyer of the goods and recovers the said amount from the buyer of the goods.

Similar is the situation in the transaction between a service provider and the service recipient. Only when the service recipient has an obligation, legal or contractual, to pay certain amount to any third party and the said amount is paid by the service provider on behalf of the service recipient, the question of reimbursing the expenses incurred on behalf of the recipient shall arise. For example, when rent for premises is sought to be claimed as reimbursement, it has to be seen whether there is an agreement between the landlord of the premises and the service recipient and, therefore, the service recipient is under obligation for paying the rent to the landlord and that the service provider has paid the said amount on behalf of the recipient. The claim for reimbursement of salary to staff, similarly has to be considered as to whether the staff were actually employed by the service recipient at agreed wages and the service recipient was under obligation to pay the salary and it was out of expediency, the provider paid the same and sought reimbursement from the service recipient.

Various Circulars of the Board relied upon by the Learned Advocate for the assessee clearly referred to amounts payable on behalf of the service recipient. For example, the Customs House Agent (CHA) paying the Customs duty to the Customs Department, paying the charges levied by the Port Trust to the Port Trust, paying the fee for testing to the Testing Organisation are clearly on behalf of the importer/exporter and the same are recoverable by the CHA as reimbursement, that too on actual basis. These Circulars cannot be held to be in support of the claim of the assessee that they can split part of the amount as reimbursable expenses and the rest as towards service charges.

The claim for reimbursement towards rent for premises, telephone charges, stationery charges, etc. amounts to a claim by the service provider that they can render such services in vacuum. What are costs for inputs services and inputs used in rendering services cannot be treated as reimbursable costs. There is no justification or legal authority to artificially split the cost towards providing services partly as cost of services and the rest as reimbursable expenses.

Keeping in view this rationale, if a simple example of architect, consulting engineer or a chartered accountant is examined wherein when an architect visits site of the client outside his home city/town and so do the engineers of a consulting engineering firm or audit team of a CA firm, the travel expenses, lodging and boarding expenses incurred and reimbursed cannot certainly form part of the ‘value’ of taxable service as the service provider has incurred such expenses only to carry out the assignment of the recipient of service and such cost does not represent its own “professional fee” that is charged for using its proficiency expertise and/or knowledge of the subject. Yet in some cases for the sake of simplicity, sometimes allowances are fixed on a daily basis for employees to avoid cumbersome paper work or to overcome practical difficulties and this many a times acts as a deterrent to prove that the ‘reimbursement’ of the expense incurred is on “actual basis” in terms of the controversial Rule 5(2) of the Valuation Rules which provides that cost incurred as “pure agent” can be excluded from the value of taxable service, subject to satisfaction of all the conditions laid down in this respect. Taking another example of a CHA or a logistics service provider, it is found that when an expense like courier charge is specifically incurred for and on behalf of the recipient and under his specific instructions or a place is acquired on rental basis on behalf of client and is client-specific and for their limited purpose, it may not form part of the cost of providing such service and therefore, service tax may not be attracted in such cases. Nevertheless, the issue is subjective as observed by the Larger Bench in Shri Bhagawathy Traders (supra) wherein admittedly the subject is dealt with a well-balanced approach. The issue therefore may be debatable and therefore litigative in many complex situations as precise parameters are not available in law for the same otherwise than Rule 5 of the Valuation Rules.

Conclusion:

Nevertheless, the draconian Rule 5(1) of the Valuation Rules and the concept of “pure agent” as enshrined in the Rule sub-clause (2) of the said Rule 5 with rigidity certainly do not deserve to exist on the statute.

In the current scenario, when all services are brought within the sweep of the service tax except the Negative List and certain exempt services, if pragmatism is applied by the Government and Rule 5 is allowed to remain struck down, to a large extent dual taxation would be avoided and guidelines by revenue may be provided on the lines ruled by the Larger Bench in the case of Shri Bhagawathy Traders (supra). Service tax administration then would not be lopsided in favour of revenue on this aspect and may extend fairness to assessees at large on the issue of levying service tax on reimbursable costs and this may also possibly cover genuine concern of many business enterprises on the open issue of leviability or otherwise of service tax on shared costs among associate/group concerns.

Nirav Shah

Article 12 of Indo US DTAA – Co-ordination fees business profits under DTAA – No PE and hence not chargeable to tax – Creative fees and database costs chargeable as they are not royalties and services not ancilliary or subsidary to enjoyment of property

15. DDIT v Euro RSCG Worldwide, inc (ITA No
7094/Mum/2010) (unreported)
Asst Year: 2010-11. Dated 27-11-2012

Article 12 of Indo US DTAA – Co-ordination fees business profits under DTAA – No PE and hence not chargeable to tax – Creative fees and database costs chargeable as they are not royalties and services not ancilliary or subsidary to enjoyment of property

Facts:

The taxpayer was an American company, which was a resident of USA (“USCo”). USCo was acting as a communicating interface between its Group entities and multinational clients. To ensure work of international standards that would meet client’s expectations, USCo had set up a team of persons to coordinate between a Group entity and a client.

USCo incurred expenditure on providing the coordination services. Hence, it charged the Group entities for these services. Further, it also provided need-based business development and managerial assistance to Group entities. During the year, USCo provided certain assistance to a Group entity in India (“ICo”) and received consideration thereof, which was split into creative fees, database costs and coordination fees. USCo contended that the consideration was in the nature of business profits under Article 7 of India-USA DTAA, and since USCo did not have a PE in India, the consideration was not chargeable to tax in India.

However, the AO concluded that the consideration was in the nature of royalties and was chargeable to tax @15% under India-USA DTAA.

The CIT(A) held that client coordination fees were in the nature of business profits, which, in absence of PE in India, were not chargeable to tax in India. As regards the creative fees and the database costs, he held that they were in the nature of FIS and accordingly, were chargeable to the tax in India. While the taxpayer accepted the findings of CIT(A), the tax department appealed to Tribunal against the order of CIT(A).

Held

The Tribunal observed and held as follows.

(i) The Tribunal concurred with the finding of the CIT(A) that USCo maintained communication channel between ICo and the clients. These services did not involve consideration for use of, or right to use, any of the specified terms in Article 12(3) of India-USA DTAA. Hence, the consideration was not royalties but business profits. As USCo did not have a PE in India, the question of taxability of consideration did not arise.

(ii) In terms of Article 12(2)(b) of India-USA DTAA, royalties (under Article 12(3)) and FIS (under Article 12(4)) are chargeable to tax @10%. However, payments for the creative fees and the database costs were neither royalties as defined in Article 12(3)(b) nor the services were ancillary or subsidiary to enjoyment of property. Hence rate of 10% was not applicable. As there was nothing on record to indicate that the rate specified under Article 12(2)(b) was applicable, rate specified under Article 12(2)(a)(ii) was applicable. Hence, the creative fees and the database costs were chargeable to tax @15%.

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Nirav Shah

(2011) 24 STR 422 (Tri.-Chennai ) — Agsar Paints Pvt. Ltd. v. Commissioner of Service Tax, Mumbai.

Cenvat — Input credit disallowed — Penalty of Rs.10,000 imposed under Rule 15 of CENVAT Credit Rules Act, 2004 — However, service tax paid on telephone service used for sale promotion is an eligible input service.

Facts
The Commissioner of Central Excise disallowed the total credit of Rs.21,360 of service tax paid on (i) telephone services (ii) vehicle maintenance (iii) fixed telephones, and (iv) courier agency and also upheld a penalty of Rs.10,000.

An appeal was filed only against the denial of credit of service tax paid on the telephone services as the same was eligible input service since used in connection with the activity of business of manufacture of final products.

Held
It was held that credit of service tax paid on the telephone services which is eligible input service since used in connection with the activity of business of manufacture of final products was admissible. The duty demand and the penalty to be requantified in light of the extended credit of service tax in respect of tax paid on telephone service.

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Nirav Shah

Ss. 40 (a) (i) 195, Article 12 of Indo US DTAA On facts, marketing, quality assurance, e-publishing and turnkey services provided by American company to Indian company did not ‘make available’ knowledge, etc. Hence, payment was not Fees for Included Services (FIS)

14. ACIT v Tax Technology International Pvt Ltd
[2012] 27 taxman.com 190 Chennai
A.Y.: 2007-08. Dated: 11-10-2012

Ss. 40 (a) (i) 195, Article 12 of Indo US DTAA on facts, marketing, quality assurance, e-publishing and turnkey services provided by American company to Indian company did not ‘make available’ knowledge, etc. Hence, payment was not Fees for Included Services (FIS)

Facts:

The taxpayer was an Indian company (“ICo”) engaged in the business of e-publishing. ICo had an American Subsidiary (USCo”). ICo executed three types of Agreements – Marketing Agreement, Offshore Development Agreement and Overseas Services Agreement – with USCo. The services provided under the respective agreement were as follows.

Marketing Agreement

USCo was to provide support to the customers and also provide market information to ICo.

Offshore Development Agreement

USCo was to scan manuscripts, upload them to India and intimate ICo by e-mail. After ICo had done typesetting in India and uploaded it to USCo, USCo was to download it, print pages and courier it to customers.

Overseas Services Agreement

USCo was to use its expertise, tools and infrastructure for e-publishing and preparation and typesetting of manuscript of printing pages and delivering it to customers. 14 For the aforementioned services, during the year, ICo made certain payments to USCo. ICo did not withhold tax from the same as, according to it, USCo was only a marketing agent and no technical services were ‘made available’ by USCo.

According to AO, USCo was rendering technical services and pursuant to introduction of Explanation u/s. 9(2) of I T Act, business connection or territorial nexus with India was not required. Further, if according to ICo, tax was not required to be withheld, it should have obtained the relevant certificate u/s. 195(2) or (3). Since neither tax was withheld nor certificate was obtained, section 40(a)(i) was attracted and the payment was disallowable.

Held:

The Tribunal observed and held as follows. To constitute FIS under Article 12(4)(b) of India-USA DTAA, it is necessary that technical knowledge, etc should be ‘made available’.

Definition of FTS under Explanation No 2 to section 9(1)(vii) of I T Act is not in pari materia with definition of FIS in Article 12(4) of India-USA DTAA. Services provided by USCo could be FIS only if such services ‘made available’ technical knowledge, etc. The Tribunal considered the scope of services under each Agreement as follows. No technical service was involved in respect of services under Marketing Agreement as no technical knowledge was ‘made available’;

Scope of services under Overseas Services Agreement, clearly indicated that USCo was to use its expertise, tools and infrastructure for receiving manuscripts for production of book using its own resources, including servicing the customers and effecting dispatches to customer locations. In other words, it provided comprehensive services. If entire work was done by USCo, it cannot be said that ICo was receiving any technical knowledge, etc.

As regards Offshore Development Agreement: In terms of Clause 3.1 USCo processed customer materials, prepared instructions and prepared files. Based on these, ICo carried out e-publishing services. Though the services provided by USCo involved technical know-how, they were not FIS as they did not ‘make available’ technical knowledge (which will give enduring benefit) to ICo. In terms of Clause 3.3, USCo was to provide quality assurance. While this too may involve some technical expertise, it cannot be said that USCo ‘made available’ such technology to ICo.

In terms of Clause 3.2, USCo provided files and instructions for carrying out digitalization services to ICo. The instructions would constitute FIS if they resulted in ICo imbibing technical expertise, etc. that gave it an enduring benefit in its e-publication business. Separate invoices were raised by USCo on ICo under three different agreements. Hence, three agreements did not constitute a composite agreement. On the issue of ‘making available’:

Based on this interpretation of the term ‘making available’ in CIT v De Beers India Minerals P Ltd [2012] 346 ITR 467 (Karn), services performed were not FIS since they were not ‘made available’. Income in respect of any service under Marketing Agreement and Overseas Services Agreement was not covered under Article 12(4) of India–USA DTAA. Therefore, ICo had no obligation to deduct tax at source.

One of the services under Offshore Development Agreement could be considered FIS since it could involve ‘making available’ technical knowledge to ICo in which case section 195 of I T Act could apply. As ICo had not applied for lower/nil deduction u/s. 195, section 40(a)(i) could be attracted. Hence, the issue in respect of payments made under Offshore Development Agreement was remitted to AO for reconsideration.

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Nirav Shah

Ss. 9 40 (a) (i), Article 12 of Indo/US DTAA – Voice call charges to USCO not managerial, technical or consultancy services – USCO having no PE in India – Payment not chargeable to tax section 195, 40 (a) (i) not applicable

13. Clearwater Technology Services Pvt Ltd v
ITO [2012] 27 taxman.com 238 (Bang)
A.Y.: 2008-09. Dated: 28-9-2012

Ss. 9 40 (a) (i), Article 12 of Indo/US DTAA – Voice call charges to USCo not managerial, technical or consultancy services – USCo having no PE in India – Payment not chargeable to tax section 195, 40 (a) (i) not applicable

Facts:

The taxpayer was an Indian company (“ICo”) engaged in providing voice based call centre services to its clients in USA. An American telecom voice service provider (“USCo”) assisted ICo in connecting to the American telecom network in respect of the calls made to USA by ICo, or calls received from USA by ICo.

During the year, ICo had made certain payments to USCo for its services. However, ICo did not withhold tax from these payments since USCo had no PE in India.

According to AO, the payments made by ICo to USCo were in the nature of Fees for Technical Services (FTS) and subject to withholding of tax u/s. 195 of I T Act. Further, since no tax was withheld, the entire expenditure was disallowable u/s. 40(a)(i).

Held:

The Tribunal observed and held as follows. Neither the I T Act nor DTAA has defined the term managerial, technical and consultancy. Hence, dictionary meaning of those terms should be referred to. On the basis of dictionary meanings, payments made to a non-resident in respect of telecom services cannot be termed as FTS.

The Tribunal referred to the following decisions : In CIT v De Beers India Minerals P Ltd [2012] 346 ITR 467 (Karn), services performed using technical knowledge, etc. were not considered as FTS since they were not ‘made available’.

Further, in DCIT v Sandoz (P) Ltd [2012] 137 ITD 326 (Mom), the Tribunal has held that even if payment for advertisement could be assessed as business profits under section 9, in absence of PE in India they could not be charged to tax. In GE India Technology Centre P Ltd v CIT [2010] 327 ITR 456 (SC), Supreme Court has held that the obligation to withhold tax u/s. 195 arises only if the income is chargeable to tax. If income is not chargeable to tax, provisions of section 40(a)(i) do not apply.

Therefore, the Tribunal held that ICo had no obligation to withhold tax on payment made to USCo. Accordingly, the payment cannot be disallowed u/s. 40(a)(i).

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Nirav Shah

USA – Advance agreements between related parties properly characterized as equity

The US Tax Court has held that advance agreements executed between related parties were appropriately characterised as equity for US Federal income tax purposes. PepsiCo Puerto Rico, Inc. v. Commissioner of Internal Revenue; PepsiCo, Inc. and Affiliates v. Commissioner of Internal Revenue, T.C. Memo. 2012-269 (Docket Nos. 13676-09, 13677-09, 20th September 2012).

The case involved a US parent corporation (PepsiCo) and its group of affiliated corporations that included Netherlands Antilles companies. The Netherland Antilles companies held promissory notes issued by the group’s US affiliated corporations (Frito-Lay, Metro Bottling, and PepsiCo) and held interests in foreign entities that were treated as partnerships for US Federal income tax purposes (foreign partnerships).

The deficits of the foreign partnerships reduced the earnings and profits of the Netherland Antilles companies, which in turn reduced the amount of the interest income from the notes that would otherwise have flowed-through to PepsiCo as subpart F income. To avoid the adverse consequences that would result from the pending termination of the extension of the US-Netherlands treaty to the Netherlands Antilles, and also to benefit from the favourable tax treatments of the US-Netherlands DTAA and Dutch corporate income tax, PepsiCo transferred the ownership of some of the foreign partnerships from the Netherland Antilles companies to newly-formed Dutch companies (PWI and PGI).

During this global restructuring, Frito-Lay, Metro Bottling, and PepsiCo issued new promissory notes to replace the existing promissory notes and the new promissory notes were ultimately contributed to PWI and PGI. In exchange for the contributed promissory notes, PWI and PGI issued advance agreements to the group’s US affiliates (BFSI and PPR). The advance agreements had terms of 40 years, which could be unilaterally extended by PWI and PGI for an additional 15 years.

The advance agreements, however, would be rendered perpetual if a related party defaulted on any loan receivables held by PGI or PWI. A preferred return unconditionally accrued on any unpaid principal amounts of the advance agreements. The preferred return included a base rate determined by reference to LIBOR plus a premium rate. However, PWI and PGI were required to make any payments of the accrued preferred return only to the extent their net cash flow exceeded the sum of accrued but unpaid operating expenses and capital expenditures made or approved by them, but in no event could the cash-flow amount be less than the interest received from the affiliated companies.

PWI and PGI were allowed to make payments on the advance agreements in full or in part at any time. In addition, the rights of the creditors of PWI and PGI were superior to the holders of the advance agreements. The group treated payments of preferred return on the advance agreements as distributions on equity on its US Federal income tax returns. Interest payments on the promissory notes were deducted by Frito-Lay, Metro Bottling, and PepsiCo u/s. 163 of the US Internal Revenue Code (IRC) and were also exempt from US withholding tax pursuant to the US-Netherlands tax treaty.

The issue of the case was whether the advance agreements were appropriately characterised as equity for US Federal income tax purposes. The US Internal Revenue Service (IRS) asserted that the advance agreements and the promissory notes were merely intercompany loans between commonly controlled related companies. The US Tax Court stated that, while the substance of a transaction governs for tax purposes, the form of a transaction often informs its substance.

The US Tax Court further stated that, although the greater scrutiny should be afforded to relatedparty transactions, disregarding the taxpayers’ international corporate structure based solely on the entities’ interrelatedness is, without more, unjustified. The US Tax Court noted that the focus of a debt-versus-equity inquiry is whether there was intent to create a debt with a reasonable expectation of payment and, if so, whether that intent comports with the economic reality of creating a debtor-creditor relationship.

The US Tax Court then applied 13 factors that it has articulated for the debt-versus-equity inquiry. After analysing those factors, the US Tax Court concluded that the advance agreements exhibited more qualitative and quantitative indicia of equity than debt. The US Tax Court determined that the advance agreements were appropriately characterised as equity for US Federal income tax purposes. 10. Netherlands Supreme Court: burden of proof regarding transfer of legal seat on taxpayer On 30th November 2012, the Supreme Court of the Netherlands (Hoge Raad der Nederlanden) gave its decision in case No. 11/05198 as to whether or not, in the context of the transfer of the legal seat of a company, the burden of proof (of the transfer) rests on the taxpayer. For the facts, legal background and issues of the case, as well as the opinion of the Advocate General (AG), the Taxpayer presented the Supreme Court with two arguments:

• Firstly, the Taxpayer appealed against the finding of the Court of Appeal (Gerechtshof) of Arnhem that it (the Taxpayer) had not shown that the place of effective management had, since 1st July 2001, been transferred to the Netherlands Antilles. The Court dismissed this appeal on the grounds that it is a reasonable finding of facts, which can as such not be considered by the Supreme Court.

• Secondly, the Taxpayer essentially argued that the burden of proof regarding its (Netherlands Antilles) residence status only extends to the year in which the transfer takes place, i.e. to 2001. The AG had concluded that the shift in the burden of proof to the Taxpayer applies for a period of 1 year after the transfer of the place of effective management has been “made plausible”.

• The Court noted, as the Court of Appeal had, that the aim of article 35b(7) of the Tax Regulation for the Kingdom of the Netherlands, as deduced from parliamentary and legislative documentation, is to combat tax avoidance which may arise from the nominal (paper) transfer of the legal seat of a company. This article provides for a shift in the burden of proof to the taxpayer in certain situations where there is a transfer of the legal seat.

• On this point, the Supreme Court agreed with the Court of Appeal, and decided that the burden of proof is shifted to the taxpayer until that taxpayer can make plausible the transfer of the place of effective management.

• This second argument, the Court noted, was somewhat academic as the first hurdle, namely proving that the place of effective management had indeed been transferred, had not been taken by the taxpayer.

[Acknowledgement/Source: We have compiled the above summary of decisions from the Tax News Service of IBFD for the period 18-09-2012 to 17-12-2012.]

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Nirav Shah

Netherland’s Supreme Court decides that Dutch thin capitalisation provisions are not incompatible with EC law and article 9 of Dutch tax treaties with France, Germany and Portugal

On 21st September 2012, the Dutch Supreme Court (Hoge Raad der Nederlanden) gave its decision in X BV v. the Tax Administration (case No. 10/05268) on the compatibility of the Dutch thin capitalisation rules with EC law and article 9 of the tax treaties Dutch tax treaties with France, Germany and Portugal.

The Supreme Court rejected the taxpayer’s argument that the thin capitalisation rules are incompatible with the EC Treaty. In the taxpayer’s view this is the case because the rules apply if a Dutch company for 95% or more is owned by a foreign company, which means that in such case mainly foreign companies are affected. The Court based its judgment on an earlier decision of 24th June 2011 (LJN BN3537) in which it was held that domestic and foreign holding companies are not in a comparable situation.

Referring to the decision of the European Court of Justice (ECJ) of 21st July 2011 in Scheuten (Case C-397/09), the Court also held that the thin capitalization rules are not incompatible with the Interest and Royalties Directive (2003/49) because that Directive deals with the position of the creditor and not with that of the debtor.

Following the opinion of the AG, the Court rejected the appeal based on article 25(5) (Non-discrimination) under the treaty with France, because the Taxpayer is not treated differently from another company which is not part of a group and is not comparable with a group company.

Thereafter, the Court decided that the provision at issue is also not incompatible with the arm’s length provisions under article 9 of the France – Netherlands Income and Capital Tax Treaty (1973) (as amended through 2004) and article 9 of the Germany – Netherlands Income and Capital Tax Treaty (1959) (as amended through 1991) because those provisions only provide for a corresponding adjustment in case of contracts and financial relations between related parties which are not at arm’s length, while the Dutch thin capitalisation rules concern the entire financing structure of a company.

Finally, the thin capitalisation rules are also not incompatible with article 9 of the Netherlands – Portugal DTAA because article X of the protocol specifically allows the Member States to apply their domestic thin capitalisation rules. Those rules may only not be applied if related companies prove that their agreements are at arm’s length based on their activities or their specific economic circumstances.

The term “thin capitalisation” is not defined in the Treaty, the term must be interpreted by means of article 31(1) of the Vienna Convention on tax treaty interpretation, which means that the meaning of the term must be determined in good faith based on the subject and purpose of the treaty. Based on the thin capitalisation rules applicable in Portugal at the time of signing of the Treaty, the Court held that the term refers to interest deduction restrictions concerning interest paid on loans to related companies. This is in line with article 9 of that Treaty, which aims to determine whether the conditions in a concrete legal case are at arm’s length. Therefore, the Court held that the term “thin capitalisation” in the Treaty with Portugal only concerns certain loans and not a general thin capitalisation rule which concerns the total financing structure of a company.

Consequently, the Supreme Court held that Dutch thin capitalisation provisions are not incompatible with EC law and article 9 of the Dutch tax treaties with France, Germany and Portugal.

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Nirav Shah

ECJ rules on definition of fixed establishment: taxable person carrying out only technical testing or research work in another Member State does not have a “fixed establishment from which business transactions are effected”

On 25th October 2012, the Court of Justice of the European Union (ECJ) gave its decision in the joined cases of Daimler AG v Skatteverket (C-318/11) and Widex A/S v Skatteverket (C-319/11). The Swedish Administrative Court of Falun (Förvaltningsrätten i Falun) had requested a preliminary ruling from the ECJ on 27th June 2011. No Advocate General’s opinion regarding this case was issued. Details of the judgment are summarised below:

(a) Facts:

In C-318/11, Daimler AG (Daimler) is a company having the seat of its economic activity in Germany and carrying out winter testing of cars in Sweden. Daimler does not carry out any activity subject to VAT at the installations in Sweden, but has a wholly-owned subsidiary there which provides it with premises, test tracks and related services. Daimler applied for a refund of input VAT paid on the purchases it had made, which had not been used for any activity subject to VAT in Sweden (i.e. the testing of cars).

In C-319/11, Widex A/S (Widex) is a company established in Denmark manufacturing hearing aids and has a research centre in Sweden carrying out research into audiology, which constitutes a division within Widex. Widex acquires goods and services for the research activity which it carries out in its division in Sweden. Widex also has a subsidiary in Sweden which sells and distributes its goods in Sweden, but the subsidiary operates totally independently from the research activities of the division.

The Swedish tax authorities rejected Daimler’s and Widex’s applications for the refund of VAT paid in Sweden on the grounds that the applicants have a fixed establishment in Sweden.

(b) Legal background: Under articles 170 and 171 of the EU VAT Directive (2006/112) taxable persons who are not established in the Member State in which they purchase goods and services or import goods subject to VAT but are established in another Member State may obtain a refund of that VAT in so far as the goods and services are used for the purposes of certain specific transactions. Under article 1 of the Eighth VAT Directive (79/1072) and, now, under article 3 of the Directive 2008/9, a taxable person is not established within a Member State and qualifies for a refund of input VAT if that person has neither the seat of his economic activity, nor a fixed establishment from which business transactions are affected in that particular Member State.

The issue was whether a taxable person for VAT established in one Member State and carrying out in another Member State only technical testing or research work, not including taxable transactions, can be regarded as having in that other Member State a “fixed establishment from which business transactions are effected” within the meaning of article 1 of the Eighth Directive and, now, in article 3(a) of Directive 2008/9 and as such be denied the right to refund of VAT in that State.

(d) Decision:

The ECJ pointed out that the criterion under which a refund of VAT can be denied due to the fact that there is a “fixed establishment from which business transactions are effected” includes two cumulative conditions: firstly, the existence of a “fixed establishment”; and secondly that “transactions” are carried out from that establishment. By referring to Commission v. Italy (Case C-244/08), the ECJ emphasised that the expression “fixed establishment from which business transactions are effected”, must be interpreted as regarding a non-resident taxable person as a person who does not have a fixed establishment carrying out taxable transactions in general. The existence of active transactions in the Member State concerned constitutes the determining factor for exclusion of the right to refund of VAT. Furthermore, the term “transactions” used in the phrase “from which business transactions are effected” can affect only output transactions. Consequently, in order to deny the right to refund, taxable transactions must actually be carried out by the fixed establishment in the State where the application for refund is made, while the mere ability to carry out such transactions does not suffice. In the cases at hand, it is not in dispute that the undertakings concerned do not carry out input taxable transactions in the Member State where the refund applications have been made through their technical testing and research departments. As such, a right to refund of the output VAT paid must be granted. As this criterion is cumulative, there is no need to examine whether Daimler and Widex do actually have a “fixed establishment”. The purpose of the Directives is to enable taxable persons to obtain a refund of the output VAT where they could not deduct output VAT paid from input VAT due because they have no active taxable transactions in the Member State of refund. The actual carrying out of taxable transactions in the Member State of refund is therefore the common requirement for excluding the right to refund, whether or not the applicant taxable person has a fixed establishment in that State.

The ECJ concluded that a taxable person for VAT established in one Member State and carrying out in another Member State only technical testing or research work, not including taxable transactions, cannot be regarded as having in the other Member State a “fixed establishment from which business transactions are effected” within the meaning of article 1 of the Eighth Directive and article 3(a) of Directive 2008/9.

In respect of the third question in Case C-318/11 on whether the fact that the taxable person has in the Member State where it has applied for the refund a wholly-owned subsidiary whose purpose is almost exclusively to supply the person with services in respect of technical testing activity influences the interpretation given to the concept of “fixed establishment from which business transactions are affected”, the ECJ noted that a subsidiary is a taxable person on its own account and that the purchases of goods and services in the main proceedings were not made by it. The case at hand also differed from DFDS (Case C-260/95) where the independent status of the subsidiary was disregarded due to the commercial reality under which both the parent and the subsidiary had carried out the active taxable transactions of supplies of services in the Member State concerned. The condition that there are active input taxable transactions carried out by the technical department is not met and hence the existence of a wholly-owned subsidiary did not influence the interpretation given to the concept.

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Nirav Shah

FCE Bank case – Court of Appeal holds UK’s former group relief rules in breach of treaty non-discrimination article

On 17th October 2012, the Court of Appeal dismissed HMRC’s appeal in CRC v FCE Bank Plc. (a) Facts and legal background HMRC had appealed against a decision from the Upper Tribunal that the UK’s pre-2000 group relief rules breached the non-discrimination article in the United Kingdom – United States DTAA (1975). The Upper Tribunal’s decision itself upheld that of the First Tier Tribunal. The domestic tax rules at issue provided for the surrender of losses between two companies in a 75% group. As respects the subsidiaries, the rules provided that either (a) one company should be a 75% subsidiary of the other, or (b) that both companies should be 75% subsidiaries of a third company. The rules however provided that, where both the claimant and the surrendering company were 75% subsidiaries of a third company, that third company had to be resident in the United Kingdom. Two UK subsidiaries (FCE Bank Plc and Ford Motor Company Ltd.) wished to avail of the group relief provisions. Their parent company Ford Motor Company was resident in the United States of America. HMRC had refused the claim for group relief. FCE Bank argued that the denial of group relief was based on the fact that their parent company was not UK-resident, and contended that the provision was in breach of the non-discrimination article of the 1975 United Kingdom – United States double taxation treaty. (b) Decision The Court of Appeal accepted the taxpayer’s argument. The Court did not accept HMRC’s argument that the discrimination was not as a result of the place of residence of the parent company, but rather, was because the parent company was not subject to UK corporation tax. According to the Court, the parent company’s liability to UK corporation tax was immaterial for the purposes of the group relief provisions at issue. HMRC’s appeal was dismissed.

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Nirav Shah

Residence Tie-Breaker Test – A home is not a home once you lease it – Australia

The Australian Taxation Office released Interpretative Decision ATO ID 2012/93 that deals with a definition of a “permanent home available to the taxpayer” in the residence tie-breaker article of the Australia – Malaysia DTAA.

The taxpayer, after living in his own house in Australia, contracts to work in Malaysia for two years. The taxpayer anticipates that after two years, he will return to Australia and leases his house for a fixed term of two years. The taxpayer is a tax resident in both countries and therefore article 2.a of the Treaty will determine the residence of the taxpayer by reference to the country in which the taxpayer has a permanent home available to him. The question is therefore whether a permanent home that the taxpayer owns in Australia, but leases while he is away in Malaysia, continues to be a permanent home available to him.

The Interpretative Decision focuses on “available” and finds, through article 3.3, that the Oxford dictionary defines “available” as “capable of being used” and since the home is temporarily rented, it is not capable of being used by the taxpayer, in a sense that he cannot occupy it. It follows that the home is not available to him for the term of the lease agreement.

The Interpretative Decision also finds that the home would not be “permanent” under the OECD Commentaries, as the taxpayer has not “arranged to have the home available to him at all times continuously” (paragraph 13 of the Commentary on article 4).

It could perhaps be noted that the full sentence in the Commentaries says “… continuously, and not occasionally for the purpose of stay which is of short duration”.

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Nirav Shah

Belgian Constitutional Court decides that denial of carry-forward of non-deductible part of 95% foreign dividend deduction re non-EEA countries is compatible with equality principle of Belgian constitution – DTAA between Belgium and Korea (Rep) and between Belgium and Venezuela

On 10th November 2012, the Belgian Constitutional Court(Cour Constitutionelle/Grondwettelijk Hof) gave its decision in the case of Agfa Gevaert NV v. Belgische Staat, FOD Financiën, Administratie der Directe Belastingen en de Belgische Staat, Fod Financiën (No. 5259) on the constitutionality and compatibility with the 1994 protocol to the Belgium – Korea (Rep.) DTAA (1977) (as amended through 1994) and the 1993 protocol to the Belgium – Venezuela DTAA (1993) of the denial of a carry-forward of the non-deductible part of foreign dividends received from a Korean and Venezuelan subsidiary.

Court of Appeal Antwerp (Hof van Beroep Antwerpen) requested a preliminary ruling from the Belgian Constitutional Court on 22nd November 2011.

The Court first held that the denial of the carryforward possibility with respect to the non-deductible part of the 95% foreign dividend deduction for non EEA-countries is not incompatible with the equality principle of articles 10 and 11 of the Belgian Constitution. The Court held decisive that the EEA constitutes a special legal order which may justify that cross-border economic activities within the EEA are not always taxed in the same manner as economic activities between an EU/EEA Member State and third countries.

Furthermore, the Court considered that the legislature may take into consideration the budgetary consequences, when deciding whether or not to expand the carry-forward possibility with respect to non-deductible part of 95% foreign dividend deduction to third countries. In this context, the Court held that its decision will not be different if the budgetary aspect is not mentioned in the Parliamentary Documentation. Based on those arguments, the Court held that the different treatment is not incorrect or unreasonable.

With respect to the compatibility with articles 63 and 64 of the DTAA on the Functioning of the EU (TFEU) on the free movement of capital in respect of third countries, the Court held that the different treatment at issue does not result from the domestic provision at issue, but from the relevant EU provisions. The Court held that it is not competent to decide on such different treatment.

Finally, the Court also held that the laws concerning the ratification of the protocol to the tax treaty with Korea (Rep.) and the treaty with Venezuela are compatible with the equality principle of the Belgian Constitution. The Court based its decision on the fact that it held that a different treatment of dividends received from an EEA Member State and a third state is compatible. This means that the legislator also has the leeway to ratify a tax treaty which maintains such distinction.

In addition, the Court held that the equality principle neither requires that Belgium under each tax treaty signed guarantees the most beneficial outcome for the taxpayer under the laws existing at the time of signing nor that the same issues are regulated in the same manner under all tax treaties. Note: It has to be seen whether the different treatment at issue will also be EU compatible. In the first place, it must be noted that with respect to domestic provisions whose application does not depend on the size of the participation, both the freedom of establishment as well as the freedom of capital can be applicable.

If the freedom of capital would be applicable, the European Court of Justice (ECJ) has repeatedly held that the freedom of capital, generally, precludes all restrictions of the freedom of capital between EU Member States and third countries. For the determination whether a restriction nevertheless can be justified, it must be considered that capital flows with third countries take place in a different legal context than capital flows with EU Member States.

Finally, the ECJ has decided that movement of capital vis-à-vis third countries may, however, be justified for a reason, which would not constitute a valid justification for a restriction on capital movements between Member States. The different treatment in such cases can be based on the need to ensure the effectiveness of fiscal supervision or fiscal coherence.

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Nirav Shah

France – Court of Appeals – Hertogenbosch decision that sportsman is entitled to avoidance of double taxation for foreign employment income attributable to a test match not appealed before Supreme Court

In a Circular (No. 2012/03814HR) of 9th October 2012, the State Secretary for Finance announced that the decision of the Court of Appeals-Hertogenbosch that a sportsman is entitled to avoidance of double taxation for foreign employment income attributable to a test match will not be appealed before the Supreme Court.

The State Secretary held decisive that the test matches (held in Spain and Thailand) were open for the public, which means that the sportsman’s performance was aimed at an audience. In addition, he took the view that the Dutch Supreme Court would confirm its earlier decision of 7th February 2007, in which it was decided that if the employment contract obliges a sportsman to participate in games and races in foreign countries, the basic salary, generally, has to be allocated to his income from personal activities in the state of performance on a pro-rata basis, unless the employment contract indicates otherwise. In that case, the Supreme Court indicated that the term “personal activities” covers the performance aimed at an audience and time spent for activities related to such performance as training, availability services, travel and a necessary stay in the country of performance.

Furthermore, avoidance of double taxation was in that case also granted for training activities, sponsoring activities and contacts with the press.

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Nirav Shah

US Supreme Court grants certiorari regarding allowance of foreign tax credit for UK windfall tax

On 29th October 2012, the US Supreme Court granted a petition for a writ of certiorari filed by PPL Corporation and Subsidiaries (petitioner). PPL Corporation and Subsidiaries v. Commissioner of Internal Revenue, No. 12-43 (29th October 2012).

The petitioner filed the petition for a writ of certiorari on 9th July 2012 to request the US Supreme Court to resolve the conflicts between the US Third Circuit and Fifth Circuit regarding whether the US foreign tax credit (FTC) should be granted u/s. 901 of the US Internal Revenue Code (IRC) for the windfall tax imposed in the United Kingdom.

The question presented in the petition is whether, in determining the creditability of a foreign tax, courts should employ a formalistic approach that looks solely at the form of the foreign tax statute and ignores how the tax actually operates, or should employ a substance-based approach that considers factors such as the practical operation and intended effect of the foreign tax.

The windfall tax is a UK tax that was imposed on the privatised UK utilities as a one-time 23% assessment on the difference between the company’s “profit-making value” and its “floating value”, i.e. the price for which the UK government sold the company to investors. In the PPL Corporation case, the Court of Appeals for the Third Circuit concluded that the UK windfall tax fails to satisfy the gross receipts requirement and thus is not an income tax that is creditable against the US income tax.

PPL Corporation and Subsidiaries v. Commissioner of Internal Revenue, Docket No. 11-1069 (22nd December 2011). The Third Circuit made this conclusion on the ground that the UK windfall tax can be formulated as a 23% tax on a 2.25 multiple (i.e. 225%) of profits, which leads to the calculation of a tax base that begins with an amount greater than 100% of gross receipts.

In a similar case involving the UK windfall tax, the Fifth Circuit found the Third Circuit’s analysis to be too formalistic and determined that the UK tax is an income tax for which a US FTC is allowable. Entergy Corporation and Affiliated Subsidiaries v. Commissioner of Internal Revenue, Docket No. 10- 60988 (5th June 2012) Certiorari is a procedure by which the US Supreme Court exercises its discretion in selecting the cases it will review.

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Nirav Shah

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