Month: March

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1. Introduction
The Domestic Transfer Pricing Regulations were introduced in India by the Finance Act, 2012 with effect from the Assessment Year 2013-14. The amendment has been brought in basically by amending Chapter X of the Income-tax Act, 1961 (“the Act”) whereby the applicability of the international transfer pricing provisions has been extended to certain domestic transactions between specified related parties referred to as the ‘Specified Domestic Transactions’ (“SDTs”). Corresponding amendments have also been brought in the specific provisions of the Act – i.e. sections 40A(2), 80A(6), 80IA(8) and 80IA(10). Thus, with effect from the Financial Year 2012-13, the SDTs are subject to the transfer pricing provisions, which hitherto, were applicable only to international transactions and accordingly, a new concept of ‘Domestic Transfer Pricing’ (“DTP”) has been introduced in India. The DTP regulations essentially provide for a mechanism to determine the arm’s length price (ALP) in cases of SDTs, require the assessees to maintain information and documents supporting the ALP of such transactions as also obtain and file an accountant’s report in respect of such transactions along with the return of income. The DTP regulation does not apply to small assessees, since a monetary limit of Rs. 5 crores has been set in respect of the SDTs for the DTP provisions to apply.

1.2. Hence, an assessee who undertakes SDTs during a financial year, aggregating in value by more than Rs. 5 crore, would require to comply with the following:

ensure that the value of such transactions is at arm’s length price having regard to the methods prescribed under the Act;

maintain and keep information and documents in relation to such transactions as statutorily required;

obtain and file an accountant’s report in respect of such transactions along with his return of income.

1.3. Genesis of the DTP provisions is the decision of the Supreme Court in the case of CIT vs. GlaxoSmithkline Asia P. Ltd. (2010) 195 Taxman 35 (SC). The Apex Court gave suggestions, in order to “reduce litigation” to consider amendments in the law with a view to:

Make it compulsory for the tax payer to maintain books and documentation on the lines of Rule 10D;

Obtain audit report from a CA;

Reflect the transactions between related entities at arms’ length price;

Apply the generally accepted methods specified in TP regulations.

1.6. T he above suggestions have been duly carried out by the legislature. The Explanatory Memorandum (“EM”) clearly recognises the suggestions of the Supreme Court. It talks about extending the TP provisions “for the purposes of section 40A, Chapter VI-A and section 10AA”. The EM states the objective to amend the Act is to provide applicability of the transfer pricing regulations to domestic transaction “for the purposes of” computation of income, disallowance of expenses, etc. “as required under provisions of sections 40A, 80- IA, 10AA, 80A, sections where reference is made to section 80-IA, or to transactions as may be prescribed by the Board…”. The relevant extract of the EM reads as under:

“the application and extension of scope of transfer pricing regulations to domestic transactions would provide objectivity in determination of income from domestic related party transactions and determination of reasonableness of expenditure between related domestic parties. It will create legally enforceable obligation on assessees to maintain proper documentation”….Therefore, the transfer pricing regulations need to be extended to the transactions entered into by domestic related parties or by an undertaking with other undertakings of the same entity for the purposes of section 40A, Chapter VI-A and section 10AA.” (emphasis supplied)

1.7. T he fundamental propositions that emerge out of this analysis are:

a. DTP provisions are computation provisions and are neither charging provisions nor disallowance provisions;
b. DTP provisions have limited applicability to specified provisions of the Act;
c. DTP provisions, in addition to governing computation, impose administrative obligation of maintaining documentations and getting accounts audited.

2. Meaning of SDT

1.1. Section 92BA of the Act defines the term ‘Specified Domestic Transactions’ in an exhaustive manner. It basically refers to the following transactions:

a. Any expenditure in respect of which payment has been made or is to be made to a person referred to in section 40A(2)(b);

b. Any transaction referred to in section 80A; c. A ny transfer of goods or services referred to in section 80-IA(8); d. A ny business transacted between the assessee and other person as referred to in section 80- IA(10);

e. Any transaction referred to in any other section under Chapter VIA to which provisions of section 80 IA(8)/(10) are applicable;

f. Any transaction referred to in section 10AA to which provisions of section 80-IA(8)/(10) are applicable; where the aggregate value of such transactions in a previous year exceeds Rs. 5 crore.

1.2. T he definition starts with the phrase “for the purposes of this section and sections 92, 92C, 92D and 92E”. Thus, ordinarily, this meaning of SDT will not be extended to any other provision of the Act. However, the term SDT is referred to in the proviso to sections 40A(2), clause (iii) of the Explanation to section 80A(6), Explanation to section 80IA(8) and the proviso to section 80IA(10). It is nothing but incorporation by reference and since these sections refer to this phrase as understood within the meaning of section 92BA, its meaning for the purposes of those sections will have to be understood as given in section 92BA.

1.3. Further, the definition excludes “an international transaction” from the scope of the term SDT. Hence, “international transaction” and “specified domestic transactions” are two mutually exclusive concepts. As a corollary, a single transaction would not be subject to both International Transfer Pricing regulations and DTP regulations. It can be subject to only one of the two regulations.

1.4. Further, the word “domestic” in the expression “specified domestic transactions” is a bit misleading, since a specified domestic transactions may be a transaction within the domestic territory of India or it may also be a cross border transaction between parties who are not “associated enterprises” as defined u/s. 92A but are covered within the scope of the specific sections included in various clauses of section 92BA. For example, take a transaction of payment of an expenditure by an Indian company to its foreign shareholder holding, say, 25% shares in the said Indian company. Since the shareholding is less than 26%, the parties will not be related as associated enterprises within the meaning of section 92A. However, since the shareholding of more than 20% amounts to “substantial interest” within the meaning of section 40A(2)1 , the transaction will qualify as a SDT.

1.5. T o constitute SDT, the value of all the transactions referred to in the definition entered into by an assessee in a previous year should exceed Rs. 5 crore. As per the EM of the Finance Bill, 2012, such monetary limit has been prescribed with a view to provide relaxation to small assessees from the requirements of the DTP regulations, such as maintenance of documents, filing of accountant’s report, etc. The monetary limit of Rs. 5 crore is applicable with respect to the aggregate value of all the transactions and not individual transactions. Hence, where several transactions of less than Rs. 5 crore sum up to the total of more than Rs. 5 crore, all such transactions would be regarded as SDTs, even though their individual value is less than Rs. 5 crore.
1.6.    It is not specified in the definition as to what value has to be considered while computing the aggregate value of the transactions i.e. is it the arm’s length price or the actual price of the transactions that needs to be considered. however, since the monetary limit has been prescribed to determine whether the ALP of the transactions have to be computed or not, logically, the monetary limit would have to computed having regard to the actual recorded value of the transactions.

1.7.    Further, where the transactions referred to in the definition cover both income as well as expense items, both the receipt as well as outflow from the transactions would be required to be aggregated for testing the monetary limit. in other words, both income side and expense side of the transactions referred to in the definition would need to be aggregated to test whether the monetary limit of Rs. 5 crore has been exceeded or not. However, while deciding as to whether the income or the expense item has to be added up or not, it should be first ascertained as to whether such item is covered within the definition or not. For example, transaction referred to in clause
(i) Of section 92BA is ‘any expenditure…..’. hence, in such cases, only expense items would need to be considered.

1.8.    Cases may arise where the same transaction falls in more than one clauses of section 92Ba. For example, transfer of goods and services between two units would fall both within clauses (ii) and (iii) of section 92Ba. Similarly, purchase of goods from a person specified u/s. 40a(2)(b) for the purpose   of an eligible unit may fall within  clauses  (i)  as well as clause (iv) of section 92Ba, which refers    to transactions referred to in section 80ia(10). In such cases, it has not been clarified as to whether such transactions should be considered twice for determining the aggregate value. However, since the section requires to aggregate the value of the transactions ‘entered into’ by the assessee, a single transaction cannot be considered twice, for the purpose of determining the sum total.

1.9.    Further, consider a case of a company getting converted into a LLP with effect from, say, october 1, 2014. it borrowed monies from a party covered u/s. 40a(2). interest cost for the period april 1, 2014 to September 30, 2014 is rs. 1.5 crores and for the period october 1,2014 to march 31, 2015 is rs. 4.5 crore. there are no other transactions falling under any of the clauses of section 92BA. A question that arises is as to whether for determining the applicability of the provisions of Chapter X, should the aggregate interest expense of the two periods be considered or whether the interest expense of the two periods on a stand-alone basis should be considered.

1.10.    One view is that upon conversion of a company into LLP, new assessee comes into existence. the company is succeeded by the LLP. For the period from april to September 2014, the company would file its return of income and for the period october 2014 to march 2015, the LLP would file a separate return of income. Section 170(1) of the act provides that where a person carrying on any business or profession (such person hereinafter in this section being referred to as the predecessor) has been succeeded therein by any other person (hereinafter in this section referred to as the successor) who continues to carry on that business or profession,—
(a) the predecessor shall be assessed in respect  of the  income  of  the  previous  year  in  which  the succession took place up to the date of succession;(b) the successor shall be assessed in respect of the income of the previous year after the date of succession. hence, the threshold should be considered separately for both the assessees.

1.11.    The other view is also possible. it proceeds on the following lines :

•     Section 92Ba refers to the aggregate of such transactions entered into by the “assessee” ;

•     the  word  “assessee”  would  include  even  its predecessor, in the view  of  the  decision  of  the Supreme Court in the case of CIT vs. T. Veerbhadra Rao (155 ITR 152) (SC).

•     the  case  was  concerning  section  36(2)  which requires that for allowing deduction in respect of a bad debt, such debt should have been taken into account in computing the income of the “assessee” and the Supreme Court held that debt if the predecessor had taken that debt into account in computing its income, the successor would be eligible for claiming bad debts if it writes off such debt in its Profit and Loss account.

•     thus a combined total ought to be taken of the predecessor and successor with a view to apply threshold of rs. 5 crore.

1.12.    Personally, the auditors prefer the first mentioned view. however, having regard to the general adversarial approach of the tax department,  it  may be safer to go by the second view and ensure compliance   of   the   transfer   Pricing   Provisions anyway.

3.    DTP in relation to section 40A(2)
3.1.    Clause (i) of section 92B, which defines Sdt, refers to any expenditure in respect of which payment has been made or is to be made to a person referred to in clause (b) of section 40a(2). Section 40a(2) is    a computation provision, providing for disallowance of an expenditure incurred in a transaction entered into with specified persons, subject to satisfaction of other conditions mentioned in that section. Under this section, such expenditure is disallowed if it is considered as excessive or unreasonable having regard to the following:

–    the fair market value of the goods, services or facilities for which the payment is made; or
–    the legitimate needs of the business or profession of the assessee; or
–    the benefits derived by or accruing to him therefrom.

3.2.    The  said  three  conditions  are  separated  by  the conjunction ‘or’, which indicates that all the three circumstances need not exist simultaneously and that these requirements are independent and alternative to each other. Further, in respect of the first condition that the expenditure incurred should be at fair market value, the Finance act, 2012 has inserted a new proviso to section 40a(2)(a) with effect from assessment year 2013-14, which reads as under:

“Provided that no disallowance, on account of any expenditure being excessive or unreasonable having regard to the fair market value, shall be made in respect of a specified domestic transaction referred to in section 92BA, if such transaction is at arm’s length price as defined in clause (ii) of section 92F.”

3.3.    This amendment is consequential to the introduction of the dtP regulations in the act. hence, post amendment, the reasonableness of an expenditure in respect of a SDT needs to be ascertained based on the transfer pricing methods prescribed in Chapter X of the act. Further, the assessee also needs to maintain proper documents to demonstrate that the transactions are entered into on arm’s length basis.

3.4.    The said clause refers only to “expenditure”. hence, items of income are not covered for the purpose of  this clause. Therefore, the section applies only to an assessee who has incurred the expenditure and not the assessee who has earned the income in the very same transaction.

3.5.    Further, though it refers to ‘any’ expenditure in respect of which payment has been made or is to be made to a person referred to in section 40a(2) (b), it does not cover such expenditure, which is not claimed as deduction by the assessee while computing its income under the head ‘Profits or Gains from Business or Profession’. in other words, it does not cover expenditure of, say, capital nature or say, claimed as deduction while computing “income from house  property”,  since  the  scope of section 40a(2)(b) is restricted only to compute “Profits and Gains from Business or Profession”. this is also clear from the em of the Finance Bill, 2012, which clearly states that the dtP provisions have been introduced ‘for the purpose of’ section 40a(2), etc. hence, clause (i) of section 92Ba cannot be applied for purpose other than for section 40a(2). the only exception to the above would be computation of income under the  head  “income for other Sources”, since section 58(2) of the act, imports the provisions of section 40a(2) for the purpose of computation of income under that head.

3.6.    Clause (b) of section 40a(2) provides for an exhaustive list of persons for various kinds of assessees. hence, where any transaction involving an expenditure is entered into with such specified persons, and such expenditure is deductible while computing the income under the “Profits or Gains from Business or Profession” or “income from other Sources”, it would automatically fall within clause (i) of section 92Ba.

4.    DTP in relation to section 80A/80IA(8):
4.1.    Clauses (ii) and (iii) of section 92Ba refers to transactions referred to in sections 80a(6) and 80ia(8), respectively. Both these sections contain provisions for computation of the eligible profits claimed as deduction under the sections specified therein having regard to the market value, in a case where there has been transfer of goods or services to or from the eligible undertaking/unit/enterprise/ business of an assessee from or to other business of the assessee. Further, the Explanation to these sections has been amended by the Finance act, 2012, providing that where such transfer of goods or services is regarded as an Sdt, the market value of the goods or services would mean the ALP as defined under section 92F(ii).

4.2.    The transaction referred to in section 80a(6)/80ia(8) is inter-unit transfer of goods or services. hence, the transaction referred to in these sections is internal transfer of goods and services as against transaction between two persons. Hence, transfers within separate businesses of an assessee covered under these sections would also need to be considered and aggregated for the purpose of determining the monetary  limit  of  Rs.  5  crore  u/s.  92Ba.  Further, unlike clause (i) of section 92BA, it would cover both items of income as well as expenses. however, where a transaction is covered under both section 80a(6) and section 80ia(8), it would be considered only once for the purpose of finding the aggregate total.

4.3.    However, mere allocation of common costs between several units/businesses of the assessee would not be covered under these sections. the said sections provides that the profits of an eligible business shall be determined based on the market value of the goods and services, where such goods or services have been ‘transferred’ by such unit to ‘any other business’ or vice versa and, in either case, the consideration, if any, for such transfer as recorded in the accounts of the eligible business does not correspond to the  market  value  of  such  goods  or services as on the date of the transfer. hence, u/s. 92Ba r.w.s. 80a(6)/80ia(8), the transfer pricing provisions have been applied to a particular unit    of the assessee, whose profit is to be determined based on arm’s length principles only in certain specified scenarios, the same being:

a.    there should be inter-unit ‘transfer’ of goods or services;
b.    Such transfer should be to/from any other ‘business’ of the assessee; and
c.    Such transfer should be at a consideration that does not correspond to the market value.

4.4.    In case of common expenses, such as managerial remuneration, general administrative expenses or research, marketing and finance expenses, etc., it may be noticed that they are not ‘transferred’ by any one unit of the assessee to another unit. Further, such activities may qualify as “services”, the same cannot be regarded as another “business” of the assessee. Hence, it may not be strictly covered u/s. 80ia(8), implying that such common cost need not be allocated to the eligible unit on an arm’s length basis.

4.5.    However, attention may be brought to sub-section (5) of section 80IA, which requires that the profits of the undertaking claiming deduction under section 80ia should be computed as if the undertaking is the only source of income of the assessee. in view of this provision, Courts have held that the essence of the phrase ‘as if such eligible business was the only source of income’ used in the said sub-section (5) is that the expenses of the business, whether direct or indirect; project-specific or common expenses, had to be considered and allocated for computation of the profits and gains of an eligible business. See:
    Nitco Tiles Ltd. vs. Deputy Commissioner of Income-tax [2009] 30 SOT 474 (MUM.);
    Kewal Kiran Clothing Ltd., Mumbai vs. Assessee ITA No. 44/Mum/2009;
    Control & Switchgear Co. Ltd. vs. Deputy Commissioner Of Income Tax;
    Nahar Spinning Mills Ltd. vs. Joint Commissioner of Income-tax, Range VII, Ludhiana [2012] 54 SOT 134 (CHD)(URO):[2012] 25 taxmann.com 342 (Chd.);
    Synco Industries Ltd. vs. Assessing Officer of Income-tax [2002] 254 ITR 608 (Bom)

4.6.    Hence, the common costs do need to be allocated to the eligible unit u/s. 80ia(5). however, such allocation is not required u/s. 80IA(8) or section 80a(6), since these provisions apply only when there is a ‘transfer’ of goods and services from an eligible ‘business’ to another or vice versa. Hence, the pre-requisite for invoking these provisions is that goods or services should be ‘transferred’ from one unit to another. in absence of any transfer, this provision would not be triggered. Indeed, when there is no transfer, no price would be regarded for any transfer of goods in the books of the eligible unit and hence, there would be no occasion to examine as to whether such price adopted by the eligible unit is as per the market value of such goods or not.

4.7.    In this context, attention may be invited to the decision in Cadila Healthcare Ltd. vs. Additional Commissioner of Income-tax, Range –  I,  [2013]  56 SOT 89 (Ahmedabad – Trib.). In that case, the assessee was carrying out only one manufacturing business that was eligible for deduction under section 80iC. Hence, it carried out both manufacturing and selling and distribution activity as a part of one single business. The issue arose before the tribunal as to whether such manufacturing and distribution businesses need to be segregated and a notional transfer of goods from the manufacturing business to the selling business needs to be assumed for determine the profits of the manufacturing business.

4.8.    It was held that for applying this provision, one cannot assume an artificial or notional transfer of good or services between the units. Section 80iC(7) read with section 80IA(8) does not require that eligible profit should be computed first by transferring the product at an imaginary sale price to the head office and then the head office should sell the product in the open market. in that case, the ao had suggested two things; first that there must be inter-corporate transfer, and second that the transfer should be as per the market price determined by the ao. it was held that both these suggestions are not practicable. If these two suggestions are to be implemented, then a Pandora box shall be opened in respect of the determination of arm’s length price vis-a-vis a fair market and then to arrive at reasonable profit. rather a very complex situation shall emerge. Specially when the Statute does not subscribe such deemed inter-corporate transfer but subscribe actual earning of profit, then the impugned suggestion of the ao does not have legal sanctity in the eyes of law. When the method of accounting as applicable under the Statute, does not suggest such segregation or bifurcation, then it is not fair to draw an imaginary line to compute a separate profit of the eligible unit. it was held that there is no such concept of segregation of profit. rather, the profit of an undertaking for section 80ia deduction purposes should be computed as a whole by taking into account the sale price of the product in the market. If the Statute wanted to draw such line of segregation between the manufacturing activity and the sale activity, then the Statute should have made a specific provision of such demarcation. But at present the legal status is that the Statute does not do so.

4.9.    Thus,  this  provision  cannot  be  invoked  by  the revenue authorities for allocating the common expenses of the assessee to the eligible business of the assessee. For example, allocation of the expenditure incurred on managerial remuneration to an eligible unit, which was debited to another non-eligible unit by the assessee, was held in Nahar Spinning Mills Ltd. vs. Joint Commissioner of Income-tax, Range VII, Ludhiana [2012] 54 SOT 134 (CHD)(URO) to be not covered u/s. 80ia(8),   in absence of any transfer of goods or services between the two units. Indeed, managerial services would qualify as “services”. Also, managerial services is not the “business” of an assessee. These provisions apply when the goods and services held for an eligible business are transferred to other business or vice-versa. Therefore, these provisions do not apply to such allocation of expenses

4.10.    Further under 80ia(5), the common cost needs to be only allocated i.e. apportioned between various eligible units on actual basis without adding any notional mark-up. had section 80ia(8) applied, then a mark-up would have been added, since in that case, it would have been regarded as transfer of goods and services by one unit to another, and as per the arm’s length principle, such transfer would have been made not at cost but at a price, which obviously includes mark – up.

4.11.    Besides, reference may also be made to sections 92(2a) and 92(2) of the act. Section 92(2a) provides that allocation of any cost or expense in relation to the Sdt shall be computed having regard to the ALP. Similarly, section 92(2) provides that where in a Sdt, two or more associated enterprises enter into a mutual agreement or arrangement for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises, the cost or expense allocated or apportioned to, or, as the case may be, contributed by, any such enterprise shall be determined having regard to the ALP of such benefit, service or facility, as the case may be.

4.12.    As would be observed, though these sections deal with computation of allocation of cost/expense having regard to ALP, such allocation should be in respect  of  a  transaction,  which  is  a  SdT.  In  other words, the allocation should be in respect of a transactions referred to in sections 40a(2), 80a(6), 80ia(8), 80ia(10) for the purposes of those sections. as stated earlier, the allocation of common cost between units of an assessee is not a transaction covered u/s. 80a(6)/80(8). Further, sections 80ia(10) and 40a(2) are totally inapplicable for the purpose of such allocation. Accordingly, since there is no Sdt at the first place, the question of applying section 92(2) or section 92(2a) would not apply.

4.13.    Also, as far as section 92(2) is concerned, it applies only in respect of Sdt between two ‘associated enterprises’. Clearly, two units of same assessee cannot be regarded as ‘associated enterprises’ as defined u/s. 92a of the act. though sub-clause (ii) of clause (a) of rule 10a, defines the term ‘associated enterprise’, in relation to Sdt entered into by an assessee to include “other units or undertakings or businesses of such assessee in respect of a transaction referred to in section 80a or, as the case may be, sub-section (8) of section 80ia”, the said definition is applicable only for the purposes of the rules and cannot be imported for the purpose of section 92(2). Hence, even u/s. 92(2)/(2a), the transfer pricing methods need not be applied in allocating the common expenses to the eligible unit.

4.14.    Difficulties could arise also where different entities of a group that are related to each other u/s. 40a(2) have arranged their affairs in such a manner that some employees and some resources are jointly used and each entity raises debit note on the other towards sharing of costs every month based on certain fixed criteria – like number of staff, turnover, etc. Since the charges are essentially towards sharing of costs, companies would like to contend that the inter-company charge is reasonable having regard to ALP as determined under CUP method. however, the point that is being missed is that the basis of sharing should really meet the arm’s length principle because if such basis is not scientific, then, the condition in section 40a(2) that the expenditure should be reasonable having regard to  not  only the ALP but also to the legitimate needs of the business and benefits derived therefrom may come under a challenge.

4.15.    Section 80ia(8) has been referred to in various other provisions of Chapter VIA and in section 10aa, so that while computing the profits eligible  for deduction under those provisions, effect needs to be given to this sub-section of section 80ia.

Clause (v) of section 92Ba provides that even such transactions of assessee claiming deduction under these other provisions to which section 80ia(8) applies would also be covered for the purpose of SDT.  For  example,  sections  80iB(13),  10aa(9), 80iaB(3), 80iC(7), 80id(5) and 80ie(6) provides  that while computing the provisions contained in section 80ia(8) shall, so far as may be, apply to the eligible business under this section. Hence, inter unit transfer of goods and services where one of the unit is eligible to claim deduction u/s. 80iB would also be regarded as transactions covered under clause (v) of section 92Ba.

5.    DTP in relation to section 80IA(10):
5.1.    Clause (iv) of section 92BA refers to any business transacted between the assessee and another person as referred to in section 80IA(10). unlike sections 80A(6) and 80IA(8), which deal with inter-unit transfer of goods and services, section 80IA(10) deals with a case where the assessee having an eligible business enters into a transaction with another person, which owing to the “close connection” between them or otherwise, is arranged in a manner which results in the eligible business showing more than ordinary profits.

5.2.    Hence, for a transaction to be covered u/s. 80IA(10) and therefore under clause (iv) of section 92Ba, it should be a transaction which is ‘arranged’ to show more than ordinary profits from the eligible business.

5.3.    Further, invoking section 80IA(10) is a prerogative of the ao. the ao can recompute the profits eligible for tax holiday if the tax payer having business with another party of “close connection” earns more than ordinary profits because of such “close connection” or  “for  any  other  reason”.  The  section  does  not provide for any objective criteria to decide whether there is any “close connection” between two parties doing business with each other. Generally, the expression ‘close connection’ has been interpreted to cover all companies which belong to  the same group 2.

5.4.    Also, “any other reason” is a term that is subjective and which reflects the legislative intent of providing freedom to the ao to examine all facts and circumstances of the case and decide. For example, an unrelated person who has lived with the assessee as a paying guest for several years and for whom he develops affection may be covered under “close connection”. At the same time two brothers separated from each other may run independent companies which may do business with each other, but the “close connection”, in substance, is absent.

5.5.    The  new  law  casts  the  onus  on  the  assessee and the auditors to identify and report such transactions! it is impossible to comply with  such a requirement unless, like section 40A(2) or section 92A there are objective criteria to determine the persons having “close connection”. Also, cases of “any other reason” can never be imagined by the assessee or the auditors for reporting.

5.6.    Further, like sub-section (8) of section 80IA, even sub-section (10) of section 80ia has been referred to in various other sections. hence, even such transactions of assessee claiming deduction under these other provisions to which section 80IA(10) applies would also be considered as Sdt.

6.    Issues in relation to DTP regulations
6.1.    Whether DTP regulations can be made applicable even in a case where there is no tax arbitrage:

The Supreme Court in CIT vs. GlaxoSmithkline Asia P. Ltd. (supra), on the facts of that case, refused to interfere “as the entire exercise is revenue neutral” and accordingly dismissed the  SLP  filed  by  the  revenue.  The  Court  has also observed that in the case of domestic transactions, the under-invoicing of sales and over-invoicing of expenses ordinarily would be revenue neutral in nature, except in those cases, which  involve  tax  arbitrage.  The  Court  has  then listed the circumstances where there could be tax arbitrage as under:

(i)    if one of the related companies is a loss making company and the other is a profit making company and profit is shifted to the loss making concern; and

(ii)    if there are different rates for two related units [on account of different status, area-based incentives, nature of activity,  etc.] and if profit   is diverted towards the unit on the lower side of the tax arbitrage. For example, sale of goods or services from non-SEZ area, [taxable division]  to SEZ unit [non-taxable unit] at a price below the market price so that taxable division will have less taxable profit and non-taxable division will have a higher profit exemption.

Hence, applying the ratio of this decision, the DTP regulations should be applicable only to such cases that involve tax arbitrage.

Further, in the context of section 40a(2), the CBDT vide Circular no. 6P dated 06-07-1968 has clearly specified that the same cannot be applied in cases where there is  no  tax  evasion.  The  relevant  extract  of  which  reads as under:

“No disallowance is to be made u/s. 40A(2) in respect of payment made to relatives and sister concerns where there is no attempt to evade tax. ITO is expected  to  exercise  his  judgment  in a reasonable and fair manner. It should be borne in mind that  the  provision  is  meant  to check evasion of  tax  through  excessive or unreasonable payments to relatives and associated concerns and should not be applied in a manner which will cause hardship in bona fide cases.” (emphasis supplied)

In CIT vs. V.S. Dempo & Co (P) Ltd [2011] 196 Taxman 193 (Bom), it has been observed that the object of section 40A(2) is to prevent diversion of income. an assessee, who has large income and is liable to pay tax at the highest rate prescribed under the act, often seeks to transfer a part of his income to a related person who is not liable to pay tax at all or liable to pay tax at a rate lower than the rate at which the assessee pays the tax. In order to curb such tendency of diversion of income and thereby reducing the tax liability by illegitimate means, Section 40a was added to the act by an amendment made by the Finance act, 1968. hence, in cases where there has been no attempt to evade tax, section 40A(2) cannot be attracted. Also see:
    CIT vs. Jyoti Industries (2011) 330 ITR 573  (P&H);
    CIT vs. Udaipur Distillery Co Ltd. (2009) 316 ITR 426 (Raj);
    Deputy  Commissioner  of   Income-tax   vs.   Ravi Ceramics [2013] 29 taxmann.com 22 (Ahmedabad – Trib.);
    CIT vs. Indo Saudi Services (Travel) (P.) Ltd. [2008] 219 CTR 562 (Bom);
    Orchard Advertising (P.) Ltd. vs. Addl. CIT [2010] 8 taxmann.com 162 (MUM);
    DCIT vs. Lab India Instruments (P.) Ltd. [2005] 93 ITD 120 (PUNE);
    ACIT vs. Religare Finvest Ltd. [2012] 23 taxmann. com 276 (Delhi);
    Aradhana Beverages & Foods Co. (P.) Ltd. vs. DCIT [2012] 21 taxmann.com 135 (Delhi);
    CIT vs. J. S. Electronics P. Ltd. (2009) 311 ITR 322 (Del).

Hence, it can be said that the dtP regulations should not be applied where there is no tax advantage to the parties, especially in cases where section 40A(2) is being applied. However, the act, as it stands today, does not so provide. transactions  between  related  resident  parties  may  be subject to the rigours of DTP regulations even if there is no tax arbitrage or an advantage obtained by any of the parties from such a transaction. For example, transaction of sale and purchase of goods between two indian companies, which are subject to the same maximum marginal rate of tax, would not lead to any tax advantage to either of them. However, if the said two companies  are related to each other under section 40A(2)(b) of the act and the volume of the transactions between the two companies exceeds rs. 5 crore in a given financial year, the transactions between the two companies would still be subject to the domestic transfer pricing regulations and accordingly, the companies would be required to maintain proper documents in support of the arm’s length price of such transactions and would also be required to obtain an accountant’s report in respect of such transactions. Similarly, in case of an assessee having two eligible units u/s. 80IA of the act, transfer of goods between the two units would not lead to any tax advantage to either of them, but nevertheless, they would be subject to the domestic transfer pricing regulations.

The  irony,  thus,  is  that  while  the  transactions  that  are revenue neutral shall not suffer any disallowance in terms of the Supreme Court ruling, the related parties entering into such transactions will,  nevertheless,  be  required to maintain documentation and records under the new transfer pricing provisions.

6.2.    Whether ‘corresponding adjustments’ are allowed under the DTP regulations in the hands of the other assessee:

On a plain reading of section  92(2a),  it  may  appear that since ALP adjustment is required both in the case  of income as also expense,  the total income of both   the parties to the transaction would be adjusted for the difference, if any, between the recorded/actual price and the aLP of the transaction.

However, this is not the case, when this  provision  is read along with section 92(3), which provides that the provisions of section 92 would not apply where such ALP adjustment has the effect of reducing the income chargeable to tax or increasing the losses.

Hence, though ALP adjustment may be required  in  case of the assessee whose income stands increased, corresponding adjustment in the case of the counter- party would not be permissible, since that would result in  reduction  of  his  taxable  income.  this  would  lead  to double taxation of same income twice. This is apparently contrary to an important canon of taxation, namely, the rule against double taxation of the same income.3

Unlike this, in case of international transactions, in most of the DTAAs, Article 9 provides that if an adjustment   on account of ALP  is  made  for  determining  the income of enterprise of the first contracting state, then corresponding adjustment shall be made to the income of enterprise of the second contracting state. hence, where there has been adjustment to the total income of the indian assessee u/s. 92(1) or section 92(2), the DTAA generally provides for a corresponding adjustment to the counter non-resident party, upon satisfaction of certain conditions.

Article 9(2) of the OECD Model provides as under:

“2. Where a Contracting State includes in the profits of an enterprise of that State — and taxes accordingly —profits on which an enterprise of the other Contracting State has been charged to tax in that other State and the profits so included are profits which would have accrued to the enterprise of the first-mentioned State if the conditions made between the two enterprises had been those which would have been made between independent enterprises, then that other State shall make an appropriate adjustment to the amount of the tax charged therein on those profits. In determining such adjustment, due regard shall  be  had  to  the other provisions of this Convention and the competent authorities of the Contracting States shall if necessary consult each other.”

Article 9 of the united nations model Convention too provides for such corresponding adjustments, though subject to certain further conditions. The relevant paras of Article 9 read as under:

“2. Where a Contracting State includes in the profits of an enterprise of that State—and taxes accordingly—profits on which an enterprise of the other Contracting State has been charged to tax in that other State and the profits so included are profits which would have accrued to the enterprise of the first-mentioned State if the conditions made between the two enterprises had been those which would have been made between independent enterprises, then that other States hall make an appropriate adjustment to the amount of the tax charged therein on those profits. In determining such adjustment, due regard shall  be  had  to  the other provisions of the Convention and the competent authorities of the Contracting States shall, if necessary, consult each other.

3. The provisions of paragraph 2 shall not apply where judicial, administrative or other legal proceedings have resulted in a final ruling that by actions giving rise to an adjustment of profits under paragraph1, one of  the  enterprises  concerned  is liable to penalty with respect to fraud, gross negligence or wilful default.”

Hence,   though   section   92(3)   of   the    act   prohibits corresponding   adjustments   even   in   the   cases   of international transactions, a relief of corresponding adjustments, subject to certain conditions, is available to the non-resident assessees in the relevant dtaas. in such cases, there is no double taxation of the said amount.

Such unequal treatment of the Indian assessees and foreign assessees would lead to hostile discrimination between them, which is not permitted under article 14  of the Constitution of india. hence, such discrimination between the two assesses may be constitutionally challenged.

6.3.    DTP and section 35AD:

Section 35ad provides for deduction/weighted deduction in respect of certain capital expenditure incurred by an assessee wholly and exclusively, for the purposes of any business specified in that section, carried on by him during the previous year.

Sub-section (7) of this section provides that “the provisions contained in sub-section (6) of section 80a and the provisions of sub-sections (7) and (10) of section 80-IA shall, so far as may be, apply to this section in respect of goods or services or assets held for the purposes of the specified business”. Hence, the provisions of section 80a(6) and section 80IA(10) are applicable even to section 35AD.

Prima facie, it may appear that in view of the reference to sections 80A(6) and 80IA(10), the DTP regulations would also be applicable to this section. however, for applying the dtP provisions, existence of a SDT is a pre-requisite. Now, on close reading of the definition of Sdt4, it would be clear that it covers transactions referred to in section 80a(6), any business transaction referred to in section 80IA(10) as also any transaction, referred to in any other section ‘under Chapter VI-A or section 10AA’, to which provisions of section 80IA(10) are applicable. however, it does not cover transactions referred to in any other provision of the act other than Chapter VIA and section 10AA, to which the provisions of section 80IA(10) apply. Now, SDT has been defined “to mean……”, so that it is an exhaustive definition and cannot be construed widely to cover transactions other than those mentioned therein. hence, since the transactions referred to in section 35AD are not covered within the  ambit  of  SDT,  the  DTP  provisions  contained in sections 80A(6) and 80IA(10) would not apply to it. Further, the other dtP provisions contained in  Chapter  X,  which  are  applicable  to  SDT,  would also not apply to transactions covered under section 35ad.

6.4.    Directors’ Remuneration -: Whether Companies Act provisions/approval is valid benchmark?

A director of a company is covered in the list of persons specified under clause (b) of section 40a(2). Hence, the remuneration paid to it by the company would be subject to the provisions of section 40A(2) and consequently, to the DTP regulations.

Now, u/s. 92C, the aLP of a transaction needs to  be determined by applying the most appropriate method.  Rule  10C  deals  with  the  criteria  for  the selection  of  the  most  appropriate  method.  the most appropriate method is one which best suits   to the facts and circumstances of each particular transaction and which provides the most reliable measure of an arm’s length  price  in  relation  to the transaction. Now, under CUP method,  the prices charged/paid for a comparable uncontrolled transaction are considered. However, having read the provision of section 92Ba read with section 40a(2)(b) of the act, payment of remuneration to a director, being a party specified in section 40a(2)(b) of the act, would always be a controlled transaction. Hence, since CUP method works only in case where comparable uncontrolled transaction exists, this method may not apply from that angle. Nevertheless, under this method, tribunals have taken a view5   that payments, if approved by appropriate authorities would be considered as being at arm’s length royalty under CUP method. See:

– DCIT vs. Sona Okegawa Precision Forgings Ltd. [2012] 17 taxmann.com 98 (Delhi);
–    Sona Okegawa Precision Forgings Ltd. vs. ACIT[2012] 17 taxmann.com 141 (Delhi);
–    Thyssenkrupp Industries India (P.) Ltd. v. ACIT [2013] 33 taxmann.com 107 (Mumbai – Trib.);
– SGS India (P.) Ltd. vs. ACIT [2013] 35 taxmann. com 143 (Mumbai – Trib.)

However, there also exist views contrary to the same. See:

– Perot Systems TSI (India) Ltd. vs. DCIT [2010] 37 SOT 358 (Delhi);
–    SKOL Breweries Ltd. vs. ACIT [2013] 29 taxmann. com 111 (Mumbai – Trib.)

Hence, it is arguable that so long as the directors’ remuneration is within the limits prescribed under the Companies act, 1956/2013, such remuneration should be regarded as at ALP under CUP method, though contrary view cannot be ruled out.

now,  RPM  is  generally  preferred  where  the  entity performs basic sales, marketing, and distribution functions (i.e. where there is little or no value addition) and therefore, it cannot be applied in the instant case. Similarly, CPm which is generally adopted in cases of provision of services, joint facility arrangements, transfer of semi-finished goods, long term buying and selling arrangements, etc, the same fails in the present case. PSm method is applicable in cases where there are multiple interrelated transactions between aes and when such transactions cannot be evaluated independently. Since payment of remuneration by Company to its directors is a single transaction capable of being evaluated separately, applicability of PSm method fails in the present case.  TNMM  requires  a  comparison  between the income derived by unrelated entities from uncontrolled transactions and the income derived by the assessee from its transactions with related parties. In this method, it is the profit and not the price that forms the basis for comparison. In case of a transaction of payment of director’s remuneration, the profits of unrelated parties shall always be from “controlled transactions” because the directors are covered within the meaning of related parties u/s. 40a(2).  Therefore,  it  is  not  possible  to  find  any comparable company that qualifies for selection for comparison of profits. Accordingly, this method is also not capable of being implemented.

As would be observed, all the methods prescribed, (except, arguably, the CUP method) are rendered unsuitable for determining the aLP in the present case. Hence, recourse may be made to the residuary  method  prescribed  under  rule  10AB  of the rules, which permits application of any rational basis for determining the ALP, where none of the other methods are applicable.

Now, the CBDT has, in its Circular No. 6P (LXXVI-66), dated july 6, 19686  , while clarifying the introduction to section 40a to act vide Finance act, 1968, at para 75 remarked that when the remuneration of a director of the Company is approved by a Company Law administration, the reasonableness of the same cannot be doubted. the relevant extract of the said circular reads as under:

“In regard to the latter provisions, the Deputy Prime Minister and Minister of Finance observed in Lok Sabha (during the debates on the Finance Bill, 1968) that where the scale of remuneration  of a director of a company had been approved by the Company Law Administration, there was no question of the disallowance of any part thereof in the income-tax assessment of the company on the ground that the remuneration was unreasonable or excessive.”

Thus, as per the CBDT’s own views, if the remuneration paid by a Company is within the ceiling limits provided under the provisions of the Companies act, 1956 or approved by the Company Law administration, then disallowance u/s. 40a(2) of the act cannot be sustained.

Hence, having regard to this Circular, one may proceed to benchmark the remuneration paid by a Company to  its directors under the residuary method. Indeed, the aforesaid CBDT circular has not been withdrawn even after the introduction of DTP regulations under Chapter X of the act. also, one may keep in mind the decision of the Supreme Court7 that circulars issued by the Board are binding on all officers and persons employed in the execution of the act.

Thus,   it   may   safely   be   concluded   that   where   the remuneration paid to the directors (including commission and sitting fees) is within the permissible limits expressly provided under the Companies act, it is at ALP.

6.5.    Whether persons indirectly related would get covered under clause (b) of section 40A(2):

Clause (b) of section 40a(2) provides for the list of persons the transactions between whom would be covered under that section. the said clause does not use the words ‘directly or indirectly’. hence, it appears that the transactions between persons who are indirectly related would not be covered within its ambit. Indeed, whatever indirect relationships were intended to be covered, the same  have  been specifically provided in the said clause. For example, a company, the director of which has substantial interest in the business of the assessee has been covered as a specified person. Clearly, such company has no direct relation with the assessee. Indeed, wherever the Legislature has intended to cover even indirect relationships, it has been specifically provided in the act. For example, section 92a of the act defines the term ‘associated enterprise’ to, inter alia, mean  an  enterprise, which participates, directly or indirectly…..in the management or control of the other enterprise.’ Hence, apart from the persons specifically mentioned in clause (b), no other person indirectly related to the assessee would be regarded as a related party.

For example, where A holds 20% equity share capital in B and B holds 20% equity share capital in C, transactions between a and B as well as between B and C could be hit by section 40a(2). However, transactions between a and C would not covered by these provisions.

In Para 73 of Circular no. 6P dated 06-07-1968, explaining the provisions of  the  Finance  act, 1968 (through which  section  40a  was  inserted), it is mentioned that ‘the categories of persons payments to whom fall within the purview of this provision comprise, inter alia………… persons in whose business or profession the taxpayer has a substantial interest directly or indirectly’.

However, the said phrase so used in the Circular cannot be construed to mean that in all cases of assessee holding indirect substantial interest in another person’s business, they would be regarded as   related   persons.  The   said   phrase   basically refers to sub-clause (vi) of Section 40a(2)(b), which provides for specific instances where the assessee and another person in whose business he has substantial interest (directly or indirectly to the extent specified in the section), would be regarded as related persons. the indirect substantial interests so covered in the said sub-clause (vi) are in case  of an individual, substantial interest through his relative and in case of other specified assessees, substantial interest through its director or partner or member, as the case may be or any relative of such director, partner or member.

Hence, the interpretation of the word ‘indirectly’ used in the Circular should be restricted to mean only the foregoing indirect interests envisaged in the section and should not be widely construed to cover cases beyond the scope of the section. For example, substantial interest of a company in another person indirectly through a company is not covered within this clause. indeed, the word “indirectly” appears to be used in the Circular merely to avoid reproducing the entire clause from the section once again and therefore, should not be interpreted to widen the scope of that section. Besides, it is an established principle that a delegated legislation (such as circulars, rules, etc.) cannot travel beyond the scope of main legislation. A circular cannot even impose on the taxpayer a burden higher than what the act itself on a true interpretation envisages.

Recently, the institute of Chartered accountants of india has also clarified in its Guidance note on report u/s. 92e of the income-tax act, 19618, at Para 4a.16 that, for the purpose of section 40a(2), it would be appropriate to consider only direct shareholding and not derived or indirect shareholding.

6.6.    Whether    section    40A(2)    applies    only    to expenditure for which deduction has been claimed, can it made applicable to adjust the expenditure capitalised on which depreciation is subsequently claimed?

Section 40A(2) applies when there is a claim for deduction of an expense. u/s. 37(1), expenditure  in the nature of capital expenditure is not allowed as deduction in computing the income chargeable under the head  ”Profits  and  gains  of  business  or profession“. Hence, strictly speaking, such expenses would not be covered by section 40A(2), since this section is applicable only for computing the deductions which are otherwise allowable while computing the “Profits and gains of business of profession”.

A question arises as to whether the section can be applied to the depreciation claimed on such capital expenditure. now, it is a settled legal position that depreciation is not an ‘expenditure’.  In Nectar Beverages P. Ltd. vs. DCIT (314 ITR 314), the apex Court has held that “depreciation is neither    a loss nor an expenditure nor a trading liability”. in Vishnu Anant Mahajan vs. ACIT (137 ITD 189)(Ahd) (SB) and Hoshang D Nanavati vs. ACIT (ITA No. 3567/Mum/07)(TMum), it has been held to be an ‘allowance’ and not an ‘expenditure’. Hence, since depreciation cannot be regarded as an ‘expenditure’, its disallowance/allowance cannot be governed by section 40A(2) of the act. it is has been held that section 40A(2) does not operate when a transaction concerns only the assets of the assessee.

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‘Income includes loss’ is a phrase found in various judicial precedents in the context of Indian Incometax laws, although commercially ‘income’ and ‘loss’ have always been understood to be antonyms. The gap between the commercial and tax-understanding is intentional. In this context, it is important to know the meaning of the terms ‘income’ and ‘loss’ (along with difference between them).

Income is a term though commonly used; is seldom understood. It has always triggered more questions rather than answers. It cannot be understood with recourse to some accepted tenets, beliefs and established class of propositions. To limit income exclusively to one or any specific sphere would be an unjustified arrest of its reach. Possibly, this is the reason that Income-tax statute also has left the definition of income open-ended.

There are various principles concerning ambit of ‘income’. One among them is ‘income includes loss’. A number of decisions including the Apex Court ruling in the case of CIT vs. J.H. Gotla (1985) 156 ITR 323 (SC) and CIT vs. Harprasad & Co. Pvt. Limited (1975) 99 ITR 118 (SC) has flagged this canon. The attempt in this write-up is to revisit and discern the meaning of the phrase ‘income includes losses’. In this journey, the write-up touches upon various instances in the Act when this principle ‘appears’ to be inapplicable or unworkable. The write-up attempts to initiate a thought whether this principle is to be applied in every situation or this has a restricted application?

Definition of income in the Income-tax Act, 1961 (‘the Act’)

Section 2(24) of the Act provides an inclusive definition of the term ‘income’. It does not define ‘income’ per se. Section 2(24), if paraphrased, would read as under:

(24) “income” includes

• profits and gains
• dividend
• voluntary contributions received by a trust
• the value of any perquisite or profit in lieu of salary taxable
• any special allowance or benefit, other than perquisite included under sub-Clause (iii), specifically granted to the assessee
• any allowance granted to the assessee either to meet his personal expenses at the place where the duties of his office or employment of profit are ordinarily performed or to compensate him for the increased cost of living
• the value of any benefit or perquisite, whether convertible into money or not, obtained from a company or by a representative assessee
• any sum chargeable to Income-tax under Clauses (ii) and (iii) of section 28 or 41 or 59
• any sum chargeable to Income-tax under Clause (iiia) of section 28(iiia)/ (iiib)/ (iiic)
• the value of any benefit or perquisite taxable under clause (iv) of section 28
• any sum chargeable to Income-tax under clause (v) of section 28
• any capital gains chargeable u/s. 45
• the profits and gains of any business of insurance carried on by a mutual insurance company or by a co-operative society
• the profits and gains of any business of banking (including providing credit facilities) carried on by a co-operative society with its members
• any winnings from lotteries, crossword puzzles, races including horse races, card games and other games of any sort or from gambling or betting of any form or nature whatsoever
• any sum received from employees towards ESIC contribution
• any sum received from Keyman Insurance policy
• Gifts or receipts for inadequate consideration.

Section 2(24) enlists various instances of income. First among them is ‘profits and gains’. The terms ‘profits’ and ‘gains’ have not been defined in the Act. It is trite to state that in the absence of statutory definition one could place reliance on the dictionary meaning or normal connotation of term(s). If dictionary meanings are referred, ‘profits’ means excess of revenue over expenditure and ‘gains’ as an increase in amount, degree or value. These twin concepts are indicative of a positive figure. There are judicial precedents to indicate that gains include ‘negative gains’ and we would keep these judicial precedents aside for the time being [and restrict ourselves to terminologies used in the Act].

Other terms used in the definition are ‘received’, ‘granted’, ‘winnings’, ‘obtained’. All these terms also have an element of ‘positivity’ inbuilt in them. Can these terms be used along with ‘losses’? A loss is something different. It is not something which is received or won or granted or obtained. It comes ‘ab-extra’ from outside. The term ‘loss’ generally accompanies verbs such as ‘incurred’, ‘sustained’, ‘computed’, ‘suffered’ etc. The use of these terms in section 2(24) appears to indicate that the law does not visualise any losses to be listed therein. This becomes more evident on a reading of the remaining instances in the definition which confine themselves to incomes which are chargeable to tax. These are obviously not concerned with losses. To conclude, although section 2(24) is an inclusive definition, the instances listed therein do not seem to accommodate ‘losses’ within its stride.

Although section 2(24) is an inclusive definition and its normal meaning should not be curtailed by various items listed therein in its inclusive sweep, it is interesting to observe that the legislature has consciously not included a ‘single’ instance to suggest that income may possibly include a negative face also.

Scope and charge of total income

Section 4 is the charging provision under the Act. The charge is in respect of the total income of a person for any year. The scope of total income is outlined by section 5 which has two sub-sections – one, dealing with residents and other with nonresidents. It enlists incomes which are includible in total income. It recognises those incomes which are to be included in total income on ‘receipt’ or ‘accrual’ or ‘deemed accrual’ basis. Cumulatively, these sections seek to include income within the scope of total income to levy a charge of tax. The question is whether losses can be charged to tax? Can losses be accrued or received or deemed so? The answer is negative in my view.

This is because, the term(s) ‘accrue or arise’ connotes ‘legal right to receive’. It is generally a stage prior to actual receipt (except for advances). The gap between accrual and actual receipt is only a matter of timing difference. It needs no explanation to state that losses cannot be ‘received’. When they cannot be received; how can there be a right to receive them? – Readers may deliberate.

Provisions of clubbing of income

Explanation 2 to section 64 reads – ‘For the purposes of this section, ‘income includes loss.’ This explanation was inserted by Finance Act 1979 whose objective is explained by Circular No. 258, dated 14-06-1979; relevant portion of which is as under:

“17.2 Under the provisions of section 64, the income of the specified persons is liable to be included in the total income of the individual in certain circumstances. The Finance Act, 1979 has inserted a new Explanation 2 below section 64(2) to provide that the term “income” for the purposes of section 64 would include a loss. Hence, for example, where the individual and his spouse are both partners in a firm carrying on a business and the firm makes a loss, the share of loss attributable to the spouse will be included in determining the total income of the individual.”(emphasis supplied)

The intention of the aforesaid amendment/insertion was to include losses in determining total income of the person in whose hands the income gets clubbed.  The inclusion was, therefore, sought to be made in ‘total income’ determination.  Losses of one person (whose income/loss get clubbed) were sought to be set-off against the income of another person (in whose hands the income is getting clubbed).  The explanation seeks to enable set-off of losses of one person in another’s hand. To effectuate this principle the legislature inserted explanation 2 WHEReby income for the purposes of this section includes loss. The important aspect here is the limited scope of this explanation.  The content of this explanation is limited to the context of section 64 only.  It does not travel beyond this. The explicit mention of such an aspect goes on to substantiate that under general principles income does not include losses.  This is a unique provision with a special purpose.

Some of the circulars on the aspect of considering losses for the purpose of set-off against income provide some insight into the purpose of such leg- islation.  In addition to Circular 258 dated 14-06-1979 (referred above) one may refer the C. B. R. Circular No. 20 of 1944 – C. No. 4(13)-I.T/ 44 dated the 15TH July, 1944 which reads as under:
Subject : Section 16(3)(a) – Loss incurred by wife or minor child – Right of set off under section 24(1) and (2).

Attention is invited to the Boards Circular No. 35 of 1941, on the above subject. It was laid down therein that where the wife or minor child of an individual incurs a loss which if it were income would be includ- ible in the income of that individual u/s. 16(3), such loss should be set-off only against the income, if any, of the wife or minor child and if not wholly set-off should be carried forward, subject to the provisions of section 24(2). The Board has reconsidered the question and has decided that, although this view may be tenable in law, the other and more equitable view is at least equally tenable that such loss should be treated as if it were a loss sustained by that individual. Thus, if the wife or minor child has a personal income of Rs. 5,000 which is not includible in the individuals income and sustains a loss of Rs. 10,000 from a source the income of which would be includible in the income of the individual, the loss should be set-off against the income of the individual under section 24(1), and if not wholly set-off should be carried forward u/s. 24(2). The wife or the minor child, would, therefore, be assessable on the personal income of Rs. 5,000. If, in any case, the wife or minor child claims a set-off of the loss against the personal income, it should be brought to the notice of the Board. Boards Circular No. 35 of 1941 is hereby cancelled.” (emphasis supplied)

Thus, losses are included to enable set-off against income. The inclusion is in the total income computation and not in income as such. The inclusion is for the limited purpose of computation. The Direct Tax Law Committee 1978, in its final report, also made some observations on this provision:

“The provisions for aggregating income of the spouse under clause (i) of section 64(1) has led to a dispute in regard to the treatment of losses which may fall to the share of the spouse from the partnership. The Gujarat High Court in Dayalbhai Madhavji Vadera vs. CIT [1966] 60 ITR 551 has ruled that the section contemplates inclusion of income and, accordingly, the share of loss arising to the spouse cannot be set-off against the total income of the other spouse. The Karnataka High Court in Kapadia vs. CIT [1973] 87 ITR 511 has dissented from this view and has held that income in this section includes a loss. On general principles, income from membership in a firm would include a loss and the context of clause (i) of sub-section (1) does not warrant the contrary construction. The liability to assessment cannot alternate from year to year between the individual and the spouse depending on whether there is a profit or a loss…” (emphasis supplied)

The Committee has categorically said that income ‘in this section’ includes loss. To state negatively, otherwise (or under normal circumstances) income does not include loss. The reason for such inclusion is to ensure consistency in the process of aggre- gating the profit or loss with the spouse’s income. It does not indicate income to include loss in all circumstances.

The scope of clubbing section is limited. It provides for clubbing of one’s income in the total income of another. By defining income to include loss, it is suggesting that loss of one person (along with income) may also be included in the total income of another person. The inclusion of loss is expanding the scope of ‘clubbing’ and not ‘income’.

Set-off and carry forward of losses

Chapter VI of the Act deals with aggregation of income and set-off of loss. Section 70 provides for set off of ‘loss’ from one source of income against ‘income’ from another source under the same head. If the losses cannot be fully set-off against income under the same head, they may be set-off against incomes under other heads (section 71). The balance losses remaining after set off against the incomes computed under other heads is carried forward to the succeeding years as per the relevant provisions of the Act. Thus, the Act recognises loss to be different from income. Loss has an effect of reducing income in the process of set-off against income. An increase in loss would reduce the income. They are inversely proportional. The opening portion of section 70 and 71 is broadly similar language which is reproduced below:

Section 70	(1) Save as otherwise provided in this Act, where the net result for any assessment year in respect of any source falling under any head of income, other than “Capital gains”, is a loss, the assessee shall be entitled to have the amount of such loss set-off against his income from any other source under the same head.
Section 71	(1) Where in respect of any assessment year the net result of the computation under any head of income, other than “Capital gains”, is a loss and the assessee has no income under the head “Capital gains”, he shall, subject to the provisions of this Chapter, be entitled to have the amount of such loss set-off against his income, if any, assessable for that assessment year under any other head.

to absorb the costs/expenditures/ other outlays; an assessee ends up with a situation of unabsorbed costs/ expenditures. This event of income falling short of outflows is called ‘loss’. Can such a situation be termed as ‘in- come’? Loss and Income are names of opposite fiscal situation(s) and cannot be equated with one another. Both the sections deal with set off of loss against income. The legislature itself recognises income and loss to be different and distinct. They are different outcomes having opposite characters. They cannot co-exist. This being the case, can one say that income includes loss?

The term ‘include’ means – ‘to comprise or contain as part of a whole’. Say for instance, if A includes B, then, A either consists of B wholly or partially. On the contrary, if the presence of B negates or diminishes the existence of A, then can we say that A includes B? In the context of clubbing, the legislature required losses (of one person) to be clubbed along with income (of another). This clubbing is to facilitate total income computation. Thus, the inclusion is only ‘quantitative’ and not ‘qualitative’. This being the case, such limited quantitative inclusion of the legislature cannot be understood to be ‘qualitative’ to paint all the incomes with such understanding.

In the context of section 70 and 71, ‘loss’ is a mere outcome in the process of computing income. This is apparent from the language used in these twin sections which read – ‘where the net result….’. Loss is a net result or consequence. The other alternative outcome is ‘income’. To elucidate further, one may look at the structure of the Income-tax Act.

Section 4 creates a charge on total income.  Section 5 (read with section 7 and 9) outline the scope for such total income.  While computing total income certain incomes are excluded by section 10 (along with 11).  Section 14 classifies income into 5 heads for the purpose of total income computation (and charge of Income-tax).  Sections 15 to 59 compute incomes under various heads.   Section 60 to 64 include (or club) certain incomes to assessee’s total income.  The focus is thus on total income computa- tion since the charge u/s. 4 is on it.  While making such computation, when the income is insufficient ‘Loss’ is conceptually different from income.  It is not defined in the Act.  Black’s law dictionary de- fines ‘loss’ as – ‘An undesirable outcome of a risk; disappearance or diminution in value; usually in an unexpected or relatively unpredictable way’.  The definition appears to reflect attributes of involuntary happening.  Although Companies Act of 1956 does not define ‘loss’ there is an indirect inference one could draw from section 210(2) therein which reads :

(2)IN the case of a company not carrying on business for profit, an income and expenditure account shall be laid before the company at its annual general meeting instead of a profit and loss account, and all references to “profit and loss account”, “profit” and “loss” in this section and elsewhere in this Act, shall be construed, in relation to such a company, as references respectively to the “income and expenditure account”, “the excess of income over expen- diture”, and “the excess of expenditure over income”. (emphasis supplied)

The meaning of loss has been explained to be ‘excess of expenditure over income’. It is a differential between expenditure and income. It is an outcome when income is unable to absorb all the expenditure/ costs. In other words, unabsorbed cost is loss. The interplay between income and expenditure results in loss. While computing income, loss could arise if the income falls short of expenditure. Loss is thus a status or situation wherein expenditure exceeds income. It is not a part of income. Something to be included in income, it should be a part of it. Income (net) or losses are two alternatives. They are outcomes. One denotes surplus and other is an epitome of deficit. From an Income-tax standpoint, marriage of these two extremes is impossible sans specific situations such as clubbing or set-off provi- sions (referred above).

Accounting standards also differentiate the two. Accounting Standard 22 [Disclosure and computation of deferred tax] defines taxable income (tax loss) as the amount of the income (loss) for a period, determined in accordance with the tax laws, based upon which Income-tax payable (recoverable) is determined.  Income and loss have been recognised as alternatives.  Loss is an antonym of income.  The question is whether such parallel and unlike concepts overlap under the Income-tax regime?

As stated in the beginning of this write-up, various courts held that income includes ‘losses’. It appears to be a fairly settled proposition. Whether this proposition is applicable in every situation?  Does ‘income’, which is inherently positive, include losses?

In my opinion, the term ‘income’ is not a polymor- phous term having an open texture. Income which indicates ‘coming in’ is an embodiment of positivity. It signifies pecuniary enrichment or accumulation. Loss is indicative of opposite emotions (to income). Loss may take various forms but would always result in deterioration. Indian tax provisions (keeping the judicial precedents aside) actually do not seek to hold these contradictory terms synonymous in every situation. At best, loss can be defined to be ‘loss of income’ and not ‘loss includes income’.

Having gone through the various instances and indications in the Act, the question still persists. The mystery around relationship between income and loss still lingers. Can these instances in the statute shake the law of land (Apex Court rulings)? Readers may deliberate whether INCOME REALLY INCLUDES LOSS?

If this proposition is accepted, can a daring attempt be made to claim that ‘losses emanating from sources of income which are exempt can be set-off against other income?’  Although this proposition is well settled by the Apex Court in the case of CIT vs. Harprasad & Co. Pvt. Limited (1975) 99 ITR 118 (SC), the attempt is to just explore an alternate school of thought:

Loss is not a part of total income

Section 2(45) defines total income to mean total amount of income referred to in section 5 and computed in the manner laid down in the Act. The definition thus contains two limbs which are
as follows:

(a)    The income includible in total income must be ascertained as per section 5; and

(b)    The income must be computed as per provisions of the Act.

‘Total income’ defined in section 2(45) presupposes an existence of ‘income’ referred to in section 5. For the reasons mentioned above, section 5 does not appear to cover losses.   Therefore, section 2(45) can never include loss (since they cannot be ascertained as per section 5).  Section 10 seeks to exclude certain incomes from total income.  When a loss is never included in total income, how can section 10 exclude something which never existed?

Section 10 can never exempt a loss

Section 10 contains provisions for exemption of certain incomes.  It never exempts a loss.  Infact, courts have held that exemptions provided by the legislature itself may furnish an infallible clue to the income character of a particular receipt [Refer All India Defence Accounts Association, In re: Shailendra Kumar vs. UOI (1989) 175 ITR 494 (All)]; although not conclusive.

The apex court in the case of UOI vs. Azadi Bachao Andolan and Another 263 ITR 706 (SC) held that the ‘liability to tax’ is a legal situation; whereas ‘payment of tax’ is a fiscal fact.   A taxing statute does not always proceed to charge and levy tax.  Exemption provisions provide exemption from payment of tax.  One among them is section 10.  The incomes enumerated therein exclude income from the total income.  However, it does not annul the charge of tax.  An exemption cannot dispense with the very levy created under the Act [Refer B.K. Industries vs. UOI (1993) 91 STC 548].  Support for this proposi- tion can be drawn from the Apex Court decision in the case of 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.” (emphasis supplied)

Taking cue from the aforesaid decision (although rendered in the context of central excise), one could argue that exemption section could operate on only those income which can come within the ambit of Income-tax levy. Loss can never be subject to Income-tax levy; so there is no occasion to take relief of exemption provisions. Moreover, it is a settled principle that exemption provisions have to be construed liberally.  The tax relief granted by a statute should not be whittled down by importing limitations not inserted by the legislature [Refer CIT vs. K E Sundara Mudaliar (1950) 18 ITR 259 (Mad) and others].

With utmost respect for the Apex Court decision in the case of Harprasad & Co. Pvt. Limited case and many other cases which have concurred or followed this proposition, the aforesaid write-up is an attempt to take a deeper insight into these landmark judgments and may be challenge the obvious.