BCAJ | Bombay Chartered Accountant Journal

Supreme Court decision in Dharmendra Textile Processors — Does it change the law on S. 271(1)(c) ?

Article

In penalty matter under the Central Excise Act, 1944 in the
case of Union of India & Others v. Dharmendra Textile Processors & Others,
(2007) 295 ITR 244 the Bench of two Judges of the Supreme Court doubted the
judgment of other two Judges of the Supreme Court in Dilip N. Shroff v. JCIT,
(2007) (291 ITR 519); but because one Coordinate Bench (which means the Bench of
the same strength of Judges) cannot over-rule the decision of another Coordinate
Bench, they recommended the formation of Larger Bench to the Hon’ble Chief
Justice of India. Accordingly, the matter was referred to the Larger Bench of
three Judges. The decision of the Larger Bench of three Judges is reported as
Union of India & Others v. Dharmendra Textile Processors and Others, (2008)
306 ITR 277. In the said decision the Larger Bench held at page 302 that “the
object behind the enactment of S. 271(1)(c) read with the Explanations indicates
that the said Section has been enacted to provide for a remedy for loss of
revenue. The penalty under the provision is a civil liability. Willful
concealment is not an essential ingredient for attracting civil liability as is
the case in the matter of prosecution u/s.276C of the Income-tax Act.”

Thus, the Larger Bench disapproved the decision in Dilip
N. Shroff (supra) and approved of what the Supreme Court held in
Chairman SEBI v. Shriram Mutual Fund, (2006) 5 Supreme Court cases 361,
which held that “mens rea is not essential for imposing civil penalties
under the SEBI Act and regulations”.

Now the limited purpose of this article is to point out that
the decision of three Judges in Union of India v. Dharmendra Textile
Processors, (2008) 206 ITR 277 is in conflict with the earlier three
decisions of three Judges of the Supreme Court and none of the earlier three
Judges’ decisions is considered by three Judges’ Bench of the Supreme Court in
Dharmendra Textile Processors, and therefore, the decision of
Dharmendra Processors is per incuriam. Besides, the Coordinate Bench
(of three Judges here) cannot over-rule the decision of another Coordinate Bench
(of three Judges). Therefore, for the above two reasons, the decision of
Dharmendra is not law under Article 141 of the Constitution of India. Let us
see those three decisions.

The earliest decision of these three decisions of three
Judges is Hindustan Steel Limited v. State of Orissa, (1972) 83 ITR 27.
The Tribunal had referred to the High Court the following question of law
u/s.24(1) of the Orissa Sales Tax Act, 1947 (corresponding to S. 256(1) of the
Income-tax Act, 1961) :

“Whether the Tribunal is right in holding that penalties
u/s.12(5) of the Act had been rightly levied and whether in view of the
serious dispute of liability it cannot be said that there was sufficient cause
for not applying for registration ?”

S. 12(5) was as follows :

“If upon information which has come to his possession, the
Commissioner is satisfied that any dealer has been liable to pay tax under
this Act in respect of any period and has nevertheless, without sufficient
cause, failed to get himself registered, the Commissioner may, at any time
within (five years) from the expiry of the year to which that period relates,
call for return U/ss.(1) of S. 11, and after giving the dealer a reasonable
opportunity of being heard, assess, to the best of his judgment, the amount of
tax, if any, due from the dealer in respect of such period and all subsequent
periods and may also direct that the dealer shall pay, by way of penalty, in
addition to the amount so assessed, a sum not exceeding one and half times
that amount.”

The High Court replied the question in the affirmative
against the assessee and the assessee appealed to the Supreme Court by Special
Leave. The Supreme Court itself framed the following relevant issue “whether
imposition of penalties for failure to register as a dealer was justified ?”
Justice J. C. Shah, the Acting Chief Justice, Justice V. Ramaswami and Justice
A. N. Grover constituted the Bench. The Court at page 29 of its judgment held as
under :

“Under the Act penalty may be imposed for failure to
register as a dealer : S. 9(1), read with 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 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.”
(Italics to provide emphasis.)

It is worth noting here that this case of Hindustan Steel was not an appeal from the conviction by a Magistrate in prosecution u/ s.25 of the Orissa Sales Tax Act. It was an appeal arising from the order of penalty u/s.12(5) of the Orissa Sales Tax Act by the Assessing Officer. It will seem that in spite of the above typographical mistake or shall I say ‘slip of tongue’ of stating S. 25(1)(a) in the above quotation in place of S. 12(5), what the Supreme Court laid down as above was without doubt regarding S. 12(5) and not S. 25, because otherwise it will not describe proceeding to be quasi-criminal proceeding. Proceedings ul s.25 are criminal proceedings before a Magistrate and no Court will commit a mistake of describing them as quasi-criminal proceedings. Looking at the importance of the topic, it is worth emphasising the following from the above quotation from Hindustan Steel; “An order imposing penalty for failure to carry out statutoru obligation is the result of a quasi-criminal proceedings 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 defiance or acted in conscious disregard of its obligation.”

Therefore, according to the Bench of three Judges of the Supreme Court in Hindustan Steel, willful contravention is an essential ingredient of attracting liability to penalty. (contra Dharmendra.)

The second decision of three Judges of the Supreme Court in point of time is in the case of D. M. Manasvi v. CIT, (1972) 86 ITR 557, Justice K. S. Hegde, Justice P. Jagmohan Reddy and Justice H. R. Khanna constituted the Bench. This was a matter u/s. 271(1)(c) of the Income-tax Act, 1961. The Court stated at page 565 as follows:

“It cannot therefore, be said that there was no relevant material or evidence before the Tribunal to hold that the assessee had deliberately concealed the particulars of his income or has deliberately furnished inaccurate particulars of income.”

For the assessee, reliance was put on the observation of the Supreme Court in CIT v. Anwar Ali, (1970) 76 ITR 696 and it was argued that from the mere falsity of the explanation, it did not follow that disputed amount represented income and that the assessee had consciously concealed particulars of income or has deliberately furnished inaccurate particulars of income. Disposing of this contention, the Court observed at page 565 :

“In this respect we find that in the present case the inference that the assessee had consciously concealed the particulars of his income or had deliberately furnished inaccurate particulars is based not merely upon the falsity of the explanation given by the assessee. On the contrary, it is made amply clear by the order of the Tribunal that there was positive material to indicate that the business of Kohinoor Mills belonged to the assessee and the whole scheme was to disguise the profits of the assessee as those of a firm of four partners. The present is not a case of inference from mere falsity of explanation given by the assessee, but a case wherein there are definite findings that a device had been deliberately created by the assessee for the purpose of concealing his income. The assessee, as such can derive no assistance from Anwar Ali’s case.” (Italics by the author to provide emphasis.)

Therefore, according to decision of three Judges of the Supreme Court in the case of Manasvi also, deliberate concealment or deliberate furnishing of inaccurate particulars is the essential ingredient for attracting penalty u/s.271(1)(c).

The last decision in point of time of three Judges of the Supreme Court is Anantharam Veerasinghaiah& Co. v. CIT (1980) 123 ITR 457. The Bench was constituted by Justice N. L. Untwalia, Justice R. S. Pathak and Justice E. S. Venkataramiah. This too was a case of penalty u/s.271(1)(c). The Court made the following emphatic and clear statement of law at page 461 :

“It is now settled law that an order imposing penalty is the result of quasi-criminal proceedings and that the burden lies on the Revenue to establish that the disputed amount represents income and that the assessee has consciously concealed the particulars of his income or has deliberately furnished inaccurate particulars: CIT v. Anwar Ali (1970) 76ITR 696 (SC). It is for the Revenue to prove those ingredients before a penalty can be imposed. Since the burden of proof in a penalty proceeding varies from that involved in an assessment proceeding, a finding in an assessment proceeding that a particular receipt is income cannot automatically be adopted as a finding to that effect in the penalty proceeding. In the penalty proceeding the taxing authority is bound to consider the matter afresh on the material before it and, in the light of the burden to prove resting on the Revenue, to ascertain whether a particular amount is a revenue receipt. No doubt, the fact that the assessment order contains a finding that the disputed amount represents income constitutes good evidence in the penalty proceedings, but the finding in the assessment proceeding can not be regarded as conclusive for the purposes of the penalty proceeding. That is how the law has been understood by this Court in Anwar Ali’s case (1970) 76 ITR 696 (SC), and we believe that to be the law still. It was also laid down that before a penalty can be imposed the entirety of the circumstances must be taken into account and must point to the conclusion that the disputed amount represents income and that the assessee has consciously concealed particulars of his income or deliberately furnished inaccurate particulars. The mere falsity of the explanation given by the assessee, it was observed, was insufficient without there being, in addition, cogent material or evidence from which the necessary conclusion attracting a penalty could be drawn. These principles were reiterated by this Court in CIT v. KhQday Eswarsa and Sons, (1972) 83 ITR 369.;’ (Italics -and underlining by the author to provide emphasis.)

Thus, it is obvious that according to earlier three Benches of three Judges of the Supreme Court (i.e., three Co-ordinate Benches) willful concealment or willful furnishing of inaccurate particulars is an Essential Ingredient for attracting penalty u/ s. 271(1)(c), whereas the latest decision of the three Judges of the Supreme Court in Dharmendra Textile Processors holds to the contrary. In fairness to the Supreme Court it must be pointed out that none of the above three decisions of three Judges was brought to the notice of the Court and the matter proceeded as if only the Bench of two Judges had laid down that willful concealment or willful furnishing of inaccurate particulars is the essential ingredient of S. 271(1)(c) penalty.

Therefore, the bottomline is that the decision of the Supreme Court in Dharmendra Textile Processors & Others, (2008) 306 ITR 277 being of three Judges cannot and has not overruled the law laid down as above by earlier three judgments of three Judges (in other words by Bench of the same strength of Judges) and what came to be laid down by three earlier judgments continues to be the law of the land. Further, it must be pointed out that right from the times of the Bombay High Court decision in CIT, Ahmedabad v. Gokuldas Harivallabhdas, (1958) 34 ITR 98, for last 50 years the law was understood on identical lines as the above three Supreme Court decisions pronounced viz., willful concealment of income or willful furnishing of inaccurate particulars of income is the essential ingredient for attracting penalty.

What the Supreme Court itself pointed out in A.L.A. Firm v. CIT, (1991) 189 ITR 285 at page 307 in regard to the decision of G. R. Ramachari & Co. v. CIT, (1961) 41 ITR 142 (Mad.) is relevant because of the principle of stare decisis.

“The view taken by the High Court has held the field for about thirty years and we see no reason to disagree even if a different view were possible.”

The Supreme Court in a later decision (1995) 6 Supreme Court Cases 84 in the case of Gangeshwar Ltd. v. State of U.P. & Others, stated as follows:

“The understanding of S. 6 of the Ceiling Act by the High Court reflected in these two decisions, when none has been placed before us to the contrary, would require upholding on the principle of stare decisis, for if we go to reinterpret the provision contrarily, it would upset the settled position in the State insofar as this area of laws is concerned. Therefore, necessity of certainty and cold prudence requires us to uphold the orders of the High Court.”

Nirav Shah

Worldwide tax trends — Fiscal Consolidation or Group Taxation

Article

The business environment is increasingly dominated by complex
corporate group structures. This brings forth the desire to tax a group by
reference to its overall performance and not merely along its legal structure.
To meet this need, a few countries have in place a ‘fiscal consolidation’ or a
‘group taxation’ regime, which taxes the group as a whole.

There is no uniform basis adopted by various countries in
their approach. However, the underlying object is to permit offsetting of losses
against the profits of the group. While group taxation is popular within the
confines of a particular jurisdiction, in a few instances, foreign subsidiaries
are also covered. For success of such a regime, it is essential that it must be
simple to administer, flexible enough to take into consideration business
exigencies such as intra-group transactions and corporate restructuring, and
have low compliance costs. Additionally, anti-abuse provisions may also need to
be built into the provisions, especially if this regime provides for
cross-border consolidation.

Broadly, the mechanism of the group taxation regime can be
classified into three distinct categories :

à
Consolidation system : Here, the income at the level of each member
company is considered and the results are combined at a group level. As the
group operates as a single entity for tax purposes, the parent company is
liable to pay the tax on behalf of the entire group.

à
The group contribution system : Here, profitable companies within the
group are permitted to make tax deductible contributions to group companies
that have incurred losses. Usually each company in the group remains liable
for its own tax obligations and files its own returns.

à
Group relief model : This system enables transfer of tax losses from
one company in the group to another. Even though these models allow for the
netting of profits and losses within the group, each company in the group
files its own tax return and pays its own tax.

Some countries adopt the ‘all-in or all-out approach’ whereby
all member companies that come within the group definition have to be included
for the purpose of group taxation. However, in some other countries, ‘cherry
picking’ is allowed, where companies within a group can elect participation.

In the following paragraphs we have provided a broad and
general overview of the group taxation regime or its variant as it exists in a
few countries.

Austria :

Definition of a group :

A new group taxation regime has been introduced in Austria
from 2005. It permits the parent Austrian company to consolidate its taxable
income with that of its subsidiaries, provided the parent Austrian company holds
directly or indirectly at least 50% of the voting rights in the subsidiary
companies, since the beginning of the subsidiary’s fiscal year. Only
corporations (not partnerships) qualify as group members.

Mechanism :

In such instances, where the shareholding criteria is met,
the entire taxable income (profit or loss) of domestic subsidiaries is allocated
to the taxable income of the parent Austrian company, regardless of the
percentage of shareholding in the subsidiary. Thus, even if 50% or 75% is held
in the subsidiary company, the entire taxable income of the subsidiary is
allocated to the taxable income of the Austrian parent. An application that is
binding for three years must be filed with the tax authorities.

Cross-border tax consolidation is permitted, but it is
limited to first-tier subsidiaries, provided that the foreign entity is
comparable to an Austrian corporation from a legal perspective. Losses from
foreign group members can be deducted from the Austrian tax base, but only in
proportion to the shareholding. Profits of a foreign group member are generally
not included in the Austrian parent’s income. Provisions exist for prevention of
dual utilisation of foreign losses. For instance, foreign losses that have been
deducted from income of the Austrian group shareholder are added in Austria, if
the losses can be offset in the foreign jurisdiction at a subsequent time.
Consequently, if the foreign country takes into account the losses in the
sub-sequent years (as a part of a loss carry forward), the tax base in Austria
is increased by that amount in order to avoid a double dip. Foreign losses must
also be added to the Austrian income tax base if the foreign subsidiary leaves
the group. Relief is provided only in the event of a liquidation or insolvency.

Italy :

Definition of a group :

The group taxation regime was introduced in 2004. To qualify
for consolidation, more than 50% of the voting rights of each subsidiary must be
owned, directly or indirectly, by the common Italian parent company. Italian
parent corporations can elect consortium relief if they hold more than 10% but
less than 50% of the voting rights in their Italian subsidiaries.

Mechanism :

This regime allows the offsetting of profit and losses of
members of a group of companies. Italian tax consolidation rules provide two
separate consolidation systems, depending on the residence of the companies
involved. A domestic consolidation regime is available for Italian resident
companies only. A worldwide consolidation regime, with slightly different
conditions, is available for multinationals.

Where more than 50% of the voting rights of each subsidiary are owned, directly or indirectly, by the common Italian parent company, the tax consolidation includes 100% of the subsidiary company’s profits and losses, even if the subsidiary has other shareholders. For a domestic tax consolidation, the election is binding for three fiscal years. However, if the holding company loses control over a subsidiary, such subsidiary must be immediately excluded from the consolidation. To prevent abuse, tax losses realised before the election for tax consolidation can be used .only by the company that incurred such losses. For groups of companies linked by more than a 50%direct shareholding net value-added tax (VAT) refundable to one group company with respect to its own transactions may be offset against VAT payable by another, and only the balance is required to be paid by, or refunded to, the group.

Cherry picking is permitted. The domestic tax consolidation may be limited to certain entities, leaving one or more otherwise eligible entities outside the group filing election.

Further, Italian parent corporations can elect consortium relief if they hold more than 10% but less than 50% of the voting rights in their Italian subsidiaries. Under this election, the subsidiaries are treated as look-through entities for Italian tax purposes and their profits and losses flow through to the parent company in proportion to the stake owned. These profits or losses can offset the shareholder’s losses or profits in the fiscal year in which the transparent company’s fiscal year ends. Tax losses realised by the shareholders before the exercise of the election for the consortium relief cannot be used to offset profits of transparent companies.

In general, in Italy, intra-corporate dividends are 95% exempt (i.e., 5% of the dividends are taxable). In this context, it is pertinent to note that dividends distributed by an eligible transparent company are not taken into account for tax purposes in the hands of the recipient shareholders. As a result, Italian corporate shareholders of a transparent company are not subject to corporate income tax on 5% of the dividends received.

The election does not change the tax treatment of dividends distributed out of reserves containing profits accrued before the exercise of the election. Another benefit from consortium relief is that an eligible transparent company does not pay corporate income tax. The consortium relief election is binding for three fiscal years and requires the consent of all the shareholders.

Netherlands:
Definition of a group:
The group taxation regime was revised, effective from January 1, 2003. To elect for the same, a parent company must own at least 95% of the shares of a subsidiary. Both Dutch and foreign companies may be included in a fiscal unity if their place of effective management is located in the Netherlands. A permanent establishment (PE) in the Netherlands of a company with its effective management abroad may be included in a fiscal unity. A subsidiary may be included in the fiscal unity from the date of acquisition.

Mechanism:
This group taxation regime permits losses of one subsidiary to be offset against profits of other members of the group. As a Dutch parent company and its non-resident subsidiary cannot apply for a group tax consolidation if that subsidiary does not have a PE in the Netherlands, the Dutch Supreme Court has on July 11, 2008, requested a preliminary ruling from the European Court of Justice (ECJ).

The ruling relates to whether the group taxation regime is compatible with the freedom of establishment principle in the EC Treaty.

We need to trace back the reason for such referral. In Marks & Spencer’s case, the UK-based group sought to offset the losses incurred by subsidiaries in several member states against the profits derived in the UK. As the UK group relief system only allowed for surrender of losses from UK resident companies, Marks & Spencer was denied the offset of the losses incurred in the non-resident subsidiaries. Even though the UK restriction was justified based on merits of the case (requirement to preserve a balanced allocation of taxing powers between the member countries; the need to prevent a double use of losses and the right to counter tax avoidance), the ECJ held that its objectives could be attained by less restrictive measures.

Even as ECJ’s ruling in the Marks & Spencer case suggests that the restriction that limits the fiscal unity regime to companies with their place of effective management located in the Netherlands does not violate EU law, it now remains to be seen how the ECJ will view the Dutch regime.

United Kingdom (UK) :

Definition of a group:

UK laws do not provide for group tax consolidation. However, a voluntary group relief system is available. In short, UK companies in a 75% or more economic relationship can opt to offset certain losses with profits for the same period realised by another UK company within the group.

Mechanism:

As mentioned above, a trading loss incurred by one company within. a 75%-owned group of companies may be grouped with profits for the same period realised by another member of the group. Similar provisions apply in a consortium situation; for this purpose, a UK resident company is owned by a consortium if 75% or more of its ordinary share capital is owned by other UK resident companies, none of which individually has a holding of less than 5%. However, the consortium-owned company must not be a 75%-owned subsidiary of any company.

In a 75%-worldwide group, the transfer of assets between group companies does not result in a capital gain if the companies involved are subject to UK corporation tax. This rule applies regardless of the residence status of the companies or their shareholders. The transferee company assumes the transferor’s original cost of the asset plus subsequent qualifying expenditure and indexation. However, under an anti-avoidance provision, if the transferee company leaves the group within six years of the date of the transfer of the asset, that company is deemed to have disposed of the asset at market value immediately after the start of the accounting period of departure or, if later, the original date of the transfer.

United States (U.S.) :

Definition of a group:

A limited consolidation system exists in the US. In general, an affiliated group consists of a U.S. parent corporation and all other US. corporations in which the parent holds directly or indirectly at least 80% of the total voting power and value of all classes of shares (excluding non-voting preferred shares).

Mechanism:

An affiliated group of U.S. corporations (as described above) may elect to determine their taxable income and tax liability on a consolidated basis. The consolidated return provisions generally allow electing corporations to report aggregate group income and deductions in accordance with the requirements for financial consolidations. Consequently, the net operating losses of some members of the group can be used to offset the taxable income of other members of the group, and transactions between group members, such as intercompany sales and dividends, are generally deferred or eliminated until there is a transaction outside the group. Under certain circumstances, losses incurred on the sale of consolidated subsidiaries are disallowed.

Conclusion:

In today’s business environment, a group taxation regime, which permits offsetting of losses against the profits within a group, would provide relief to corporate entities. The above paragraphs provide a bird’s-eye view of the group taxation regime, as it exists in a few developed tax economies.

Keeping in mind the factors which need to be considered in designing such a regime, it would be much simpler to initially introduce a domestic consolidation regime in India. At a later stage, after giving consideration to anti-abuse issues, the mechanism could be extended to cover cross-border situations.

Nirav Shah

Adoption of IFRS in India

Background :

Users of financial statements have always demanded transparency in financial reporting and disclosures. However, the willingness and need for better disclosure practices have intensified only in recent times. Globalisation has helped Indian companies raise funds from offshore capital markets. This has required Indian companies, desirous of raising funds, to follow the Generally Accepted Accounting Principles (GAAP) of the investing country. The different disclosure requirements for listing purposes have hindered the free flow of capital. This has also made comparison of financial statements across the globe impossible. A movement was initiated by an international body called International Organisation of Securities Commissions to harmonise diverse disclosure practices followed in different countries. This would ease free flow of capital and reduce costs of raising capital in foreign currencies.

IFRS v. U.S. GAAP :

The policy makers in India have also realised the need to follow IFRS and it is expected that a large number of Indian companies would be required to follow IFRS from 2011. This poses a great challenge to the preparers of financial statements and also to the auditors. There is an urgent need to understand the nuances in IFRS implementation. The biggest difference between U.S. GAAP and IFRS is that IFRS provides much less overall detail. Its guidance regarding revenue recognition, for example, is significantly less extensive than GAAP. IFRS also contains relatively little industry-specific instructions. Because of long-standing convergence projects between the IASB and the FASB, the extent of the specific differences between IFRS and GAAP has been shrinking. Yet significant differences do remain, any one of which can result in significantly different reported results, depending on a company’s industry and individual facts and circumstances.

Some of the examples are :

• IFRS does not permit Last-In, First-Out (LIFO).

• IFRS uses a single-step method for impairment write-downs rather than the two-step method used in U.S. GAAP, making write-downs more likely.

• IFRS has a different probability threshold and measurement objective for contingencies.

• IFRS does not permit debt for which a covenant violation has occurred to be classified as non-current unless a lender waiver is obtained before the balance sheet date.

IFRS compliance in India :

Applicability of IFRS in India :

The convergence note of ICAI states that IFRS is applicable from 2011. IFRS in India would cover the following public interest entities in its first wave.

• Listed companies

• Banks, insurance companies, mutual funds, and financial institutions

• Turnover in preceding year exceeding 100 crores

• Borrowing in preceding year exceeding 25 crores

• Holding or subsidiary of the above

First-time adoption of International Financial Reporting Standards :

Applicability to Financial Statements :

• IFRS-1 is applicable to the following financial statements :

1. First annual financial statement in which the entity adopts International Financial Reporting Standards, by an explicit and unreserved statement of compliance with International Financial Reporting Standards.

2. Each interim financial report that the entity presents as part of its first annual financial statement in which the entity adopts International Financial Reporting Standards by an explicit and unreserved statement of compliance with International Financial Reporting Standards.

Period :

• The first IFRS reporting period for entities in India having accounting period beginning on 1 April would be 1 April 2011 to 30 June 2011. For an entity whose accounting period begins on 1 January, the first IFRS reporting period would be 1 January 2012 to 31 March 2012.

Date of transition :

• As per Institute of Chartered Accountants of India’s announcement, an entity in India should have its financials as per IFRS on 1 April 2010 which is the date of transition to International Financial Reporting Standards for entities whose accounting periods begin on 1 April. The entity is required to prepare and present opening IFRS statement of financial position as at the date of transition to International Financial Reporting Standards.

• An entity that presented financial statements in the previous year containing an explicit and unreserved statement of compliance with IFRS would not be a first-time adopter of IFRS even though it contains a qualified audit report.

Accounting policies :

• The entity cannot change its accounting policy during the periods presented in its first IFRS financial statements. For an entity whose accounting period begins on 1 April, the periods presented would be 1 April 2010 to 31 March 2011 and 1 April 2011 to 31 March 2012. No voluntary change in accounting policies is permitted during the period 1 April 2010 to 31 March 2012.

• The entity should adopt accounting policies that are in compliance with each IFRS effective as at 30 June 2011, if the entity prepares and presents an interim financial report or 31 March 2012.

• The adjustments due to changes in accounting policies from previous GAAP to International Financial Reporting Standards at the date of transition to International Financial Reporting Standards should be adjusted directly in retained earnings or a specific reserve such as IFRS transition reserve.

De-recognising of some old assets and liabilities :

The entity should eliminate previous GAAP assets and liabilities from the opening balance sheet if they do not qualify for recognition under IFRSs. [IFRS 1-10(b)] For example :

IAS 38 does not permit recognition of expenditure on any of the following as an intangible asset: research, start-up, pre-operating, and pre-opening costs, training, advertising and promotion, moving and relocation if the entity’s previous GAAP had recognised these as assets; they are eliminated in the opening IFRS balance sheet.

If the entity’s previous GAAP had allowed accrual of liabilities for ‘general reserves’, restructurings, future operating losses, or major overhauls that do not meet the conditions for recognition as a provision under IAS 37, these are eliminated in the opening IFRS balance sheet.

If the entity’s previous GAAP had allowed recognition of reimbursements and contingent assets that are not virtually certain, these are eliminated in the opening IFRS balance sheet.

Recognition of some new assets and liabilities:

Conversely, the entity should recognise all assets and liabilities that are required to be recognised by IFRS even if they were never recognised under previous GAAP. [IFRS 1.10(a)] For example:

IAS 39 requires recognition of all derivative financial assets and liabilities, including embedded de-rivatives. These were not recognised under many local GAAPs.

IAS 19 requires an employer to recognise its liabilities under defined benefit plans. These are not just pension liabilities but also obligations for medical and life insurance, vacations, termination benefits, and deferred compensation. In the case of ‘over-funded’ plans, this would be a defined benefit asset.

IAS 37 requires recognition of provisions as liabilities. Examples could include an entity’s obligations for restructurings, onerous contracts, decommissioning, remediation, site restoration, warranties, guarantees, and litigation.

Deferred tax assets and liabilities would be recognised in conformity with IAS 12.

Reclassification:

The entity should reclassify previous GAAP opening balance sheet items into the appropriate IFRS classification. [IFRS 1.10(c)] Examples:

IAS 10 does not permit classifying dividends declared or proposed after the balance sheet date as a liability at the balance sheet date. In the opening IFRS balance sheet these would be reclassified as a component of retained earnings.

If the entity’s previous GAAP had allowed treasury stock (an entity’s own shares that it had purchased) to be reported as an asset, it would be reclassified as a component of equity under IFRS.

Items classified as identifiable intangible assets in a business combination accounted for under the previous GAAP may be required to be classified as goodwill under IFRS 3, because they do not meet the definition of an intangible asset under IAS 38. The converse may also be true in some cases. These items must be reclassified.

IAS 32 has principles for classifying items as financialliabilities or equity. Thus mandatory redeemable preferred shares that may have been classified as equity under previous GAAP would be reclassified as liabilities in the opening IFRS balance sheet.

Note that IFRS 1 makes an exception from the ‘split-accounting’ provisions of IAS 32. If the liability component of a compound financial instrument is no longer outstanding at the date of the opening IFRS balance sheet” the entity is not required to reclassify out of retained earnings and into other equity the original equity component of the compound instrument.

The reclassification principle would apply for the purpose of defining reportable segments under IFRS 8.

The scope of consolidation might change depending on the consistency of the previous GAAP requirements to those in IAS 27. In some cases, IFRS will require consolidated financial statements where they were not required before.

Some offsetting (netting) of assets and liabilities or of income and expense items that had been acceptable under previous GAAP may no longer be acceptable under IFRS.

Retrospective adjustments:

An entity need not make retrospective adjustments for complying with all IFRS from the inception/ origination of asset/liability. An entity may opt for the following exemptions:

1. Not applying IFRS 3 to business combinations that occurred before 1 April 2010

2. Taking fair value at the date of transition or re-valuation done before transition date as deemed cost for property, plant & equipment, intangible assets and investment property

3. Recognise all actuarial gains and losses that are unrecognised at 1 April 2010, even though the entity follows corridor approach for recognising actuarial gains and losses

4. Ignore unrecognised cumulative translation differences at the date of transition

5. Need not separate liability and equity component of a compound financial instrument where the liability component is not outstanding as at 1 April 2010

6. Take the values of assets and liabilities of the subsidiary stated in the parent’s consolidated financial statements after removing consolidation adjustments where the subsidiary adopts IFRS later than parent

7. Take the values of assets and liabilities of the subsidiary stated in its separate financial statements if the parent adopts IFRS later than the subsidiary

8. Designate a financial asset as available for sale or at fair value through profit or loss and a financialliability as at fair value through profit or loss at 1 April 2010

9. Not apply IFRS 2 to equity instruments that vested before 1 April 2010

10. Apply transitional provisions in IFRS 4 to insurance contracts at 1 April 2010

11. Not add to or deduct from the cost of the asset for changes in existing decommissioning, restoration and similar liabilities as specified in IFRIC 1 that occurred before 1 April 2010

12. Determine as at 1 April 2010 whether an arrangement contains a lease on the basis of the facts and circumstances existing on 1 April 2010

13. Take transaction value as fair value of financial assets and financial liabilities

14. Apply transitional provisions in IFRIC 12 to Service Concession Arrangements at 1 April 2010.

IFRS 1 prohibits retrospective application in the following cases:

1. Not apply de-recognition requirements of IAS 39 to transactions that resulted in de-recognition under previous GAAP and that occurred before 1 January 2004

2. Measure all derivatives at fair value at 1 April 2010

3. Designate derivative as hedge instruments from 1 April 2010.

4. Attribute to the owners of the parent and to the controlling interests even if this results in non-controlling interests having a deficit balance

5. Account for changes in parent’s controlling interest in a subsidiary that does not result in loss of control as equity transaction.

The adjustments to be made to the values of assets and liabilities at 1 April, 2010 reflect the changes in accounting policies. No adjustments are required for changes in estimates made under previous GAAP.

Set of financial statements:

An entity’s first IFRS financial statements should contain :

1. Three statements of financial position (i) As at 31 March 20P (ii) As at 31 March 2011 (iii) As at 1 April 2010

2. Two statements of comprehensive income (i) For the period ended on 31 March 2012 (ii) For the period ended on 31 March 2011

3. Two statements of cash flows (i) For the period ended on 31 March 2012 (ii) For the period ended on 31 March 2011

4. Two statements of changes in equity (i) For the period ended on 31 March 2012 (ii) For the period ended on 31 March 2011

Annual reconciliation:

IFRS 1 requires the following reconciliation in that entity’s financial statements for the period ended on 31 March 2012 :

1. Reconciliation of equity reported under Inter-national Financial Reporting Standards and previous GAAP for (a) 1 April 2010 (b) 31 March 2011.

2. Reconciliation of total comprehensive income under International Financial Reporting Standards with that reported under previous GAAP for the period 1 April 2010 to 31 March 2011.

3. Explanation of material adjustments in the statement of cash flows – IFRS 1 requires reconciliations in that entity’s interim financial reports presented during the period 1 April 2011 to 31 March 2012 between International Financial Reporting Standards and previous GAAP.

Quarterly Interim reconciliation:

The reconciliation required for a quarterly interim financial report as at 30 September 2011 is:

1. Reconciliation of equity as at 30 September 2011between that reported under International Financial Reporting Standards and that re-ported under previous GAAP.

2. Reconciliation of total comprehensive income for the period ended 30 September 2011 and 30 September 2010 between that reported under International Financial Reporting Standards and that reported under previous GAAP.

3. Reconciliation of total comprehensive income for the year to date period ended 30 September 2011 and 30 September 2010 between that reported under International Financial Reporting Standards and that reported under previous GAAP.

4. Explanation of material adjustments to statement of cash flows for the period ended 30 September 2011 and 30 September 2010 between that reported under International Finanial Reporting Standards and that reported – under previous GAAP.

5. Explanation of material adjustments to statement of cash flows for the year to date period ended 30 September 2011 and 30 September 2010.

Nirav Shah

GAPs in GAAP – Accounting for carbon credits

Accounting Standards

A number of Indian companies generate carbon credit under the
Clean Development Mechanisms (CDM). The amount involved is material enough to
the overall viability of a project.

Under IFRS, the International Accounting Standards Board (IASB)
had issued an interpretation IFRIC 3 Emission Rights, which was withdrawn
in June 2005. Thus, the IASB is still debating on an appropriate treatment for
CERs (Carbon Emission Reduction). Under IFRS most entities generating CERs
treat the same as government grant covered under IAS 20 Accounting
for Government Grants and Disclosure of Government Assistance. This is
because an international agency grants the same. Accordingly, based on IAS 20
requirements, a generating entity recognises CERs as asset once there is a
reasonable assurance that it will comply with conditions attached and CERs will
be received.

IAS 20 gives an option to measure such grant either at
fair value or nominal value. Most entities will measure the CERs at fair
value to ensure appropriate matching with the costs incurred. They will
recognise the same in the income statement in the same period as the related
cost which the grant is intended to compensate. The corresponding debit will
be to intangible assets in accordance with IAS 38 Intangible Assets.

No guidance is currently available under Indian GAAP;
consequently various practices exist (a) income from sale of CERs is recognised
upon execution of a firm sale contract for the eligible credits, since prior to
that there is no certainty of the amount to be realised (b) income from CERs is
recognised at estimated realisable value on their confirmation by the concerned
authorities (c) income from CER is recognised on an entitlement basis based on
reasonable certainty after making adjustments for expected deductions.

The Accounting Standards Board (ASB) of the Institute of
Chartered Accountants of India (ICAI) has issued an Exposure Draft (ED) of the
Guidance Note on Accounting for Self-generated Certified Emission Reductions.
The ED proposes to lay down the manner of applying accounting principles to CERs
generated by an entity.

As per the ED the generating entity should recognise CERs as
asset only after receipt of communication for credit from UNFCCC and provided it
is probable that future benefits associated with CERs will flow to the entity
and costs to generate CERs can be measured reliably. Further, such assets meet
the definition of the term ‘inventory’ given under AS-2 Valuation of
Inventories and hence are valued at lower of cost and net realisable value.
Only the costs incurred for the certification of CERs bring the CERs into
existence and, therefore, only those costs should be included in the cost of
inventory. All other costs are either not directly relevant in bringing the
inventory to its present location and condition or they are incurred before CERs
come into existence as per the prescribed criteria. Thus, those costs cannot be
inventorised.

The ED will result in significant cost and revenue
mismatch in the financial statements. This is because entities would need to
expense most of their costs as soon as incurred (with an insignificant amount
being capitalised as inventory), but will recognise revenue arising from CERs
only when these are actually sold. Clearly the accounting recommended by the
ICAI is very different from existing practices under Indian GAAP, and hence
every company that has significant revenue from carbon credits will have to
consider the impact of the ED very carefully.

The treatment prescribed in the ED appears to be inconsistent
with the existing Indian GAAP literature in more than one regard. The ED
requirement to recognise CERs as asset only when these are credited by UNFCCC in
a manner to be unconditionally available is contrary to the principles currently
followed for recognition of an asset. In most cases, recognition of an asset is
based on criteria of probability/reasonable assurance as against absolute
certainty prescribed in ED. For example, both under AS-9 Revenue Recognition
and AS-12 Accounting for Government Grants, recognition of income is
based on the criteria of reasonable assurance.

The ED is also inconsistent with an Expert Advisory
Committee’s (EAC) opinion on export incentives. As per the EAC opinion DEPB
credit should be recognised in the year in which the export was made, without
waiting for its actual credit in the subsequent year, provided there are no
insignificant uncertainties of ultimate collection. The EAC opinion is based on
the application of the existing accounting principles, including definition of
the term ‘asset’ given in the Framework, which is based on the
probability theory.

In the authors view, the ED should not have been issued since
it clearly conflicts with the existing requirement and practices under both
Indian GAAP and IFRS and is contrary to the definition of an asset in the
Framework. As India is adopting IFRS and the guidance in these areas is
being developed under IFRS, issuing India-specific guidance is duplicating the
effort and creating more differences in how the 2 GAAPs are applied, which will
have to be then taken care of in 2011, which is the transition date for adopting
IFRS.

levitra

Nirav Shah

GAPs in GAAP – Accounting for SMEs

Accounting Standards

The publication of a simplified form of IFRS for private
entities has been long awaited by national standard setters and small and
medium-sized entities, which have been required to apply full IFRS in the past.
The International Accounting Standards Board (IASB) has issued its International
Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs).

The standard consists of 230 pages of text, arranged into 35
chapters that cover all of the recognition, measurement, presentation and
disclosure requirements for SMEs. There is no cross reference to other IFRS
(with one exception relating to financial instruments discussed below). This
underscores the fact that IFRS for SMEs is viewed by the standard setter as
independent from the full IFRS.

The standard is intended for use by SMEs. SMEs are defined in
the standard as small and medium-sized entities that do not have public
accountability and which also publish general-purpose financial statements for
external users. An entity has public accountability if its debt or equity
instruments are traded in a public market, or it holds assets in a fiduciary
capacity for a broad group of outsiders.

While this definition is necessary for an understanding of
the entities to which IFRS for SMEs is applicable, the preface to the standard
indicates that the decision as to which entities are required or permitted to
apply the standard will lie with the regulatory and legislative authorities in
each jurisdiction. However, if a publicly accountable entity uses the standard,
it may not claim that the financial statements conform to IFRS for SMEs even if
its application is permitted or required in that jurisdiction, as the entity
would not meet the definition of an SME.

In India, various regulatory authorities such as the Ministry
of Corporate Affairs, RBI, IRDA, SEBI, etc will have to define the term SME.
Considering the manner in which the term SME is defined in the standard, these
would include entities other than listed companies, banks, financial
institutions, insurance companies, etc.

IFRS for SMEs is based on the fundamental principles of full
IFRS, but in many cases, it has been simplified to make the accounting
requirements less complex and to reduce the cost and effort required to produce
the financial statements. To achieve this, IASB has removed a number of
accounting options available under full IFRS and attempted to simplify
accounting for SMEs in certain areas.

For example in the case of share based payments, the fair
value of shares in equity-settled share-based payment transactions can be
measured using the directors’ best estimate of fair value if observable market
prices are not available. Another example of simplification is investment
property which can be accounted as fixed assets, if fair valuing them involves
undue cost or effort or does not provide a reliable measure.

The IFRS for SMEs includes a set of illustrative financial
statements and a presentation and disclosure checklist to assist entities with
preparing their financial statements. The application of this standard is
expected to reduce the compliance costs for many smaller entities and help make
the financial statements of such entities less complex.

As the standard is very much principles-based, interpretation
issues are likely to arise, which will require a globally consistent resolution.
In order to ensure this standard achieves international consistency and
comparability of financial reporting, it is important that interpretations are
not developed by each jurisdiction. It would appear logical that the
International Financial Reporting Interpretations Committee (IFRIC) could be
approached to provide any interpretative guidance that users may require.

In India, one major criticism against the full implementation
of IFRS was that they would impose an unnecessary burden and hardship on SMEs.
With the issuance of the SME standard, one of the major hurdles for the
implementation of IFRS in India has been removed. The ICAI and the Ministry of
Corporate Affairs (MCA) should now take appropriate and swift measures to
legalize the adoption of full IFRS by public interest entities and IFRS for SMEs
by SMEs from 2011. As a first step, the ICAI and other regulatory bodies should
define an SME. Also, it is desirable that all regulatory agencies define SME in
a consistent manner to the extent practicable.

levitra

Nirav Shah

Provident Fund contribution for International Workers

The Government of India has recently made fundamental changes in the Employees Provident Fund Scheme, 1952 and the Employees Pension Scheme, 1995 (collectively referred to as Indian Provident Fund schemes) which will impact the expatriates and the employers with whom they work in India.

Background :

Before we discuss the details, it is important to understand the context in which these changes have been introduced. Indian employees are often deputed by their employers to different countries. These international assignments could be for a few months to a few years. The Indian assignees and their employers are generally required to contribute to the Social Security schemes of the host country. These contributions only add to the cost of the assignment without any corresponding benefit, as neither the employee nor the employer is generally able to withdraw the contributions on completion of assignment. Further, the employee is also generally not entitled to any benefits under the scheme on return to India due to the period for which contributions were made to the overseas schemes, not meeting the minimum required as per the social security law of the host country. Correspondingly, the expatriates working in India are generally not required to contribute to the Indian Employee Provident Fund and the Pension Scheme as their salaries exceed the threshold limit of INR 6,500 (USD 145) per month.

These changes impact employers who have expatriates working for them in India, except for expatriates from the countries with which India has signed a Social Security Agreement (‘SSA’) and hence, these changes are likely to put pressure on other countries to sign SSAs with India.

On the other hand, Indian companies and their employees working in countries with which SSAs have been signed are likely to benefit, as employees’ and employer’s contributions would be required to be made only under the Indian Provident Fund scheme and not under the host country schemes. This will reduce assignment cost for the Indian entities and enable them to be more cost effective in the competitive global environment.

Recent amendments in Indian Provident Fund Schemes :

International Workers (covers expatriates) :

A new concept of ‘International Workers’ (‘IWs’) has been introduced which includes expatriates (foreign citizens) working for an employer in India and Indian employees working overseas.

As per the Notification dated 1 October 2008 ‘International Worker’ means :

“(a) an Indian employee having worked or going to work in a foreign country with which India has entered into social security agreement and being eligible to avail benefits under a social security programme of that country, by virtue of the eligibility gained or going to gain, under the said agreement;

(b) an employee other than an Indian employee, holding other than an Indian passport, working for an establishment in India to which the Act applies;”

The IWs are required to join the scheme from 1st November 2008. Relief has been provided in case of an ‘Excluded Employee’ which primarily refers to an IW coming from a country with which India has entered into an SSA.

In this article, we have discussed the implications only with respect to the second category of IWs i.e. foreign nationals working in India.

As per the Notification dated 1st October 2008 ‘Excluded Employee’ means

“an International Worker, who is contributing to a social security programme of his/her country of origin, either as a citizen or resident, with whom India has entered into social security agreement on reciprocity basis and enjoying the status of detached worker for the period and terms, as specified in such an agreement.”

Amount of contribution :

The IWs (other than excluded employees) are required to contribute 12% of their salary to the Indian Provident Fund scheme. Further, the employers are also required to match an equal amount i.e. 12% of salary as their contribution to the scheme.

Compliance requirements :

Every employer is required to file a return in the specified form, giving details of the IWs including their nationality, basic wage, etc. within 15 days of the commencement of the scheme (i.e. 15th October 2008). The employers are also required to file a ‘NIL’ return in case they do not have any IW working with them.

Employers are also required to file monthly returns (within 15 days of the close of the month) in the specified forms furnishing necessary details.

Social Security Agreements :

India had earlier signed an SSA with Belgium and France and has recently signed Social Insurance Agreement with Germany. It is understood that India is in the process of signing SSAs with the US, Australia, Netherlands, Czech Republic, Spain, Portugal, Switzerland, Norway, Sweden and other countries.

Key features of the SSAs :

Employees on an assignment upto specified periods (Belgium and France — 60 months; Germany — 48 months with an extension of 12 months) are exempt from making social security contributions in the host country provided they continue to make social security contributions in their home countries.

Employees on assignment for more than the specified period and making social security contributions under the host country laws will be entitled to export the benefits under the SSA to the home country on completion of their assignment or on retirement. However this is not provided under the Social Insurance Agreement with Germany.

The Additional Central Provident Fund Commissioner (‘ACPFC’) has also issued certain clarifications with respect to these amendments and the Ministry of Labour has posted responses to Frequently Asked Questions (‘FAQs’) on their website clarifying the position relating to the IWs.

Key clarifications as per the ACPFC letter :

Payment of benefits: The payment of benefits in case of an IW holding other than an Indian passport and coming from a country with which India has signed an SSA, shall be as per the provisions of the SSA.

Contributions required to be made in India: All expatriates, except expatriates from Belgium (as the SSA with Belgium is effective from 1st September 2009) but including expatriates coming from France and Germany and holding foreign passports are required to contribute to the Indian Provident Fund schemes as the SSAs with these countries are not yet effective.

Withdrawal of Pension benefits under Employee Pension Scheme: For the IW (holding other than an Indian passport) coming from a country with which India has no SSA, the withdrawal of benefit under Employee Pension Scheme shall be based on the principle of reciprocity.

Other key clarifications as per the FAQ:

An Indian employee shall be an employee, holding or entitled to hold an Indian passport and employed by a covered establishment.

The Provident Fund rules will apply irrespective of whether the salary is paid in India or outside India.

In case of a split payroll, the contribution is required to be made on the total salary earned by the employee.

Even where an IW has multiple country responsibilities and spends some part of his time out-side India, his total salary will be considered for Provident Fund contribution.

There is no minimum period of stay in India for triggering the Provident Fund compliances. Every eligible IW has to be enrolled from the first date of his employment in India.

The purpose of the visit would determine the Provident Fund compliance requirements for an individual. The type of visa may help in determining the purpose of visit to India e.g. a foreign national coming to India on an employment visa would be considered as working in India.

The cap on the salary for the purpose of Employee Pension Scheme and Employees Deposit Linked Insurance Scheme remains unchanged at Rs.6,500 as against no cap on salary for Provident Fund purposes.

Key issues:

Any change in legislation would generally lead to open issues which require further clarification. This notification leaves many questions in the minds of the employers and expatriates coming and working in India. Some of the issues which need to be addressed are:

Applicability to the establishment:

An issue that comes to mind is whether PF would be payable by a foreign employee of an employer, who is otherwise not liable to PF for any reason, e.g. if the number of employees are less than 20. In this regard, it is pertinent to note that applicability of the PF Act is qua the ‘establishment’, i.e. only if the establishment is covered under the scope, will the Act apply. Typically, factories and establishments employing 20 or more employees are covered (as per recent press reports, this threshold may be reduced to 10 employees to enhance the coverage of the PF Act). As such, PF would not be payable by a foreign employee of an employer, who is otherwise not liable to PF under the Act on account of any reason, e.g. if the number of employees is less than 20.

Employer-employee relationship:

In most cases, expatriates are seconded to the Indian entity while continuing as legal employees of the home country employer entity. For the PF Act to apply, an Employee of an Establishment should be deputed to work ‘in’ or ‘in connection with’ the work of such an Indian ‘Establishment’ to which the provisions of this Act applies. In such cases, it may need to be further examined whether an employer-employee relationship exists between the expatriate and the Indian establishment. There is no formula for determining the existence of a master-servant relationship and courts in India have laid down various tests such as accountability, right to recruit, right to decide leave, right to terminate, to ascertain whether an employer-employee relationship exists.

‘Salary’ to be considered:

Further, the quantum and manner of computing salary on which the contributions are to be based is also contentious. For example, in cross-border movement of employees, there could be different employment arrangements and services could be rendered in different jurisdictions, salary could be paid in different countries and also at times, by more than one employer. A question arises in all such arrangements on whether salary paid by the overseas entity would need to be taken into account for this purpose. If the IW is employed by the Indian establishment to which the PF Act applies and is rendering services in connection with the establishment in India, then a point that may need further examination is whether only the Indian salary which is covered by the Indian employment contract is to be considered. While, the FAQ has confirmed that total salary will have to be considered for PF, the legal position would need to be examined.

Contrary positions for income-tax purposes:

In certain cases, the Double Taxation Avoidance Agreements between countries provide exemptions to employees from double taxation of salary income in both countries, if the prescribed conditions are satisfied. Typically, these would be – duration of stay in India should be less than 183 days during the relevant period and the remuneration is paid by, or on behalf of, an employer who is not a resident of India i.e. implying that the overseas entity should be the employer.

Accordingly, in cases where the above-mentioned short-stay exemption is claimed, the overseas entity is considered as the employer for Income-tax purposes. As per the FAQ, PF would be payable by the Indian entity in its capacity of ’employer’ irrespective of the duration of stay in India. This would imply that the Indian entity is the employer for PF purposes. As a result, different positions would be adopted for the same individual under the Income-tax law and Provident Fund regulations and this may give rise to disputes and litigation.

Withdrawal of pension:

There are also issues around withdrawal of the balance at the end of the assignment. When an IW completes his assignment in India and leaves India to continue his employment abroad, he would be permitted to withdraw the accumulated PF balance.

However, the employer’s contribution to the Pension Scheme (i.e. 8.33 per cent of INR 6,500) can be withdrawn only subject to satisfying certain prescribed conditions such as:

Eligible service of 10 years or more and retirement on attaining the age of 58 years;

Early pension if rendered eligible service of 10 years or more and retirement or otherwise cessation of employment before attaining 58 years.

The withdrawal also depends on the principles of reciprocity with the home country of the IW where there is no SSA in place. Therefore, if the IW comes from the US, as an example, it would depend on whether the US would allow to freely repatriate such balance for Indians on completion of the assignments in the US.

Therefore practically, the withdrawal of the pension amount appears to be difficult.

Recovery by employer:

Another important point that arises is that, most expatriates are generally equalised on income tax and social security benefits, i.e. they would be guaranteed atleast the same net salary (after tax and social security deductions) while on assignment in India as they earned in their home country, prior to coming on assignment. On completion of the India assignment, the IW would receive the refund which consists of the employer and employee PF contributions and the interest thereon. As part of the equalization policy, the PF contributions may have been borne by the employer and hence, the expatriate may now be obligated to repay the employer this amount.

The PF Act protects the amount standing to the credit of any member in the Fund and states that this amount shall not be capable of being assigned or charged and shall not be liable to attachment under any decree or order of any Court for any debt or liability. Further, neither the official assignee appointed under the Presidency Towns Insolvency Act 1909 nor any receiver appointed under the Provincial Insolvency Act 1920 shall be entitled to or have any claim on any such amount even though the employer may have funded the employee’s PF contribution (in addition to the employer’s contributions). This poses problems of recoverability for the employer especially since the amount involved may .be significant considering it is nearly 24% of salary.

Tax impact:

As most assignments are typically for less than five years, the withdrawal of the PF amount before completion of the five years may give rise to additional income tax implications.

In conclusion:

The laws in this regard are still evolving and there are a lot of open questions which need to be answered. Realistically, the SSAs may take a long time before they are effective and until then the cost of the assignment of the expatriates in India, along with the compliance requirements is likely to increase.

Nirav Shah

TDS on exempt incomes (especially agricultural income)

It is obvious that the TDS provisions are going to be expanded day by day even in the direct Tax Code era. In the process to recover more and more tax through this mode of recovery, in many cases tax is also deducted from incomes which are expressly exempt. Many cases are wandering the corridors of various courts of law on this ground. This is also reflected in the decided cases. It seems that the issue gets complicated with the increase of TDS coverage. It will be interesting to go through the law and the judge-made law on the issue.

Questions to be answered :

To understand the intricacies of the issue we need to address the following questions :

(1) To what incomes/payments TDS provisions especially S. 194I is applicable ? The question assumes importance because the words in the Explanation to S. 194I are :

(i) ‘rent’ means any payment, by whatever name called, under any lease, sub-lease, tenancy or any other agreement or arrangement for the use of (either separately or together) any :

(a) land; or . . . .

This has created doubts about whether the land here includes agricultural land rent.

(2) What is the nature of the Rent income received from Agricultural land ?

(3) Whether the exempt income is covered under the TDS provisions ?

(4) Whether tax treatment in the hands of the payer is relevant ?

Analysis of the questions :

1. What is agricultural land ?

1.1 Agricultural land is not defined under the Income-tax Act. Hence we will have to rely on allied laws and interpretations by courts.

1.2 Under The Bombay Tenancy and Agricultural Lands Act 1960, (BTAL) in clause (a) of S. 2(8) ‘land’ means :

“(a) land which is used for agricultural purposes or which is so used but is left fallow, and includes the sites of farm buildings appurtenant to such land; . . . . .”

1.3 Under the Income-tax Act, 1961, various Courts have interpreted agricultural land.

The Delhi High Court said :

“In order to come within the category of agricultural land, it must not only be capable of being used for agricultural purposes but should have been actually used as such at some point of time. A temporary non-user for agricultural purposes will not affect the character of the land but a permanent abandonment of user for agricultural purposes will affect the character of the land as agricultural land.”

[Shri Shankar Lal v. CIT, (1974) 94 ITR 433, Delhi High Court.]

The Kerala High Court states :

    ” ‘Agricultural land’, as we understand it, is land on which a prudent owner will undertake any of the processes of farming in its widest sense. The fact that a particular area is being used for agriculture may indicate that the land is agricultural in character. But a current user is by no means conclusive.”

    [Venugopala Varma Rajah v. CED, (1967) 64 ITR 358 (Ker.)]

    2.0 What is the nature of the rent income received from agricultural land ?

2.1 The following discussion confirms that Rent received for renting out the agricultural land, and any such income derived from the said land is an agricultural income.

2.2 Agricultural income is defined under the Income-ax Act, 1961 in clauses (a), (b) and (c) of S. 2(1A).

Clause (a) of S. 2(1A) reads as :

“any rent or revenue derived from land which is situated in India and is used for agricultural purposes;”

2.3 It is obvious that the rent derived from agricultural land is an agricultural income as per S. 2(1A) of the Income-tax Act, 1961.

The Patna High Court has stated :

“Rent is obviously an agricultural income which the landlord makes by reason of his having a proprietary interest in the land which he lets out to the tenant and the tenant pays it as a part of the consideration for the use and occupation of the land which he enjoys. The source of the income is the landlord’s superior interest in the agricultural land and, consequently, it is an agricultural income.”

[Srimati Lakshmi Daiji v. CIT, (1944) 12 ITR 309 (PAT)]

2.4 This is also confirmed by various Courts including the Supreme Court :

(i) CIT v. Haroocharai Tea Co., (1978) 111 ITR 495 (Gau.)

(ii) CIT v. Janab Haji Muhammad Sadak Khoyee Sahib, (1935) 3 ITR 1 (Mad.)

(iii) CIT v. Raja Benoy Kumar Sahas Roy, (1957) 32 ITR 466 (SC)

3.0 To what payments TDS provisions, especially S. 194I, are applicable ?

3.1 TDS provisions are contained in Chapter XVII of the Income-tax Act, 1961 and cast a responsibility on the person responsible for payments. The incomes from which TDS is to be deducted and person responsible for paying are defined in S. 204 of the Act, which reads as follows :

“204. For the purposes of the foregoing provisions of this Chapter and S. 285, the expression ‘person responsible for paying’ means :

(i) in the case of payments of income chargeable under the head ‘Salaries’, other than payments by the Central Government or the Government of a State, the employer himself or, if the employer is a company, the company itself, including the principal officer thereof;

(ii) in the case of payments of income chargeable under the head ‘Interest on securities’, other than payments made by or on behalf of the Central Government or the Government of a State, the local authority, corporation or company, including the principal officer thereof;

(iia) in the case of any sum payable to a non-resident Indian, being any sum representing consideration for the transfer by him of any foreign exchange asset, which is not a short-term capital asset, the authorised dealer responsible for remitting such sum to the non-resident Indian or for crediting such sum to his Non-resident (External) Account maintained in accordance with the Foreign Exchange Regulation Act, 1973 (46 of 1973), and any rules made thereunder;

iii) in the case of credit, or as the case may be, payment of any other sum chargeable under the provisions of this Act, the payer himself, or if the payer is a company, the company itself including the principal officer thereof … “

3.2 It is obvious from the section itself that TDS is to be deducted from income chargeable under the Act. The portion in bold letters and underlined clearly shows this without any ambiguity.

3.3 The next question naturally comes is what is chargeable income under the Act.

3.4 Charge of income is stated in S. 4 of the Act and it states that tax shall be charged on the total income of the previous year of every person. Total income is defined in S. 2(45) and S. 5 of the Act. Hence income chargeable has to be decided as per S. 2(45) and S. 5 of the Act.

3.5 S. 2(45) defines ‘Total income’ and reads as under:

“total income means the total amount of income referred to in 5.5, computed in the manner laid down in this Act;”

S. 5 with the heading reads:

“Scope of total income.

5. (1) Subject to the provisions of this Act, the total income of any previous year of a person who is a resident includes all income from whatever source derived which ….. “

Bombay High Court has interpreted the highlighted words .’Subject to’ in S. 5 as follows:

“The expression ‘subject to’ used in the opening portion of both Ss.(I) and Ss.(2) of S. 5 has to be read keeping in mind that S. 5 is intended to explain the scope of total income. Therefore, what the use of the said expression shows is that in considering what is total income u/s.5, one has to exclude such income as is excluded from the scope of total income by reason of any other provision of the IT Act and not that the other provisions of the IT Act override the provisions of S. 5.

[CIT v. F. Y. Khambaty, (1986) 159 ITR 203 (Bom.)]

3.6 Hence, it is obvious that the TDS provisions are not independent of other provisions of the Act and whether the income is chargeable to tax under the Act or not has to be considered while deducting TDS.

4.0 Whether the exempt incomes, especially the Agricultural Rent income, is covered under the TDS provisions?

4.1 Rent of Agricultural land is an agricultural income as explained in Point Nos. 2.0 to 2.04 supra. Agricultural Income is exempt from income tax and is not to be included even in the total income.

4.2 Chapter In of the Act deals with incomes which do not form part of total income. Relevant S. 10(1) reads with its heading as:

“Incomes not included in total income.

10. In computing the total income of a previous year of any person, any income falling within any of the following clauses shall not be included

(1) agricultural income;”

4.3 It is obvious that in computing the total in-come under the Act, incomes which are exempt u/ s.10 have to be excluded. Consequently they have to be excluded while applying the TDS provisions also. Hence, TDS is not to be deducted on payment of incomes exempted and excluded from the scope of total income under the Act.

4.4 Agricultural Rent is an agricultural income and clearly excluded from the scope of total income u/s.10(1) of the Act.

4.5 Even the parliament has given powers to tax agricultural income to the States only and not to the Union (Central Government).

“Reading entry 82 of the Union List and entry 46 of State List of the Seventh Schedule of the Constitution, it is clear that the Parliament is not competent to tax agricultural income. The expression ‘agricultural income’ occurring in the said entries has to be understood in the manner and in the sense defined in clause (lA) of S. 2.”

[J. Raghottama Reddy v. ITO, (1987)35 Taxman 298 (AP).]

4.6 It is obvious that Rent of Agricultural land is completely out of the purview of not only TDS provisions but even income-tax.

4.7 In another case before the Andhra Pradesh High Court in Andhra Pradesh Forest Development Corporation Ltd. v. ACIT & Anr., (2005) 272 lTR 245 the question was whether items of sale viz. bamboo, eucalyptus and pepper are forest produce or non-forest produce and that the petitioner is under an obligation to collect tax at the time of effecting sales.

The Court held that in order to attract the provisions of S. 206C it has to be examined whether items sold are forest produce or not – Legislature intends to apply this provision in respect of timber and other produce obtained from forest and not any produce and that if the produce i.e. bamboo, eucalyptus and pepper are forest produce, then only the provisions of S. 206C would be applicable and not otherwise.

4.8 Considering other incomes, various courts have taken a clear view that incomes which are not includible in total income (exempt) are clearly out of the TDS net.

4.9 High Court of Rajasthan had an occasion to test applicability of TDS provisions to interest paid to a non-resident in CIT v. Manager, State Bank of India, 13 DTR (Raj.) 294.

In this case during a survey conducted on the assessee bank, it was found that TDS was not deducted on interest paid to NRIs on deposits in In-dian rupees.

The AO did not accept the contention of the bank and levied penalty and ClT confirmed the same. But the Tribunal set aside the ClT’s order. In appeal to the High Court, the revenue contended that interest paid on TDRISTDR doesn’t fall u/s.10(15)(iv) (fa) of the IT Act, hence deduction was not admissible, and learned Tribunal has committed error in accepting appeals on this ground whereas the assessee contended that as per provisions of S. 10(15)(iv)(fa), interest income was exempt from taxable income. The provisions of S. 10(15)(iv)(fa), as it then stood were:

“(fa) by a scheduled bank to a non-resident or to a person who is not ordinarily resident within the meaning of Ss.(6) of S. 6 on deposits in foreign currency where the acceptance of such deposits by the bank is approved by the RB!.”

Relying on the observations of the Apex Court in the case of Transmission Corporation of A.P. Ltd. & Anr. v. CIT, (1999) 239 ITR 587 (SC) which has held that tax is to be deducted at source only on the sum on which income tax is leviable, and which income could be assessed to tax under the Act, the High Court held that STDR – Interest on TDR/STDR paid to non-resident Indians being exempt u/ s. 10(15)(iv)(fa), there was no question of deduction of tax at source.

4.10 Before the Gauhati High Court in Sing Killing v. ITO & Ors., 255 ITR 444, the question was – when the transactions entered into by the petitioner in respect of the forest lease situated in Sixth Schedule area and income arising therefrom is exempt from payment of income-tax u/s.10(26) whether collection of income-tax at source under the provisions of S. 206C was applicable.

Petitioner, a member of Scheduled Tribe, was granted a lease of a forest area specified in Sixth Schedule area. The ITO also granted a certificate to the petitioner certifying that he is not liable to pay income-tax u/s.10(26).

The Court held that, Entitlement of the petitioner to the benefit of S. 10(26) in respect of transactions arising out of the lease is not in doubt, S. 206C was not therefore applicable. If the income itself is exempted, any deduction/collection, on account of income-tax, at source, would be beyond the powers conferred by the provisions of the Act.

4.11 In a case to decide disallowance u/sAO(a)(ia) in case of legal fees paid in UK in connection with legal proceedings in UK it was held that where the provisions of Article 15 of the DTAA, between India and UK were applicable, payment of fees for legal consultancy services to UK-based firm of solicitors was taxable in UK and was not exigible to tax in India. Therefore, the assessee (tax deductor) was under no obligation to deduct tax at source from the payment so made. IMP Power Ltd. v. ITO Mumbai E Bench, (2007) 107 TTJ 522.

4.12 In a case before Karnataka High Court in Hyderabad Industries Ltd. v. ITO & Anr., 188 ITR 749 the issue was whether S. 10(6A) has nothing to do with deduction of tax at source and it is attracted only for purposes of computing the total income of a foreign company. In other words, the contention was that, in case the foreign company has to face an assessment proceeding, then only S. 10(6A) will be attracted.

The Court held that, “the construction sought to be placed by the Revenue (to deduct tax) is based on a distinction, which has no substance in it. It is not understandable as to why, a benefit which will not be included in the total income of a person, should be considered as ‘income’ for the purpose of deduction of tax at source at all. Purpose of deduction of tax at source is not to collect a sum which is not a tax levied under the Act; it is to facilitate the collection of the tax lawfully leviable under the Act. The interpretation put on those provisions by the Revenue would result in collection of certain amounts by the State, which is not a tax qualitatively. Such an interpretation of the taxing statute is impermissible. Tax paid on behalf of foreign company, therefore, will not form part of its income.”

“S. 10(6A) nowhere confines its operation to an assessment proceedings; there is no exclusion of its operation from other proceedings under the Act. Language of S. 10 is quite simple and clear. It governs the computation of the total income of the person covered by it; a benefit, which is not includible in the total income of a person, necessarily implies that the said benefit is not the ‘income’ of the person.”

4.13 Transmission Corporation of A.P. Ltd. & Anr. v. CIT, (1999) 239 ITR 587 (SC).

In this case the Apex Court had to decide whether the TDS provisions are applicable to Gross Receipt vis-a-vis Income Receipt in case of payments made to non-residents.

The Court observed in Para 8 that, “the scheme of Ss.(l), Ss.(2) and Ss.(3) of S. 195 and S. 197 leaves no doubt that the expression ‘any other sum chargeable under the provisions of this Act’ would mean ‘sum’ on which income-tax is leviable. In other words, the said sum is chargeable to tax and could be assessed to tax under the Act.

Consideration would be – whether payment of a sum to non-resident is chargeable to tax under the provisions of the Act or not? That sum may be income or income hidden or otherwise embedded therein. If so, tax is required to be deducted on the said sum – what would be the income is to be computed on the basis of various provisions of the Act including provisions for computation of the business income, if the payment is trade receipt.

However, what is to be deducted is income-tax payable thereon at the rates in force. Under the Act, total income for the previous year would become chargeable to tax u/s.4. Ss.(2) of 5.4 inter alia, provides that in respect of income chargeable u/s.(1), income-tax shall be deducted at source where it is so deductible under any provision of the Act …. “

4.14 While deciding the applicability of the TDS provisions it is necessary to look into the fact whether the income is exempt from being included in the total income. There is a difference between income not chargeable to tax and not includible in the total income (agricultural income) and income which forms part of total income but which is made taxfree. The Apex ,Court observed in – CIT v. Williamson Financial Services & Ors., (2008) 297 ITR v. 17 (SC) that – Agricultural income not being chargeable to tax does not fall under various computation provisions ….. There is a vital difference between income not chargeable to tax and not includible in the total income (agricultural income) and income which forms part of total income but which is made tax-free ….

4.15 Further CBDT has issued Circular No. 736 dated 30-1-1996 to deal with incomes received by certain defense funds and clearly states that “….no tax may be deducted at source u/s.194-I, since the income of these organisations is exempt from tax u/s.10(23AA) ….”

Although it is for the purpose of defense funds the principle of exempt incomes is clearly borne out.

5.0 Whether tax treatment in the hands of the payer is relevant?

The last question is whether the tax treatment of the amount paid as agricultural rent or exempt income in the hands of the payer will have any effect on the TDS applicability.

TDS provisions nowhere mention anything about the tax treatment for payments made in the hands of the payer.

As explained hereinabove TDS provisions are not applicable to agricultural land rent or exempt incomes. Hence, this will not have any adverse effect in the hands of the payer i.e. lessee/company, as far as the TDS provisions are concerned. The questions u/s.40(a)(ia) have already been resolved by various Court decisions as discussed in the foregoing paras.

Considering all the relevant facts and the law as discussed hereinabove, and relying and based on the same as mentioned above, it is obvious that, TDS provisions are not applicable to Rent for Agricultural land and TDS cannot be deducted there-from or from incomes which are expressly exempt.

Nirav Shah

Disciplinary Mechanism of ICAI

1 Introduction

1.1 We are currently in the diamond jubilee year of our Republic as well as of our Institute. The motto of our nation is Satyameva Jayate (Truth alone triumphs). We can only dream of poetic justice of truth winning over untruth. In this Kaliyug, real life events often shatter this fond belief. The recent episode of ‘Satyam Computers’ has evoked a storm in our profession as well. The motto of our Institute of Chartered Accountants of India is ‘Ya esha Supteshu Jagarti’ (He who is awake when others are asleep.) This was actually spoken about the ‘Soul’ — the ‘Atman’ in the Upanishadas. It implies that our conscience should always be awake. Unfortunately, the overall scenario is such that not only others but our own professionals have started losing faith in the profession. The situation calls for a good degree of introspection and self-criticism.

1.2 In recent years, there was a spate of complaints against our professional brothers for alleged misconduct. I had occasion to handle quite a few such cases which gave me some insight in the field. It is not only torturous for the respondents whom I represented, but even more stressful to me. I have, therefore, taken it as a mission to spread awareness of this subject and caution our fellow-members, since prevention is always better than cure.

1.3 The topic is too vast. The experiences which I wish to share are often frightening and depressing. But unless all of us develop positive attitude, assertive approach and collective action, the future seems to be very gloomy. Not much can be expected from our leaders. It is the same state of affairs as in our Indian democracy. Our own indifference and inaction will put us into deeper trouble. Time has come to really wake up and get out of our slumber.

The purpose of this article is to make readers conscious of the grave reality. I have consciously avoided technicalities and focussed on practical aspects.

2 Some glaring statistics

2.1 When the Chartered Accountants’ Act was originally passed in the year 1949, the ‘Disciplinary Committee’ consisted of 5 persons. viz. President, Vice-President, two other elected members of Central Council and one Government Nominee. This Committee was supposed to hear the cases all over India. Today our membership is nearing 1,50,000 and till 2007, the same committee was discharging this function.

2.2 Times have changed. General tolerance level of people has gone down. People have not only become aware of nuisance value, but have started using it. In the first 30 to 40 years of our Institute’s existence, there might have been about 300 to 400 complaints; whereas now the rate is about 500 to 600 hundred per year.

2.3 Due to various scams, mass scale complaints are received by the Council or initiated suo moto based on ‘Information’. Such scams add 100 to 200 cases in one stroke.

2.4 A complaint can be filed within 10 years from the occurrence of the event complained against — Regulation 14 of the ICAI Regulations, 1988. Unfortunately, there is no time-limit prescribed for disposal. For example, even today, a few cases filed in the year 1996 in respect of accounts for the year 1987-88 might have remained undecided.

After the passage of CA Amendment Act, 2006, the new procedure seeks to cut short the time by introducing a procedure for summary disposal.

2.5 A survey carried out in the USA revealed that 95% of the complaints against professionals (doctors) are filed out of ego problems —mainly due to improper communication by the professionals.

3 Certain fundamental principles

3.1 A complaint once filed could not be withdrawn under the old system. Under the new system, it can be withdrawn subject to the permission of Director Discipline and Board of Discipline.

3.2 For holding a member guilty, the following points are considered absolutely inconsequential —

(a) Whether the complainant or anybody is aggrieved or not.

(b) Whether the complainant, although aggrieved, wants to pardon a respondent.

(c) Whether the complainant has approached the Council with clean hands or whether the complainant himself is a confirmed criminal or has committed contributory negligence.

(d) Whether the respondent has compensated the complainant for the loss that was incurred by him due to negligence of the respondent.

(e) Whether the complainant backs out and remains absent during the hearing.

3.3 Nevertheless, the basic duty of adducing evidence against the respondent does lie on the complainant. These are quasi-criminal proceedings and the Disciplinary Committee has the powers of the Civil Court.

3.4 The basic objective of the Council is to examine whether the respondent is fit to continue as a member. This is as per a Calcutta High Court decision. The Council does not have jurisdiction to examine the conduct of the complainant or a non-member. It is primarily concerned with safeguarding the credibility and image of the profession. A clear message should go to the public at large that an unscrupulous member is severely punished; and that the Code of Ethics is religiously and rigorously enforced.

3.5 A general feeling in the society is that complaints are not processed expeditiously. There are delays and members are treated leniently. The Society expects that the Code of Ethics should be strictly implemented.

4. Reasons for delays

4.1 Many a time, complaints are filed even after 6 to 7 years of the occurrence of alleged misconduct. The permissible time is 10 years as per Regulation 14.

4.2 Sometimes, the complaints remain unattended at the Council for a number of years — may be due to administrative pressures or due to sudden shifts in priorities.

4.3 After a complaint is received by the Council, it is forwarded to the respondent asking him to file an explanation (written statement). That written statement is forwarded to the complainant with a request to send a rejoinder. To that rejoinder again, the respondent is asked to give his comments. Thus, both the parties get two innings. This was under old regime.

In the amended system, the last limb (comments on the rejoinder by respondent) has been eliminated. This is in respect of complaints filed on or after 28th day of February 2007. However, the Disciplinary Directorate may seek further information from the concerned parties, if required.

4.4 After this preliminary data, the Director Discipline forms a prima jacie opinion as to whether the Respondent is ‘prima facie’ guilty. Under the old system, this decision rested with the Council of 30 members. One can imagine the delay inherent in the old system.

4.5 The instant reaction of any person on receiving a complaint against him is either total nervousness; or a serious anger against the complainant. Both these extremes result in loss of objectivity. The respondent on some pretext or the other seeks extension of time to write a reply.

4.6 Normally, a member tries to hide this from his friends and colleagues; and approaches some lawyer. Lawyers can seldom appreciate the substance of the complaint in the context of our profession. If it requires knowledge of accounting standards and audit technicalities, lawyers may have serious limitations. They usually write a legalistic reply which is often in the nature of counter-attack on the complainant. As stated earlier, the Council is not much concerned with the conduct of the complainant. Thus, the reply becomes either verbose or irrelevant, in the context of our Council’s perception. It is necessary to write a concise and objective reply, by briefly describing the background. In most of the cases, a member is made a scapegoat, as an arm-twisting pressure tactic, in the dispute of the complainant with some other party. (for interesting instances, see para 6)

When a person is found ‘prima facie’ guilty, the disciplinary proceedings are deemed to have commenced. The disqualification or ineligibilities for allotment of bank audits, C & AG Audits, etc. become applicable from this point of time. It should be noted that these ineligibilities are as per the norms of the appointing authorities and not of the ICAI.

4.8 Hearing of cases under the new system is just commencing. At present, the old cases are still pending. The Disciplinary Committee (DC) has its sittings for one or two days each at various important cities in the country. In Mumbai, for example, it might visit on 4 to 5 occasions in a year.

4.9 Duration of a hearing may range from half-an-hour to 8 to 10 hours. Once or twice, a case may be adjourned at the request of the parties. During the hearing, there are witnesses summoned, examined and cross-examined, evidences adduced, submissions made, and complainants as well as respondents are interrogated. Proceedings are tape-recorded and verbatim report (minutes) are made available to the parties. There is a high degree of transparency. Sometimes, submissions are so voluminous that they may run into a couple of thousand pages.

4.10 After the hearing is concluded, it takes normally not less than 10 to 12 months to receive a report. Basically, the DC members are themselves very busy professionals.

They are on tours off and on and have many other issues to deal with. Sitting in judgment against fellow-members is a very delicate task, far from pleasant. Ordinarily, out of five members, only three of them actually sit for hearing. Either the President or the Vice-President presides over the proceedings.

4.11 The report of the DC is basically in the nature of fact finding. It is not conclusive. Under the old system, the DC report is considered by the entire Council. Members of the DC who had sat for the actual hearing at DC cannot sit in the Council while their report is considered. So also, a few other members may be disqualified. In the Council again, both the parties are represented and heard.

Before the DC, a lawyer or any member of ICAI could represent; but before the Council, only a member can represent.

4.12 After the hearing, the Council takes the decision immediately, usually by a majority vote. The Council may take any of the following decisions :

a) Send back the matter to the DC for reconsideration.

b) In case of misconduct specified in schedule I, decide whether a member is guilty and if yes, to award punishment. Since, for Schedule I, the Council’s decision is as good as final, the Council gives one more hearing to the respondent before awarding punishment – Sec. 21(4) of CA Act, 1949.

c) In respect of offences in the second Schedule, the Council has only a power to recommend to the High Court – both the aspects – viz. Whether the Respondent is guilty and if yes, what is the punishment.

For First Schedule, in case the punishment recommended is suspension of membership for a period exceeding 5 years or for life, then also, the Council has to refer it to the High Court.

4.13 Readers may be aware that the High Court in turn may take a few more years. It is thus possible that the decision may become final (unless contested in the Supreme Court) after about 15 to 20 years from the occurrence of the alleged misconduct.

5 Types of punishment

Under the old system, there were only two types of punishment-

For First Schedule-

i) reprimand or

ii) suspension of membership for not exceeding five years.

For Second Schedule-

i) reprimand or

ii) suspension of membership for any length of time.

6 Interesting (and alarming) instances

6.1 As mentioned earlier, the chartered accountant has become a very soft target. The role of a CA, especially as an auditor, is very vulnerable. There is an increasing tendency to make him a victim of disputes between two parties. The CA is totally unconnected with the dispute.

6.2 I am not trying to say that the work of the CAs in these instances was flawless. There were lacunae; but by no stretch of imagination there was any serious lapse or negligence or mala fide intention or misbehaviour. It was sheer misfortune that brought them into trouble. One very important lesson one should learn is ‘not to do anything in good faith’.

6.3 So far, I have had occasion to handle quite a few cases. The following live instances can really be eye-openers-

6.3.1 For co-operative Societies, there is a system that after consecutive two years, the auditor should be changed. Audits are in individual name. There was a couple, both CAs. The wife did a particular audit for 2 years; followed by the husband doing it. Unfortunately, there was a legal separation proceeding between the two; and the wife lodged a complaint that the husband accepted the audit without communicating with the previous auditor.

6.3.2 A private limited company, only two shareholders – brothers; and both were directors. A reputed CA firm doing audit for more than 15 years. In one particular year, since the younger brother was busy in visa formalities since both were to travel together -auditor signed the accounts when only one – elder brother – who was MD with 60% holding – signed the accounts.

Income-tax return was filed thereafter, younger brother refused to sign and filed a complaint that the auditor signed without signature of two directors – Sec. 215 of the Companies Act.

At this juncture, let me point out that in terms of Sec. 215, it is not enough that two directors have signed. What is more important is the approval of accounts in a Board Meeting. This aspect is often overlooked. I would advise that the auditor should retain at least one copy of accounts signed by not only two, but all directors or partners as the case may be.

Interestingly, the reason behind this complaint was that the auditor had declined the complainant’s personal request to accommodate his daughter as a ‘dummy article’.

6.3.3 Mr. A – held Certificate of Practice. – but never pursued it. He was always into a business with Mr. B – Both promoters and co-directors. B’s son completed articleship under A. Unfortunately, there was a dispute between A and B. B’s son files a complaint that A was engaged in a business without obtaining the Council’s permission.

6.3.4 Situation is all the more vulnerable in co-operative housing societies. Invariably, there are internal quarrels. A co-operative housing society received a large sum on sale of FSI five years ago. There was no issue with the Income Tax. Due to the disputes among members and also the managing committee, one member files a case that as an honest citizen, he will approach the LT. authorities to issue notice u/s 148, make the society pay the tax and recover from auditor since he did not give proper advice! The purpose was to exert pressure on the other party by threatening the auditor.

6.3.5 A fraudulent lady entered into an ‘arrangement’ with the proprietor of 100% export business. The auditor who was basically a tax practitioner, used to do the audit basically for Sec. 44AB and 80HHC of the Income Tax Act. There was total exemption under Income Tax as well as Sales Tax. The lady in collusion with the businessman and CMD of a nationalised bank, fraudulently got a huge loan disbursed. She herself took away the money. All the three (the lady, the businessman and CMD of bank) were chargesheeted by CBI. And the lady files a complaint that she was misguided bv the audited figures. It could be r roved beyond doubt that the auditor and the accounts had no role to play in the entire deed.

Nevertheless, certain shortcomings which are inherent in any accounts were exposed and the otherwise innocent chartered accountant had to face disciplinary proceedings.

6.3.6 One proprietor CA signed the tax audit report of a medium-scale CA firm – all the partners of which were his close friends. The total collection of the firm about 10 years ago was nearing Rs. two crores.

Unfortunately, in the scrutiny assessment of the firm, it was found that on one particular day, there was a negative cash balance of a few hundred rupees. The Assessing Officer intimated this to the ICAI as a misconduct.

I repeat that in none of the cases one could say that there was no mistake at all. However, the courts have held that the charge in terms of Clause (7) of Part I of Second Schedule is that of ‘gross negligence’ and not of ‘inefficiency’. Every mistake is not a gross negligence. I am sure, these stories are representative of the present scenario.

Our fellow members will be well-advised to proceed with utmost care and caution.

What is essential is a positive perception and conviction that the Code of Ethics is for our protection. It is not a burden, but a shield.

I wish all the readers a trouble-free practice and good luck.

6.3.7 In a deal of immovable properties between Mr. A & Mr. B, Mr. C – a CA was representing Mr. B. In the course of documentation, there were certain differences. C’s presence was felt inconvenient by A and his lawyer. Hence, a complaint was filed against C that he was rendering services of ‘legal drafting’ which is not permissible for a CA.

Under the amended law, there are three types of punishments prescribed.

For First Schedule

i) reprimand

ii) suspension of membership for not exceeding 3 months; or

iii) fine not exceeding Rs. one lakh.

For Second Schedule

i) reprimand

ii) suspension of membership for any length of time.

iii) fine not exceeding Rs. five lakhs.

Further, under the new system, the Council’s function is now entrusted to an Appellate Tribunal of five constituents.

Note: After the amendment in the year 2006, the procedure has undergone a radical change. The same will be dealt with in a separate article. At present, a number of old cases are still pending and readers need to know the real position in its perspective.

Nirav Shah

Step-down Indian subsidiaries of multinational corporations — are these public companies ?

Article

1. Multinational corporations have been carrying on business
in India through private limited companies (‘Indian Companies’) set up by them
under the Companies Act, 1956 (‘the Act’). Often, such private limited companies
are not subsidiaries of the principal holding company (which has public
shareholding), but are step-down subsidiaries of subsidiary companies of such
principal holding companies. Also, the subsidiaries which hold the shares of the
Indian Companies are themselves private companies under the laws of the relevant
jurisdictions in which they are incorporated. In such cases, a question often
arises as to whether such Indian Companies, being step-down subsidiaries of
public companies outside India, are deemed to be public companies within the
meaning of Ss.(7) of S. 4 of the Act. This aspect gains significance where the
Indian Company desires to issue different classes of shares. While the issue of
shares with differential rights can easily be provided for in the Articles of
Association of private limited companies, the Act prescribes a number of
restrictions in relation thereto in case of public companies. In the above
circumstances, this article discusses the provisions of S. 4 of the Act as
applicable to Indian Companies which are subsidiaries of foreign companies.

2. S. 4 of the Act explains in detail the meaning of the
terms ‘holding company’ and ‘subsidiary company’ used in the Act. Ss.(1) of S.
4, inter alia, provides that a company is a subsidiary of another if such
other company (a) controls the composition of its Board of Directors; or (b)
holds more than half of the nominal value of its equity shares; or (c) if it is
a subsidiary of any company which is the sub-sidiary of the other company (i.e.,
a step-down subsidiary). Ss.(5) of S. 4 of the Act, inter alia, provides
that for the purpose of S. 4 of the Act, the expression ‘company’ includes any
body corporate, thereby implying that even companies incorporated outside India
would be regarded as holding and subsidiary companies of Indian companies, and
that the relationship would not be restricted to companies incorporated under
the provisions of the Act. Ss.(6) of S. 4 recognises that since a relationship
of a holding and a subsidiary company would exist between a foreign company (i.e.,
a company incorporated under the laws of a foreign country) and an Indian
company, the laws under which a foreign company has been incorporated would also
have to be considered for the purpose of determining the relationship of a
holding company and a subsidiary company. Ss.(7) of S. 4 of the Act provides
that a private company which is a subsidiary of a body corporate incorporated
outside India (which body corporate would be regarded as a public company if
incorporated in India) would be deemed for the purposes of the Act to be a
subsidiary of a public company if the entire share capital of that private
company (incorporated in India) is not held by that body corporate
whether alone or together with one or more bodies corporate incorporated outside
India.

3. Therefore, by virtue of the provisions of Ss.(1) of S. 4
of the Act, the Indian Company would be regarded as a subsidiary of not only its
immediate holding company but also a (step-down) subsidiary of the principal
holding company (which has public shareholding). As stated above, Ss.(5)
clarifies that the term ‘company’ used in S. 4 would refer to not only a company
incorporated under the Act, but also to any body corporate incorporated outside
India and therefore for the purposes of the Act, the principal holding company
(which has public shareholding) would be a holding company of the Indian
Company. With the aforesaid background, we now discuss the manner in which the
provisions of Ss.(7) of S. 4 of the Act would apply to such Indian Company.

4.1 Ss.(7) of the said S. 4 is divided into two parts. The
first part states that a private company incorporated in India would be
deemed to be a public company if it is the subsidiary of a public company
incorporated outside India. The second part of the said Ss.(7) exempts
from the provisions of this sub-section those private companies whose entire
share capital is held by a public company outside India whether alone or
together with other bodies corporate incorporated outside India.

4.2 The first part of the said Ss.(7) of S. 4 is very
wide and refers to any and every holding company of an Indian company and
therefore on a plain reading thereof, all step-up holding companies of the
Indian Company would be governed by the provisions of the first part of Ss.(7).
As a consequence thereof, even if a step-up holding company abroad is a public
company, the Indian step-down subsidiary would in terms of the said Ss.(7) be
regarded as a public company, unless exempted in terms of the second part
thereof.

4.3 The second part of Ss.(7) on the other hand is
restricted in its scope. The said second part refers only to that particular
body corporate incorporated outside India (being the holding company), which (i)
is the public company, and (ii) which holds shares of the Indian company
and does not refer to any other step-up holding company. As a consequence
thereof, the second part refers only to the immediate holding company of the
Indian subsidiary.

4.4 It is imperative that the two parts of Ss.(7) of S. 4
must be read harmoniously as a whole and not disjoint from one another. In order
to give such a harmonious interpretation it is imperative that the restricted
meaning given to the term ‘body corporate’ in the second part of Ss.(7) should
necessarily be read into the first part thereof. Therefore, for the purposes of
Ss.(7), the term ‘body corporate’ in both parts should be read to mean only that
body corporate, which directly holds shares in the private limited company
incorporated in India.

4.5 Therefore, briefly stated, for the purposes of Ss.(7) of
S. 4 of the Act, it is only the status of that company which holds shares of the
Indian subsidiary company, which is to be considered for determining as to
whether the Indian subsidiary is a subsidiary of a foreign public company.

4.6 Support in favour of the aforesaid argument is taken form the following paragraphs contained on pages 450 and 451 of “Principles of Statutory Interpretation” by Guru Prasanna Singh, Tenth Edition 2006 :

“The rule of construction noscitur a sociis as explained by Lord Macmillan means: “The meaning of a word is to be judged by the company it keeps”. As stated by the Privy Council: “It is a legitimate rule of construction to construe words in an Act of Parliament with reference to words found in immediate connection with them”. It is a rule wider than the rule of ejusdem generis; rather the latter rule is only an application of the former. The rule has been lucidly explained by Gajendragadkar, J. in the following words: “This rule, according to Maxwell, means that when two or more words which are susceptible of analogous meaning are coupled together, they are understood to be used in their cognate sense. They take as it were their colour from each other, that is, the more general is restricted to a sense analogous ) to a less general. The same rule is thus interpreted in Words and Phrases. Associated words take their meaning from one another under the doctrine of noscitur a sociis, the philosophy of which is that the meaning of the doubtful word may be ascertained by reference to the meaning of words associated with it;
……………
……………
……………

In S. 232 of the Indian Companies Act, 1913, which enacted that “where any company is being wound up by or subject to the supervision of the Court, any attachment, distress or execution put into force without leave of the court against the estate or effects or any sale held without leave of the court of any of the properties of the com-pany after the commencement of the winding up shall be void, the words ‘any sale held without leave of the court’ were construed in the light of the associated words, ‘any attachment, distress, or execution put into force’ and thereby restricted to a sale held through the intervention of the court thus excluding sale effected by a secured creditor outside the winding up and without intervention of the court.” (See M. K. Ranganathan v. Government of Madras, AIR 1955 SC 1323.)

4.7 Therefore, the provisions of Ss.(7) of S. 4 of the Act must be read as a whole and the second part of Ss.(7) which is more specific should necessarily be read into the first part thereof, which is general in nature.

5.1 We now consider the implications of giving a wider interpretation to the term ‘body corporate’ in the first part of Ss.(7) of S. 4 of the Act, so as to include within its ambit all step-up holding companies, while restricting the exemption in the second part to select Indian companies whose shares are held by bodies corporate abroad. Such an interpretation would lead to some anomalies which can be explained by the following example:

If A were a public limited company incorporated outside India and B a private limited company incorporated in India of which the entire share capital was held by A, then by virtue of the provisions of the second part of Ss.(7), B would not be deemed under the said Ss.(7) to be a subsidiary of a public company. However, if B in turn were to have a wholly-owned subsidiary say C, then strictly speaking, while C would be a step-down subsidiary of A (being the public company incorporated outside India), the shares of C would not be held by A. Therefore, C would not enjoy the exemption given under Ss.(7) of S. 4 of the Act. This would lead to an absurd interpretation whereby B,being the wholly-owned subsidiary of A, would not be deemed to be a public company, but C being a wholly-owned subsidiary of Band the step-down subsidiary of A would be deemed to be a public company under Ss.(7) of 5.4 of the Act.

5.2 Therefore, the provisions of Ss.(7) of 5.4 of the Act should be interpreted harmoniously to prevent such an anomalous construction thereof. Ss.(7) of S. 4 must necessarily be construed as applying only to those private limited companies whose shares are directly held by public limited companies incorporated abroad. It is evident that the provisions of Ss.(7) of S. 4 would not and cannot apply to step-up holding companies or step-down subsidiary companies, as it would otherwise create an anomalous situation which does not appear to be intended by the provisions of the Act.

6. It is interesting to note that the provisions of Ss.(7) of S. 4 of the Act seem to have been done away with under the Companies Bill, 2008 (‘the Bill’), presently pending sanction of the Parliament. The implication of omission of the present Ss.(7) of S. 4 of the Act, in the Bill, would prima facie appear to be that the exemption available to Indian subsidiaries of foreign public companies has been withdrawn and that such subsidiary companies would also be regarded as public companies under the Act. However, the actual implication is exactly the opposite, since the other provisions of S. 4 have also been omitted in the Bill.

7. To recapitulate, for the purposes of 5.4 of the Act, the term ‘company’ includes a ‘body corporate’ and therefore Indian subsidiaries of foreign holding companies are also regarded as subsidiary companies under the Act. Such subsidiaries are regarded as ‘public companies’ under the Act if the conditions specified in Ss.(7) of S. 4 of the Act are satisfied. However, under the Bill, the terms ‘holding company’ and ‘subsidiary company’ have both been defined as follows so as to bring within their scope only ‘companies’ i.e., companies incorporated under Indian laws:

‘holding company’, “in relation to one or more other companies, means a company of which such companies are subsidiary companies”

‘subsidiary company’ or ‘subsidiary’ in relation to any other company (hereinafter referred to as the holding company), means a company in which the holding company:

i) controls the composition of the Board of Directors; or
ii) exercises or controls more than one-half of the total voting power.

Explanation: For the purposes of this clause, a company shall be deemed to be a subsidiary company of the holding company even if the control referred to in sub-clause (i) or sub-clause is of another subsidiary company of the holding company.”

8. Under the Bill, an Indian subsidiary company, being a wholly-owned subsidiary of a company registered outside India, would not be regarded as a ‘subsidiary company’ of such foreign company. The relationship of the Indian subsidiary company with the foreign holding company not being recognised under the Bill, there can be no question of the Indian company being regarded as a public company or otherwise, under the Bill merely by virtue of it being a subsidiary of a foreign public company.

9. In effect, if the Bill is passed, while Indian subsidiaries of Indian public companies would be regarded as public companies, Indian subsidiaries of foreign public companies would continue to be regarded as private companies, if so incorporated, though such an effect may never have been intended. In light of the aforesaid, provisions such as those contained in S. 4 of the Act should be incorporated in the Bill.

Nirav Shah

Accounting for financial instruments and derivatives – Part 2

Article

In Part One, we
discussed accounting principles of recognition and measurement of two categories
of Financial Assets, viz. Financial Assets held at fair value through profit and
loss and Loans & Receivables. We now discuss the other two categories of
Financial Assets, viz. Held to Maturity and Available for Sale. Thereafter, this
Article covers accounting of Financial Liabilities.

Financial assets
— Held to maturity :

Held to
maturity financial assets are non-derivatives with fixed or determinable
payments and fixed maturity that an entity has a positive intention and ability
to hold to maturity. These assets are initially recognised at fair value plus
transaction costs directly attributable to the transaction. They are
subsequently measured at amortised cost using the effective interest method and
are tested for impairment. The methodology of the computation of effective
interest method was discussed in Part One of this series of Articles.

The amount of
loss on impairment is measured as the difference between the carrying value and
the present value of expected future cash flows discounted at the effective
interest rate computed at the point of initial recognition. Such impairment can
be reversed in subsequent periods if it can be established that the event
leading to such reversal occurred after the date of recognition of the
impairment.

Merely because an
entity intends to hold the asset for an indefinite period, the asset cannot be
categorised as held to maturity. If the entity intends to sell the financial
asset as a result of changes in interest rates, risks, yields, liquidity needs,
foreign currency rates, then it cannot categorise the instrument as held to
maturity. If the issuer of the instrument has a right to settle the instrument
at a value significantly lower than its amortised cost, such an instrument
cannot be categorised as held to maturity.

An equity
instrument and perpetual debt instruments cannot be categorised as held to
maturity, as they do not have a fixed or determinable redemption date. Floating
interest rate instruments are not precluded from this classification so long as
they are not perpetual debt instruments. A default risk does not by itself
preclude this categorisation. If the instrument is callable by the issuer, the
instrument can be classified as held to maturity if at this point, the holder
can recover all or substantially all of the carrying value. If the callable
price is such that the holder cannot recover a substantial portion of the
carrying value, then such an instrument cannot be classified as held to
maturity. A puttable financial asset cannot be classified as held to maturity,
because a put feature is not consistent with intention to hold to maturity.

If the entity
transfers a held-to-maturity financial asset before maturity, the consequences
could be significantly adverse. The entity is required to reclassify its entire
held-to-maturity basket out of this basket immediately. Further, the entity is
not allowed to categorise any new financial asset as held to maturity in this
financial year and in the succeeding two financial years. Exceptions to this
treatment are few and include the following :

Sale of the
financial asset as a result of significant decline in creditworthiness of the
issuer
Changes in tax
laws that may eliminate or reduce tax exempt status of such assets
Major business
combination or disposition that necessitates transfer of such assets to
maintain the entity’s risk management or interest rate policies
Changes in
statutory or regulatory requirements including changes in risk weightages of
such financial assets.

The entity’s
intention and ability to hold such financial assets to maturity are required to
be re-evaluated at each reporting date.

Available for
sale :

These are
non-derivative financial assets that are either designated as available for sale
or are not designated as any of the other three categories, viz. held at
fair value through profit and loss, loans & receivables or held to maturity.
They are measured at fair value plus transaction costs directly attributable to
the transaction on initial recognition. They are subsequently measured at fair
value without any adjustment for potential transaction costs on disposal.

However, if this
category includes any equity investments that do not have a quoted market price
in an active market and whose fair value cannot be reliably measured, then these
are measured at cost. This category of financial assets is subject to impairment
tests.

Gains and losses
on revaluation of available-for-sale financial assets are recognised in an
equity reserve account. These gains or losses are accumulated from period to
period in this account and recycled into the Profit and Loss Account on sale or
transfer of the financial asset. Dividends are recognised in the Profit and Loss
Account when the right to receive dividends is established. Interest income or
expense is recognised in the Profit and Loss Account based on effective interest
rate methodology. Impairment losses and foreign exchange gains or losses are
also recognised in the Profit and Loss Account.

Example :

Your entity
bought a G Sec for Rs.98 (Face value Rs.100, Tenor 7 years, Coupon 8% payable
annually in arrears). Let us assume for simplicity that this G Sec was bought on
day one of the accounting year. At the end of one year, the market price of this
G Sec is Rs.97.51. Your entity has categorised this G Sec as an
‘available-for-sale’ financial asset.

Let us examine
how this G Sec will be reflected in the financial statements.

The effective interest rate of the G Sec works out to 7.376%. The amortisation table for the G Sec is presented here:

The Profit and Loss Account of year one recognises an interest income of Rs.7.2285 as computed above. The difference between the carrying value as computed above (Rs.98.2285) and the market price (Rs.97.5100) is a loss of Rs.0.7185, which will be charged to reserves. The carrying value in the Balance Sheet will be Rs.97.51, which is arrived at after giving effect to interest income and mark to market impact.

Financial liabilities at fair value through profit and loss:

This category would comprise of :

Financial liabilities held for trading

Portfolio of financial instruments that are managed together for which there is evidence of short-term profit taking

Derivatives

Instruments which upon initial recognition are designated by the management into this category (this is permitted subject to various precedent conditions).

One may wonder what kind of financial liabilities could be held for trading. A common example is short seiling of equity shares. The entity selling short would borrow securities from the market. The entity is now obliged to return back securities to the lender. The value of such securities would appear as financial liabilities in its Balance Sheet and would fluctuate with the price of the security.

On initial recognition, these financial liabilities are recognised at fair value. Transaction costs are charged to Profit and Loss Account. Subsequently, they continue to be carried in the Balance Sheet at fair value and gains/losses in fair value are recognised in the Profit and Loss Account. These liabilities are not tested for impairment.

Other financial liabilities:

Financial liabilities other than those carried at fair value through profit and loss are categorised as ‘other financial liabilities’. They are initially recognised in the Balance Sheet at fair value minus transaction costs directly attributable to the transaction. They are subsequently carried at amortised cost in the Balance Sheet. Interest expense computed on effective interest rate method is recognised in the Profit and Loss Account.

When held to maturity securities are reclassified into Available-for-Sale category, the difference between the carrying amount (which would typically be computed on amortised cost) and the revised carrying amount (which would typically be fair value) would berecognised in reserves. As discussed earlier, if a significant quantum of held-to-maturity assets are sold or transferred or reclassified, the entire portfolio of such assets gets ‘tainted’ and is required to be reclassified into Available for Sale. The entity is not permitted to then classify any financial asset into held to maturity basket for that financial year and the succeeding two financial years.

Where a financial asset is classified into the held to maturity category, the carrying amount on the day of reclassification is recognised as its amortised cost. In case of a financial asset with fixed maturity any amount that has been previously recognised in reserves is required to be amortised over the balance time to maturity using effective interest rate method. If the asset does not have a fixed maturity, the amount previously recognised in reserves will remain in reserves till disposal of the asset.’

De-recognition of financial assets:

The entity is required to de-recognise a financial asset when the contractual rights to the cash flows from the financial asset expire. In the world of securitisation, transfers of financial assets involve complex conditionalities and the standard deals with such complexities in an elaborate manner. These are not discussed in this Article.

On de-recognition of an asset, the difference between its carrying amount and the sum of (a) the consideration received and (b) the amount recognised in a reserve account till date should be recognised in the Profit and Loss Account.

Example:

Your entity bought an equity share of L&T for Rs.3,200. This was revalued at the last quarter end at Rs.l,OOO.The investment revaluation reserve carries a debit balance of Rs.2,200 being the cumulative impact of revaluations from the date of purchase to the last quarter end. The entity now sells this share for Rs. 1,025 (ignoring transaction costs).

The profit and loss account will recognise a loss of Rs.2,175. This comprises a gain of Rs.25 (difference between carrying amount of Rs. 1000 and consideration of Rs.l,025) and the cumulative previously recognised losses of Rs.2,200 in reserves, which are now recycled into the Profit and Loss Account.

There appears to be no bar on such an investment revaluation reserve carrying a debit balance as per paragraph 61(b) of AS-30.

De-recognition of financial liabilities:

Financial liabilities’ are de-recognised when the liability is extinguished, that is when the obligation in the contract is discharged or cancelled or expires. An exchange between a borrower and a lender of financial instruments substantially different from existing instruments should be treated as an extinguishment of the earlier liability and a new liability should be recognised.

The difference between the carrying amount and the consideration paid, including any non-cash assets transferred or liabilities assumed, should be recognised in the Profit and Loss Account.

Nirav Shah

Are MAT companies liable to advance tax ?

Article

Currently companies are required to pay MAT tax if the tax
payable under normal provisions of the Act is lower than 10% (15% w.e.f. A.Y.
2010-11) of the book profit as defined u/s.115JB of the Act. An issue which
arises is whether an assessee liable to MAT should pay interest u/s.234B and
u/s.234C for shortfall in payment of advance tax.

Bombay High Court in Snowcem India Ltd. :

Recently the Bombay High Court in the case of Snowcem India
Ltd. (313 ITR 170) had an opportunity to consider this issue in the context of
S. 115JA of the Act. The Court held that S. 115JA is same or similar to S. 115J
of the Act. It further held that since the Karnataka High Court’s decision in
Kwality Biscuits Ltd. was affirmed by the Supreme Court by dismissing the
appeals, it was binding on them. Accordingly, the Bombay High Court allowed the
appeal in favour of the assessee.

It may be noted that the Bombay High Court in Snowcem has
held that the terminology in S. 115JA is the same or similar as that contained
in S. 115J. Attention is invited to the fact that the wordings in S. 115JA(4)
and S. 115JB(5) which provide that ‘save as otherwise provided in this Section
all other provisions of this Act would be applicable’ were not present in the
earlier S. 115J of the Act. Also the Finance Act in the years when S. 115J was
applicable did not provide for payment of advance tax on income chargeable
u/s.115J of the Act as is currently provided. This distinction is explained as
follows :

Section	115J	115JA	115JB
Assessment year onwards	1988-89 to 1990-91	1997-98 to 2000-01	2001-02
All other provisions applicable	—	115JA(4)	115JB(5)
Advance tax payable as per Finance Act	—	—	S. 2(8)

It appears that the provisions of S. 115JA(4) were not
considered by the High Court leading to the conclusion that the terminology is
the same.

Karnataka High Court in Kwality Biscuits Ltd. :

This issue was earlier addressed by the Karnataka High Court
in the case of Kwality Biscuits Ltd., 243 ITR 519 in the context of S. 115J of
the Act. The Karnataka High Court considering the contention of the assessee
held that for the purpose of assessing tax u/s.115J, firstly, the profit as
computed under the Income-tax Act has to be prepared, thereafter the book profit
as contemplated by the provisions of S. 115J are to be determined and then the
tax is to be levied. The liability of the assessee for payment of tax u/s.115J
arises if the total income as computed under the provisions of the Act is less
than 30% of its book profits. The Court then observed that since the entire
exercise of computing the income or that of book profit could be only at the end
of the financial year, the provisions of S. 207, S. 208, S. 209 or S. 210 cannot
be made applicable, until and unless the accounts are audited and the balance
sheet is prepared as even the assessee may not know whether the provision of S.
115J would be applicable or not. Accordingly, the Court held that interest could
not be charged u/s.234B and u/s.234C of the Income-tax Act. The judgment of the
Karnataka High Court was contested by way of SLP to Supreme Court which passed
an order dismissing the appeals (284 ITR 434).

Bombay High Court in Kotak Mahindra Finance Ltd. :

It may be mentioned here that the Bombay High Court in Kotak Mahindra Finance Ltd. (265 ITR 119) had taken the view that even in a case covered by S. 115J the provisions of S. 234B and S. 234C were attracted. While deciding the issue the learned Bench of the Court negated the contention as raised on behalf of the assessee that provisions of S. 234B and S. 234C are not attracted in cases falling u/ s.115J as book profits were determinable after the end of the financial year. The Court held that the difficulty faced by the assessee in the matter of computation cannot defeat the liability for payment of advance tax and that u/ s.207 of the Income-tax Act, advance tax is payable during any financial year in respect of the ‘current income’. The Court held that the words ‘current income’ refer to computation of total income under the provisions of the Income-tax Act including S. 115J. The Court further observed that u/s.207 of the Income-tax Act the words ‘total income’ have been equated to the expression ‘current income’. The Court held that the interest leviable u/ s.234B and u/ s.234C is compensatory in nature and it has no element of penalty. Therefore, if there is non-payment or short payment of tax on the current income, then the assessee has to pay interest as the income has accrued to the assessee for the previous year. The distinction sought to be made in respect of companies falling u/s.115J was not accepted. While holding so, the learned Bench observed that the view being taken is supported by the judgment of the Gauhati High Court in the case of Assam Bengal Carriers Ltd. v. CIT, (1999) (239 ITR 862) as also the judgment of the Madhya Pradesh High Court in the case of Itarsi Oils and Flours (P) Ltd. v. ClT, (2001) (250 ITR 686). The Court further held that they disagreed with the judgment of the Karnataka High Court in the case of Kwality Biscuits Ltd. v. ClT, (2000) (243 ITR 519).

Legislative history of MAT:

Let us look at the legislative history of the Sections and how it has been amended from time to time.

Initially S. 115J was inserted by the Finance Act, 1987 as per which tax at the regular rates on 30% of the book profit was levied if the same was found to be more than the total income computed under the Act. S. 115J(1) provided that where the total income computed under the Act is found to be less than 30 per cent of the book profit the total income of the assessee, shall be deemed to be an amount equivalent to 30% of such book profit. Thus, the concept of ‘deemed total income’ emerged. The liability to pay MAT would arise only on the determination of book profits which by necessary implication could be determined only after the accounts are audited as held in Kwality Biscuits case. S. 115J ceased to be effective from the A.Y. 1991-92.

The scheme of MAT, however, was revived effective from A.Y. 1997-98 by insertion of a new charging S. 115JA and under the said provision where the total income computed under the provisions of the Act was found to be less than 30% of the book profit, the total income chargeable to tax would be deemed to be an amount equivalent to 30% of the book profit. S. 115JA operated up to and including

A.Y. 2000-01 when it gave way for another charg-ing S. 115JBeffective from A.Y. 2001-02. It was different from its predecessor in one respect in not seeking to deem any total income but providing for tax payable to be deemed at 7.5% of such book profit. S. 115JB was amended by the Finance Act, 2002 with retrospective effect from 1-4-2001 substituting for the words ‘the tax payable for the relevant previous year shall be deemed to be seven and one-half percent of such book profit’ the words ‘such book profit shall be deemed to be the total income of the assessee and the tax payable by the assessee on such total income shall be the amount of income-tax at the rate of 7.5%’. The main difference between the provision as introduced initially and later amended is that the former provided for an obligation to pay tax at 7.5% of the book profit without deeming the book profit to be total income.

S. 115JB as it stands now is as follows:

1) Notwithstanding anything contained in any other provision of this Act, where in the case of – an assessee, being a company, the income-tax, payable on the total income as computed under this Act in respect of any previous year relevant to the assessment year commencing on or after 1-4-2007 is less than 10% of its book profit, such book profit shall be deemed to be the total income of the assessee and the tax payable by the assessee on such total income shall be the amount of income-tax at the rate of 10%.”

2) Every assessee, being a company, shall, for the – purposes of this section, prepare its profit and loss account for the relevant previous year in accordance with the provisions of Parts 11and III of Sched ule VI to the Companies Act, 1956 (1 of 1956).

…………………
…………………

5) Save as otherwise provided in this section, all other provisions of this Act shall apply to ev-ery assessee, being a company, mentioned in this section.”

CBDT Circular No. 13/2001 was issued on 9-11-2001 clarifying that all companies are liable for payment of advance tax under the new MAT pro-visions of S. 115JB of the Act. It is abundantly made clear in the said Circular that the new provisions of S. 115JB as introduced by the Finance Act, 2000 are a self-contained Code. Ss.(l) lays down the manner in which income-tax payable is to be computed.

Ss.(2) provides for computation of ‘book profit’. Ss.(5) specifies that save as otherwise provided in this section, all other provisions of this Act shall apply to every assessee, being a company mentioned in that section. The Circular clarifies that except for substitution of tax payable and the manner of computation of book profits, all the provisions relating to charge, definitions, recoveries, payment, assessment, etc., would apply in respect of the provisions of this Section.

The Circular further goes on to explain the scheme of the Income-tax Act. S. 4 of the Act charges to tax the income at any rate or rates which may be prescribed by the Finance Act every year. S. 207 deals with liability for payment of advance tax and S. 209 deals with its computation based on the rates in force for the financial year, as are contained in the Finance Act. The first proviso to S. 2(8) of the Finance Act, 2001 provides that tax would be payable by way of advance tax in respect of income charge-able u/s.115JB as introduced by Finance Act, 2000. The Circular clarifies that consequently the provisions of S. 234B and S. 234C for interest on default in payment of advance tax and deferment of advance tax would also be applicable.

This was the view taken by the Karnataka High Court in the case of Jindal Thermal Power Co. Ltd. 286 ITR 182 in the context of S. 115JB. This view has also been taken by the Mumbai Tribunal in Madaus Pharmaceuticals P. Ltd. 24 SOT 180 following Karnataka High Court in Jindal Thermal Power Co. Ltd.

It may be appropriate to mention that the Mumbai Tribunal in Deepak Fertilizer and Petrochemicals Corporation [304 ITR (AT) 167], the Cochin Tribunal in Escapade Resorts P. Ltd. (13 SOT 300) and the Bangalore Tribunal in IBM India Ltd. [290 ITR (AT) 183] have in the context of S. 115JA taken a view in favour of the assessee following the principle laid down by the Supreme Court in Kwality Biscuits Ltd.

Ahmedabad Special Bench in Ashima Syntex Ltd. :

However, attention is invited to the Ahmedabad Special Bench decision in the case of Ashima Syntex Ltd. 310 ITR (AT) 1. The Special Bench has held that the aforesaid decision in the case of Kwality Biscuits Ltd. was not rendered in the context of the provisions of S. 115JA of the Act. The Special Bench has analysed various decisions in detail. It has stated that for the purpose of payment of advance tax, all the assesses including companies, are required to make an estimate of their current income. Even before the introduction of the provisions of S. 115J of the Act, companies had been estimating their total income after providing deductions admissible under the Act. In fact, all the assesses who maintain books of account have to undertake this exercise for the purpose of payment of advance tax. If a profit and loss account can be drawn up on estimate basis for the purpose of the Income-tax Act, it is not understood as to why a similar profit and loss account on estimate basis under the Companies Act cannot be drawn up. If the explanation of the companies that the profits u/s.115JA of the Act can only be determined after the close of the year were to be accepted, then no assessee who maintains regular books of account would be liable to pay advance tax as in those cases also, income can only be determined after the close of the books of account at the end of the year. The provisions of S. 207 to S. 209 of the Act do not exclude the income determined u/s.115JA of the Act from the purview of current income on which advance tax is payable. Similarly, there is no scope for considering the hardship of the assessee as the levy is automatic and does not require any opportunity to be given to the assessee. S. 4 of the Act envisages charge to tax the income at any rate or rates which may be prescribed by the Finance Act every year and S. 207 deals with liability for payment of advance tax and S. 209 deals with its computation based on the rates in force for the financial year, as are contained in the relevant Finance Act.

Accordingly the Special Bench has held that all other provisions of the Act including provisions relating to payment of advance tax are applicable even when income is computed u/s.115JA of the Act.

Conclusion:

It may be concluded that subsequent to incorporation in the Finance Act of the requirement for payment of advance tax by companies falling u/s.115JB, there can be no doubt in the matter. Considering the difference in the language of S. 115J and S. 115JA/ S. 115JB,provisions of the Finance Act and the view taken by Ahmedabad Special Bench and the Karnataka High Court, MAT companies would be liable to pay advance tax u/s.115JB. If they don’t do so they may land up paying heavy interest u/ s.234B and u/s.234C which is not tax deductible.

Nirav Shah

‘Corporate Governance’ and agency theory

Introduction :

‘Corporate Governance’ — these words have been hitting the
headlines of financial magazines for quite some years, particularly post Enron,
and in India they have once again triggered debates post Satyam scam. Satyam
— this word would no longer be used as an adjective to signify the attribute of
truthfulness, but will now be used as a noun to signify systemic failure in
history of Indian corporate governance system. Satyam story holds within it,
legion of myriad hidden lessons for a spectrum of bodies, from directors to
investors and from auditors to regulators.

A lot has been and will be written and discoursed on the
concept of corporate governance and its raison d’être. This article
discusses one of such aspects. In the first part, it highlights the portent of
Adam Smith and tries to prove how Adam Smith had prescient of the inherent flaw
in the model — ‘Corporation’. The second part advocates a prescription
for good governance practice.

Smith’s Portent & Prophecy :

Corporations today are based on, ‘Agency Theory’ (a
branch of organisational behaviour) wherein the owners of funds (alias
principals) invest their money in a company that is managed by altogether
different group of people called directors and managers (alias agents);
this agency relationship between the shareholders and directors is based on the
premise of trust; shareholders lend their money to directors under trust that
the latter shall deploy the money in a manner that would maximise shareholders’
interests.

Agency Theory is defined by Chartered Institute of Management
Accountants as — ‘Hypothesis that attempts to explain elements of
organisational behaviour through an understanding of the relationships between
principals (shareholders) and agents (directors and managers). A conflict may
exist between the actions undertaken by agents in furtherance of their own self
interest and those required to promote the interest of principals.’

Some of the instances wherein a conflict can exist between
owners and managers can be :

à Managers
are interested in short-term profits against long-term shareholders’ value, as
it has positive impacts on their compensation, incentives, bonus and
promotion. The episode of sub-prime crises in United States exemplifies this
conflict wherein the investment bankers and financial institutions took
recourse to highly complex derivative products in order to inflate short-term
profits and thereby inflate their incentives.

à Management
myopia on short-term profits also motivates them to resort to creative
accounting, inflating the top line and bottom line. Enron’s episode best
exemplifies such myopia where the company resorted to creative accounting to
show better profitability.

à Quite
often, managers having financial interest in their own company tend to send
wrong cues to the market in order to inflate the share prices and ultimately
increase their own wealth.

à Managers
deploy shareholders’ funds in risky investments so as to get quick and
immediate returns, at the cost of preserving shareholders’ wealth.

à
Shareholders’ funds are siphoned into projects in which the management may
have personal interest; examples of this can be — deploying funds in a company
that is owned by a relative of the managing director or awarding a contract to
a vendor company that is operated by a relative of one of the executives.

à Managers of
companies that are subject to a takeover bid often put up a defence to repel
the predator, even though such a takeover may be in the long-term interest of
shareholders of the acquired company; managers of the acquired company do so
in fear of losing their jobs or status to the managers and functional heads of
the predator company.

Adam Smith, known as father of economics, was highly cynical
and pessimistic about the success of corporation as a model of creating wealth
and pursuing economic growth. The entire idea of dilution of ownership, whereby
the owner and manager of funds are two different groups/persons, was not at all
invidious to Smith. Smith had prescience of the inherent and institutional flaw
in the model of corporations. He wrote in his book ‘The Wealth of Nations’
(abbreviated name for ‘An Inquiry into the Nature and Causes of the
Wealth of Nations’) :

‘The directors of such companies . . . . being the managers
of other people’s money rather than of their own, it cannot well be expected
that they should watch over it with the same anxious vigilance with which the
partners in a private co-partnery frequently watch over their own. Like
stewards of rich man, they are apt to consider attention to small matters as
not for their master’s honour and very easily give themselves a dispensation
from having it. Negligence and profusion, therefore, must always prevail,
more or less, in the management of the affairs of such a company . . .’

This statement of Smith came in 1776, almost 200 years after
incorporation of East India Company in 1600 — the Company that ruled India and
which was the first company to hold democratic general meeting of shareholders
and was later on accused of mis-management aimed at generating personal gain (in
violation of the ‘agency theory’).

Smith believed so strongly in the power of self interest and
the conflicts it generates, that he was extremely pessimistic about the ability
of the joint stock company to survive in any but the simplest of activities
where management’s behavior could be easily monitored.

‘Without a monopoly a joint stock company cannot long
carry on any branch of foreign trade. To buy in one market, in order to sell,
with profit, in another, when there are many competitors in both; to watch
over, not only the occasional variations in the demand, but the much greater
and more frequent variations in the competition, or in the supply which that
is likely to get from other people, and to suit with dexterity and judgment
both the quantity and quality of each assortment of goods to all these
circumstances, is a species of warfare of which the operations are continually
changing, and which can scarce ever be conducted successfully, without such an
unremitting exertion of vigilance and attention, as cannot long be expected
from the directors of a joint stock company’.

Smith had strong surmise about the sustainability of a corporation without it being granted a state monopoly. Only activities where this model can work, according to Smith, were those that were easily monitored; Smith implicates this when he says in his words – “which all the operations are capable of being reduced to what is called a routine, or to such a uniformity of method as admits of little or no variation”.

Smith was well aware of the benefits of corporations, including their ability to concentrate large amounts of money into capital-intensive undertakings. But he thought and believed that:

The costs of agency relationship would always I.be too high. (Today there is intense debate in the USA on ‘managerial remuneration’.)

Those costs shall rise with the increase in size of business.

Bigger a business got, the worse would be waste because of negligence.

Negligence, profusion and conflict of interest would ruin the corporation as its business scaled high and it would be predicament for anyone to preclude these costs, by whatsoever checks, balances, controls and regulations being instituted. (Pending outcome of investigation, it was negligence and profusion that resided at the bottom of Satyam pyramid.)

These agency costs viz. negligence, profusion and conflict of interest, are today reflected in the form of corporate debacles, be it Enron, World-corn or Satyam. It is sad, but the fact is that Smith has been proven right hitherto specifically in last decade if one is to go purely on regression analysis.

Smith’s prophecy that ‘negligence and profusion must always prevail’ made 200 years before, still holds good today. The irony is: it is only now when we realise the unfathomable truth in his profound statement.

To conclude: Enron brought a sea change in our perspective towards corporate governance; it had its own lessons to teach and so would Satyam. Stringent and vigilant controls would be instituted by regulatory bodies, in the form of codes, rules, audits, and peer reviews; investigations will be carried out, special committees will be appointed, white papers will be issued and; significant amount of research would be done in investigating why this happened, how this happened, could it have been prevented or at least predicted, what to do to prevent its re-occurrence, who should be held responsible, how should they be punished, etcetera. How-ever, the fact is and as Smith aptly wrote, this model of corporation possesses an inherent flaw and this would time and again be reflected in the form of more Enrons and Satyams. These are bound to take place in future, irrespective of checks and balances because of the inherent greed and conflict of interest.

Prescription for good governance practice:

In the midst of academic debate as to what constitutes good governance practices, below are a few canons that inter alia form the basis for good governance. These are simple principles and values taken from different sources of management theory that have been practised at different times in history. Co-incidentally, these canons also happen to be in order of vowels of English literature (AEIOU) and therefore, one may also term them as vowels of good governance practice.

1. Altruism:
Etymologically, altruism origins from the word alter, which is the latin word for other. An altruist is a person who works for the benefit of others and who is more concerned with welfare of others. Likewise, the board and management need to practise altruism, whereby their actions are directed in maximising interest of shareholders and other stakeholders, instead of their own.

2. Egalitarianism:
Egalitarianism is a principle or belief that all the people are equal and deserve equal rights and opportunities. Relating it to ‘governance practice’, it basically means that board should adopt a stakeholder approach, rather than a shareholders’ approach in performing its actions.

Lately, although stakeholder approach has been adopted by academia, it has not been reflected in governance practice in real life. In fact, in Germany the legal system itself mandates explicitly that firms do not have a sole duty to pursue the interest of shareholders and that other stakeholders also need to be represented on the board. The Germans have the system of co-determination, in which employees and shareholders in large corporations share an equal number of seats on the supervisory board of the company, so that the interests of both are taken into account. Japan and France have also adopted stakeholders’ approach in governance of companies. This is not the case in other developed countries like US and UK. Even in India, the directors on board represent and are accountable to shareholders. However, several reports now advocate a ‘Stakeholder’ approach and advocate the three P approach to governance.

3. Integrity and independence:
Integrity is the attribute of having moral principles; being straightforward and honest. It means being ethical in discharging one’s duty. In terms of governance, it primarily means being transparent in disclosing information to shareholders and other stakeholders.

Independence stands for the strength of an individual to adopt an unbiased view on the matters, undaunted by any favour or frown. Relating it to governance practice it means the board must be independent in its actions whereby it should not be subordinated by the wishes or directions of management. This particular attribute of governance is one of the imperative corner stones of good governance practice.

4. Oracle:
Oracle is basically a noun, rather than an adjective. It means having a vision and an ability to foresee future. In terms of governance practice it means that the board needs to have vision and provide strategy to management for execution. One of the important roles of a board is to set objectives – objectives that translate long-term vision of the board, which is in the interest of stakeholders.

5. Utilitarianism:
Utilitarianism is a doctrine that emphasises that actions are right if they are useful or for the benefit of a majority; it emphasises: greatest happiness of greatest number. This is one of the most precious attributes that one can gain from Indian epics, both Ramayana and Mahabharata. This attribute also augments the canon of egalitarianism.

The board while dealing with different interests of different stakeholder groups cannot satisfy all the interests of all the stakeholders at the same time. There are bound to be conflicts between interests of different stakeholders. For instance – shareholders may often question the expenditure on corporate social responsibility as it ultimately impacts their dividend. The board is often confronted with such a dilemma wherein interest of two or more stakeholders conflict. It is at this point where the board needs to exercise the canon of utilitarianism i.e., it must act in a manner that provides greatest benefit to greatest number.

Nirav Shah

Priority of claim : State due has first charge over the dues of banks, financial institutions and other secured creditor. Constitution of India Articles 254, 245, 246]

New Page 1

Priority of claim : State due has first charge over the
dues of banks, financial institutions and other secured creditor. Constitution
of India Articles 254, 245, 246]

[ Central Bank of India v. State of Kerala & Ors.,
(2009) 4 Supreme Court cases 94]

The question which arose for determination before the Apex
Court was whether S. 38-C of the Bombay Sales Tax Act, 1959 (the Bombay Act)
and S. 26-B of the Kerala General Sales Tax Act, 1963 (the Kerala Act) and
similar provisions contained in other State legislations by which a first
charge was created on the property of the dealer or such other person, who was
liable to pay sales tax, etc. were inconsistent with the provisions contained
in the Recovery of Debts due to Banks and Financial Institutions Act, 1993
(the DRT Act) for recovery of ‘debt’ and the Securitisation and Reconstruction
of Financial Assets and Enforcement of Security Interest Act, 2002 (the
Securitisation Act) for enforcement of ‘security interest’ and whether by
virtue of non obstante clauses contained in S. 34(1) of the DRT Act and
S. 35 of the Securitisation Act, the two Central legislations had primacy over
State legislations.

The borrower, who had mortgaged his properties to the
creditor bank failed to repay the dues. The appellant bank therefore filed a
suit which was ultimately decreed by the Debts Recovery Tribunal.
Consequently, a recovery certificate was issued in favour of the bank and the
recovery officer issued notice for sale of the properties of the borrower. At
that stage the Tahsildar issued a notice to the borrower for recovery of a
certain sum as arrears of land revenue. The notice stated that the properties
had been attached and steps were being taken to sell the same by auction. The
Tahsildar claimed that by virtue of S. 26-B of the Kerala Act, the State Govt.
had got first charge over the attached properties. The bank filed a writ
petition contending that being a Central legislation, the DRT Act would
prevail over the Kerala Act. The writ petition was dismissed. The bank
appealed therefore to the Supreme Court.

Similarly a company borrowed a certain sum from the
appellant bank by creating an equitable mortgage of its properties in favour
of the bank. Due to the company’s failure to repay the amount, its account was
classified as a non-performing asset and the bank initiated proceedings under
the Securitisation Act by issuing notice u/s.13(2). The bank took possession
of the properties of the company and sold the same. The ACST informed the bank
that sales tax dues constituted a first charge against the company and,
therefore, the bank could not have taken possession of the mortgaged
properties and sold them. The bank filed a writ petition contending that in
view of the conflict between S. 38-C of the Bombay Act and S. 35 of the
Securitisation Act, the latter being a Central legislation, the first charge
created by the State Act could not have priority over debts of the bank. The
High Court held that since there was no provision in the Securitisation Act
providing for first charge in favour of the banks, S. 35 of the Securitisation
Act would not be held to override S. 38-C of the Bombay Sales Tax Act.

The Supreme Court held that Article 245 of the Constitution
is the source of legislative power of Parliament and the State Legislatures.
The legislative fields of Parliament and the State Legislatures have been
specified in Article 246. The combined effect of the different clauses of
Article 246 is that in respect of any matter falling within List I, Parliament
has exclusive power of legislation, whereas the State Legislature has
exclusive power to make laws for such State or any part thereof with respect
to any of the matters enumerated in List II in Schedule VII and with respect
to the matters enumerated in List III, both Parliament and the State
Legislature have power to make laws.

Article 254 contains mechanism for resolution of conflict
between the Central and State legislations enacted with respect to any matter
enumerated in List III of Schedule VII.

There is no provision in the DRT Act or the Securitisation
Act by which first charge has been created in favour of banks, financial
institutions or secured creditors qua the property of the borrower.

U/s.13(1) of the Securitisation Act, limited primacy has
been given to the right of a secured creditor to enforce security interest
vis-à-vis S. 69 or S. 69-A of the Transfer of Property Act. In terms of S.
13(1), a secured creditor can enforce security interest without intervention
of the Court or Tribunal and if the borrower has created any mortgage of the
secured asset, the mortgagee or any person acting on his behalf cannot sell
the mortgaged property or appoint a receiver of the income of the mortgaged
property or any part thereof in a manner which may defeat the right of the
secured creditor to enforce security interest.

In an apparent bid to overcome the likely difficulty faced
by the secured creditor which may include a bank or a financial institution,
Parliament incorporated the non obstante clause in S. 13,
Securitisation Act, 2002 and gave primacy to the right of secured creditor
vis-à-vis other mortgagees who could exercise rights u/s.69 or u/s.69-A of
the Transfer of Property Act. However, this primacy has not been extended to
other provisions like S. 38-C of the Bombay Act and S. 26-B of the Kerala Act
by which first charge has been created in favour of the State over the
property of the dealer or any person liable to pay the dues of sales tax, etc.
S. 13(7) which envisages application of the money received by the secured
creditor by adopting any of the measures specified u/s.13(4) merely regulates
distribution of money received by the secured creditor. It does not create
first charge in favour of the secured creditor.

The non obstante clauses contained in S. 34(1) of
the DRT Act and S. 35 of the Securitisation Act give overriding effect to the
provisions of those Acts only if there is anything inconsistent contained in
any other law or instrument having effect by virtue of any other law. In other
words, if there is no provision in the other enactments which are inconsistent
with the DRT Act or the Securitisation Act, the provisions contained in those
Acts cannot override other legislations. S. 38-C of the Bombay Act and S. 26-B
of the Kerala Act also contain non obstante clauses and give statutory
recognition to the priority of the State charge over other debts, which was
recognised by Indian High Courts even before 1950. In other words, those
Sections and similar provisions contained in other State legislations not only
create first charge on the property of the dealer or any other person liable
to pay sales tax, etc., but also give them overriding effect over other laws.
Thus the appeals were dismissed.

Nirav Shah

Whether Service Tax is applicable to the sale of computer software ?

Article

Brief background :

The Finance Act, 2008 brought some new services under the
Service Tax net. One of them is Information Technology Software Service.

Inclusion of a new services category — Information Technology
Software Services — within the ambit of Service Tax legislation has created
confusion among software firms. The levy of this new service along with other
services has become effective from 16 May, 2008.

Post the Notification, many feel that from 16 May, 2008,
packaged software will also attract 12.36% of Service Tax. So far, packaged
software attracts Value Added Tax (VAT) of 4% and 12% of excise duty.

The confusion arises as the Notification does not make a
clear demarcation of whether ‘software’ is to be sold as goods and hence liable
for sales tax (VAT) or considered as ‘services’ and liable for a Service Tax or
both.

Packaged softwares are products that are sold off the shelf.
Examples of the products that would fall under this are Microsoft, Autodesk,
Adobe and several security software packages for computers. This will also
include accounting software from Tally.

Normally Service Tax is payable to the Central Government
when a service is offered, while VAT is applicable when a product is sold.

In case of softwares which are not sold off the shelf, the
sale price includes free initial installation and implementation of the
software. This includes some modifications or customisations to suit the
customers, but without disturbing the basic structure of the software or its
performance.

The copyright in the software is protected and always remains
the property of the creator. What is sold is the right to use the software.

The sale is with a condition for exclusive use of the
software by the customer at the exclusion of others. The sale gives absolute
possession and control to the purchaser/user of the right to use the software.

The sale normally gives a warranty period and after the said
period some annual maintenance charges are recovered for the services rendered,
popularly called Annual Maintenance Contract (AMC).

At present the sale is subjected to tax under the Maharashtra
Value Added Tax Act, 2002, (MVAT) and AMC is subjected to Service Tax.

The confusion is created due to the amendment in the Service
Tax by the Finance Act, 2008 which has added “Information Technology Software
Service” by way of sub-clause (zzzze) in Cl. 65(105) of the Finance Act, 1994,
and further sub-clause (53a) in Cl. 65, defining the term “information
technology software.”

The query :

Whether Service Tax is applicable to the sale of computer
software ? Whether MVAT is also applicable to the same ?

Questions to be answered/verified :

To answer the query, the following crucial questions will
have to be addressed :

1. Is the software ‘Goods’ and covered as a ‘Sale’ under
the MVAT Act, 2002 ?

2. Is it a service chargeable to Service Tax under Cl.
65(105)(zzzze) of the Finance Act, 1994 ?

3. Whether both the MVAT and Service Tax are applicable ?

4. What is the value chargeable to Service Tax, if
applicable ?

5. Facts from the sale/licence agreements.

6. Conclusion.

Analysis of the questions :

1. Is the software ‘Goods’ ?

1.01 The question is very important and is relevant to decide
its taxability.

The question assumes importance, because if it is ‘Goods’, it
is subjected to tax under the MVAT. If it is not goods, then it may be subjected
to Service Tax.

1.02 ‘Goods’ is defined in S. 2(12) under the Maharashtra
Value Added Tax Act, 2002, as :

“In this Act, unless the context otherwise requires,
goods means every kind of moveable property not being newspapers,
actionable claims, money, stocks, shares, securities or lottery tickets and
includes livestocks, growing crop, grass and trees and plants including the
produce thereof including property in such goods attached to or forming part
of the land which are agreed to be severed before sale or under the contract
of sale.”

1.03 Under Article 366(12) of the Constitution of India,

“Goods include all materials, commodities, and articles.”

1.04 Further, Entry 39 in Schedule C to the Maharashtra Value
Added Tax Act, 2002, which decides the rate of tax, describes goods under that
entry as :

“Goods of intangible or incorporeal nature as may be
notified, from time to time, by the State Government in the Official Gazette”;

and the Notification VAT-1505/CR-114/Taxation-1, dated
1-6-2005 notifies a list of goods in which Item (5) reads :

“Software Packages.”

1.05 Further, it would be worth to look to the definition of
‘Sale’ under the Maharashtra Value Added Tax Act, 2002, S. 2(24) :

“Sale means a sale of goods made within the State for cash or deferred payment or other valuable consideration, but does not include a mortgage, hypothecation, charge or pledge; and the words ‘sell’, ‘buy’ and ‘purchase’, with all their grammatical variations and cognate expression, shall be construed accordingly.

Explanation :

For the purpose of this clause :

(a)……………

(b)(iv) the transfer of right to use any goods for any purpose (whether or not for a specified period) for cash, deferred payment, or other valuable consideration;…………..

shall be deemed to be a sale.”

1.06 It can be seen that ‘goods’ has been defined under all the relevant acts very widely and includes the right to use any goods which can be sold.

1.07 There have been many instances where the courts of law had occasions to examine whether the software is goods. Although with some limitations, but the most relevant on the subject was the case of :

Tata Consultancy Services v. State of A.P., (2004) 271 ITR 401 (SC)

This is a landmark judgment of the Supreme Court of India, on the definition of ‘Goods.’ A detailed discussion on the same throws light on the term in the correct perspective.

1.08 Tata Consultancy Services (TCS) provides

consultancy services including computer consultancy services. They prepare and load on customers’ computers custommade software and also sell ready-made computer software packages off the shelf. The readymade software is also known as canned software.

The assessing officer, first appellate authority and the Sales Tax Tribunal Andhra Pradesh held that canned softwares are goods and sales tax is leviable on their sale.

TCS filed a tax revision case to the Hon. Andhra Pradesh High Court, which was dismissed.

The appellant preferred an appeal before the Supreme Court and the question raised in the appeal was whether canned software sold by the appellant can be termed to be ‘goods’.

The appellant submitted that the term ‘goods’ in S. 2(h) of the Andhra Pradesh General Sales Tax Act only includes tangible moveable property, and the words ‘all material articles and commodities’ also cover only tangible moveable property, and computer software is not tangible moveable property.

The appellant further submitted that the definition of ‘computer’ and ‘computer programme’ in the Copyright Act, 1957 shows that a computer programme falls within the definition of Literary Work and is intellectual property of the programmer.

The appellant also submitted that computer software is nothing but a set of commands, on the basis of which the computer may be directed to perform the desired function.

It was further contended by the appellant that software is unlike a book or a painting. When the customer purchases a book or a painting, what he gets is the final product itself and in the case of software the consumer does not get any final product, but all that he gets is a set of commands which enable his computer to function.

It was further argued that having regard to its nature and inherent characteristic, software is intangible property which cannot fall within the definition of the term I goods’ in S. 2(h) of the Andhra Pradesh General Sales Tax Act.

The Supreme Court did not agree with these arguments and held as under:

The term ‘goods’ as used in Article 366(12) of the Constitution of India and as defined under the said Act are very wide and include all types of movable properties, whether these properties be tangible or intangible. We are in complete agreement with the observations made by this Court in Associated Cement Companies Ltd., (2001) 124 STC 59. A software programme may consist of various commands which enable the computer to perform a designated task. The copyright in that programme may remain with the originator of the programme, but the moment copies are made and marketed; it becomes goods, which are susceptible to sales tax. Even intellectual property, once it is put on to media, whether it be in the form of books or canvas (in case of painting) or computer disks or cassettes, and marketed would become “goods”. We see no difference between a sale of a software programme on a CD / floppy disc from a sale of music on a cassette / CD or a sale of a film on a video cassette/ CD. In all such cases, the intellectual property has been incorporated on a media, for purpose of transfer. Sale is not just of the media which by itself has very little value. The software and the media cannot be split up. What the buyer purchases and pays for is not the disc or the CD. As in the case of paintings or books or music or films, the buyer is purchasing the intellectual property and not the media; i.e., the paper or cassette or disc or CD. Thus a transaction of sale of computer software is clearly a sale of ‘goods’ within the meaning of the term as defined in the said Act. The term, “all materials, articles and commodities” includes both tangible and intangible/incorporeal property which is capable of abstraction, consumption and use and which can be transmitted, transferred, delivered, stored, possessed, etc. The software programmes have all these attributes.

The Supreme Court dismissed the appeal and held that canned software is “goods”.

This judgment more or less has defined the test to decide what is goods and the event when it becomes goods i.e., the moment copies are made and marketed, it becomes goods, which are susceptible to sales tax. Even intellectual property, once it is put on to media, whether it be in the form of books or canvas (in case of painting) or computer disks or cassettes, and marketed would become “goods”.

1.09 In the landmark judgment of Bharat Sanchar Nigam Ltd. v. Union of India, (2006) 1453 STC 91 – the Hon. Supreme Court held that a goods may be a tangible property or an intangible one, it would become goods, if it satisfies the test. It observed in para 56 that:

This view was adopted in Tata Consultancy Services v. State of Andhra Pradesh, for the purposes of levy of sales tax on computer software. It was held:

“A ‘goods’ may be a tangible property or an intangible one. It would become goods provided it has the attributes thereof having regard to (a) its utility; (b) capable of being bought and sold; and (c) capable of being transmitted, transferred, delivered, stored and possessed. If a software whether customised or non-customised satisfies these attributes, the same would be goods.”

This makes it clear that whether the software is a customised one or otherwise, it would be goods.

1.10 Further in the latest judgment of – Infosys Technologies Ltd. v. Special Commr. of Commercial Taxes,
(2008) 17 VST 256 (Mad.), while deciding the question “whether customised or non-customised software satisfies the test of the’ goods’ and is ‘goods’ for sales tax ?”, following the Supreme Court judgment in Bharat Sanchar Nigam Ltd. v. Union of India, (2006) 145 STC 91, it was held that goods may be a tangible property or an intangible one, it would be goods provided it has the attributes having regard to (a) its utility, (b) capable of being bought and sold; and (c) capable of being transmitted, transferred, delivered, stored and possessed.

If a software, whether customised or non-customised, satisfies these attributes the same would be goods.

2.0 Is it a service chargeable to Service Tax under Cl. 65(105) (zzzze) of the Finance Act, 1994 ?

2.01 The services provided under the Information Technology Software Service head on or after 16-5-2008 have been made taxable.

2.02 The statutory definition in S. 65(53a) of the Finance Act, 1994 is :
‘information technology software’ means any representation of instruction, data, sound or image, including source code and object code, recorded in machine readable form, and capable of being manipulated or providing interactively to a user, by means of a computer or an automatic data processing machine or any other device or equipment.

2.03 S. 65(105) (zzzze) of the Finance Act, 1994, inserted, defines taxable service as :

“any service provided or to be provided to any person, by any other person in relation to information technology software for use in the course, or furtherance, of business or commerce, including:

(i) development of information technology software,

(ii) study, analysis, design and programming of information technology software,

(iii) adaptation, upgradation, enhancement, implementation and other similar services related to information technology software,

(iv) Providing advice, consultancy and assistance on matter related to information technology software, including conducting feasibility studies on implementation of a system, specifications for a database design, guidance and assistance during the startup phase of a new system, specification to secure a database, advice on proprietary information technology software,

(v) Acquiring the right to use information technology software for commercial exploitation including right to reproduce, distribute and sell information technology software and right to use software components for the creation of an inclusion in other information technology software products,

(vi) Acquiring the right to use information technology software supplied electronically.

On a plain reading of the scope, apparently Sale of Software seems to be covered under the charge of Service Tax.

2.04 The Circular/Letter D. O. F. No. 334/1/2008-TRU, dated 29-2-2008, discusses salient features of the changes made by the Finance Act, 2008. It states in Para 4.4.1., that:

Transfer of the right to use any goods is leviable to Sales Tax/VAT as deemed sale of goods [Article 366(29A)(d) of the Constitution of India]. Transfer of right to use involves transfer of both possession and control of the goods to the user of the goods.

It also states in Para 4.4.2, that:

Excavators, wheel, loaders, dump-trucks, crawler carriers, compaction equipment, cranes, etc. off-shore construction vessels & barges, geotechnical vessels, tug and barge, flotillas, rigs and high-value machineries are supplied for use, with no legal right of possession and effective control. Transaction of allowing another person to use the goods, without giving legal right of possession and effective control, not being treated as sale of goods, is treated as service.

It further states in Para 4.4.3, that:

Proposal is to levy Service Tax on such services provided in relation to supply of tangible goods, including machinery, equipment and appliances, for use, with no legal right of possession or effective control. Supply of tangible goods for use and leviable to VAT/sales tax as deemed sale of goods, is not covered under the scope of the proposed service. Whether a transaction involves transfer of possession and control is a question of facts and is to be decided based on the terms of the contract and other material facts. This could be ascertained from the fact whether or not VAT is payable or paid.

Although the clarification is under the head Supply of Tangible Goods for Use, it is equally applicable in the present case also.

This is because the Supreme Court also has held the right to use as goods.

It is obvious that the test to decide any transaction as a sale as is accepted in taxing statutes, is whether a transaction involves transfer of possession and control is a question of facts and is to be decided based on the terms of the contract and other material facts.

2.05 The further test for checking about the applicability of Service Tax is to check whether MVAT is payable or paid.

It is obvious from the clarification by the Department itself that transfer of right to use any goods is subjected to VAT and where VAT is payable or paid, the service is not covered under the scope of Service Tax.

2.06 This is a very important point as it relates to a clarification per Constitution.

2.07 Further, Service Tax since its inception has never been intended to be levied on Sale of Goods and the same principle has throughout been followed consistently by the Department. The reason is obviously related to the Constitutional power of the Union Government to levy tax on an item covered under Article 246 read with List II – State List to Schedule VII to the Constitution of India. This is more particularly explained in the following paras 3.00 to 3.14.

2.08 The mutual exclusivity of taxes which has been reflected in Article 246(1) of the Constitution means that taxing entries must be construed so as to maintain exclusivity.

i) Gujarat Ambuja Cements Ltd. v. UOI, (2005) 4 SCC 214, (para 23)

2.09 Presumption that a Legislature is acting within its competence:

In constructing an enactment of a Legislature with limited competence, the Court must presume that the Legislature in question knows its limits and that it is only legislating for those who are actually within its jurisdiction.

i) State of Bihar v. Charusila Dasi, 1959 S.c. 1002

ii) P. N. Krishna Lal v. Govt. of Kerala, (1995) Supp.(2) SCC 18 (Para 8)

iii) Anant Prasad Laxminiwas Genriwal v. State of A.p., 1963 S.c. 853.

In all the amendments that may take place, the Legislature has to remain in the framework defined by the Constitution.

Service Tax is never intended to, nor can it, be levied on subjects which are enumerated in List-II i.e., a State List.

Hence, even if wordings are drafted to suggest some different meanings, it cannot travel beyond the framework.

The Courts have laid down the principles of inter-pretations and while deciding matters like this the test called ‘pith and substance’ has to be applied ignoring the apparent words.

2.10 The State Legislature has legislative competence to treat a particular sale or purchase as the first sale or purchase.

i) Food Corporation of India v. State of Kerala, (1997)

ii) Arjun Flour Mills v. State of Orissa, (1998) 8 SCC 89 (Para 1).

2.11 Whenever the question of legislative competence arises, the issue must be solved by applying the rule of pith and substance whether that legislation falls within any of the entries in List-II. If it does, no further question arises and article 246 cannot be brought in to yet hold that the State Legislature is not competent to enact the law.

i) State of A.P. v. McDowell & Co., (1996)3 SCC 709 (para 7)

2.12 Doctrine of pith and substance

This doctrine means that if an enactment substantially falls within the powers expressly conferred by the Constitution upon the Legislature which enacted it, it cannot be held to be invalid, merely because it incidentally encroaches on matters assigned to another Legislature.

i) Bharat Hydro Power Corpn. Ltd. v. State of Assam, (2004) 2 SCC 553-561 (para 18)

The doctrine of pith and substance is sometimes invoked to find out the nature and content of the legislation. However, when there is an irreconcilable conflict between the two legislations, the Central legislation shall prevail. However, every attempt would be made to reconcile the conflict.

i) Special Reference No. 1 of 2001. In re, (2004) 4 SCC 489, 499-500 (para 15)

The express words employed in an entry necessarily include incidental and ancillary matters so as to make the legislation effective.

i) Hindustan Lever v. State of Maharashtra, (2004) 9 SCC 438, 457-58 (para 34)

The Court is required to ascertain the true nature and character of the enactment with reference to the legislative power. It must examine the whole enactment, its object, scope and effect of its provision. If on such adjudication, it is found that the enactment falls substantially on a matter assigned to the State Legislature, the enactment must be held valid even though the nomenclature of the enactment shows that it is beyond the legislative competence of the State Legislature. When a levy is challenged, its validity has to be adjudged with reference to the competency of the State Legislature to enact such a law and real nature and character of the levy, its pith and substance is to be found out and adjudged with reference to the competency of the Legislature.

i) State of Karnataka v. Drive-in-Enterprises, (2001) 4 SCC 60, 63-64 (para 6)

If by applying the rule of pith and substance, the legislation falls within any of the entries of List I1, the State Legislature’s competence cannot be questioned on the ground that the field is covered by the Union List.

i) State of Rajasthan v. Vulan Medical & General Store, (2001) 4 SCC 642, 652-53 (para 11)

In other words, when a law is impugned as ultra vires, what has to be ascertained is the true character of the legislation. If on such examination it is found that the legislation is in substance one on a matter assigned to the Legislature, then it must be held to be valid in its entirety, even though it might incidentally trench on matters which are beyond its competence.

i) Krishna A. S. v. State of Madras, AIR 1957 SC;

ii) Kantian Devon Produce & Co. s. State of Kerala, (1972) 2 S.CC 218;

iii) P. N. Krishnd Lal v. Govt. of Kerala, 1995 Supp (2)SCC 187 (para 8 and 9).

In a situation of overlapping, the rule of pith and substance has to be applied to determine to which entry a given piece of legislation relates. Thereafter, any incidental trenching on the field reserved to the other Legislature is of no consequence.

i) Goodricke Group Ltd. v. State of W.B., 1995 Supp SCC 707 (para 12)

ii) ITC Ltd. v. A P M C, (2002) 9 SCC 232 (para 182)

iii) E. V Chinnaiah v. State of A.P., (2005) I SCC 394, 413 (para 29)

It is the function and power of the court to interpret an enactment and to say to which entry an enactment relates. The opinion of the Govt. in this behalf is but an opinion and not more.

i) Goodricke Group Ltd. v. State of W.B., 1995 Supp SCC 707 (para 37)

In order to examine the true character of the enactment, one must have regard to the enactment as a whole to its objects and to the scope and effect of the provisions. It would be quite an erroneous approach to the question to view such a statute not as an organic whole, but as a mere collection of sections, then disintegrate it into parts, examine under what heads of legislation those parts would severally fall and by that process determine what portions thereof are intra vires and what are not.

i) Bharat Hydro Power Corpn. Ltd. v. State of Assam, (2004) 2 SCC 553, 561 (para 18)

2.13 It is obvious from the discussion above that the doctrine of pith and substance has to be applied while interpreting the situation like the one in the present case.

3.0 Whether both the MVAT and Service Tax are applicable?

3.01 The issue is already clarified by the Department itself as mentioned in Point No. 2.04 above that, where VAT/Sales Tax is payable or paid, the service will be beyond the scope of Service Tax.

This is a very important point as it relates to a Constitutional clarification.’ Various courts have clarified this point in many cases.

3.02 The reason for this is the Constitution of India gives powers to the Parliament and to the Legislatures of the States to charge tax on various things/ subjects.

Article 246 enumerates the powers and Lists I, II and in Schedule VII to the Constitution enumerate various matters. List I is a Union List, List II is a State List and List III is a Concurrent List.

We are at present concerned with List-I and List-Il.

3.03 In List-I

For Service Tax there is a specific Entry 92C – Taxes on Services – inserted by 95th Amendment Bill, 2003 (to be called 88th Amendment Act, 2003) and passed by Lok Sabha on 6-5-2003 and Rajya Sabha on 5-5-2003.

But this has not been made yet effective.

Entry-97 is a residuary entry and presently Service Tax is covered by this. This reads as :

97. Any other matter not enumerated in List 11or List III including any tax not mentioned in either of those Lists.

3.04 In List-II – State List

Entry 54 reads:

Taxes on the sale or purchase of goods other than newspapers, subject to the provisions of Entry 92A of List I.

(92A in List-I, is for taxes on Sale or Purchase in the interstate trade.)

3.05 Sale of Goods is a State subject and goods which are subjected to State Sales Tax/VAT cannot be subjected to Union tax – i.e., Service Tax in the present case.

There have been many instances where both the Union and the State claim the taxes. There are instances of transactions of multiple taxing events. In all such questions as to whether both the taxes are applicable to the same event, various courts of law including the Supreme Court, have clarified that there cannot be a double taxation on the same thing. This is evident from the following decided cases on the subject.

3.06 Held in International Tourist Corporation v. State of Haryana, AIR 1981 SC 774; (1981) 2 SCC 319 – that:

Before exclusive legislative competence can be claimed for Parliament by resort to the residuary power, legislative incompetence of the State Legislature must be clearly established. Entry 97 itself is specific in that a matter can be brought under that Entry only if it is not enumerated in List 11or List and in the case of a tax, if it is not mentioned in either of those lists.

3.07 In State of West Bengal v. Kesoram Industries Ltd., 266 ITR 721 (SC 5-Member Constitution Bench 4 v. 1 judgment), it was held that:

Measure of tax is not determinative of its essential character. The same transaction may involve two or more taxable events in its different aspects. Merely because the aspects overlap, such overlapping does not detract from the distinctiveness of the aspects. Two aspects of the same transaction can be utilised by two Legislatures for two levies which may be taxes or fees.

3.08 It was held in – Builders’ Association of India v. UOI, 73 STC 370 (SC 5-Member Constitution Bench) that:

After the 46th Amendment, works contract which was indivisible one is by a legal fiction altered into one for sale of goods and the other for supply of labour and services. After 46th Amendment, it has become possible for States to levy tax on value of goods involved in a works contract in the way in which sales tax was leviable on the price of goods and materials supplied in a building contract which had been entered into two distinct and separate parts. (Really, in the observation ‘an indivisible works contract, is by a legal fiction altered into one for sale of goods and the other for supply of labour and services’, the second part is obiter, since the 46th Amendment does not provide that other part will be deemed for supply of labour and services).

Article 366(29A) provides for ‘deemed sale of goods’ and not ‘deemed provision of service’.

3.09 In Godfrey Philips India Ltd. v. State of Up, 139 STC 537 (SC 5-Member Constitution Bench), it was observed as follows :

The Indian Constitution is unique in that it contains an exhaustive enumeration and division of legislative powers of taxation between the Centre and the States. This mutual exclusivity is reflected in Article 246(1).

3.10 In Kerala Agro Machinery Corpn. v. CCE, (2007) (CESTAT),a strong prima facie view is expressed that when sales tax is paid on a transaction, service tax will not be payable.

3.11 In the Shorter Constitution of India, Dr. Durga Das Basu, while commenting on Union’s and State’s powers and Entries in Schedule VII :

Scope of legislative (fiscal) power under Schedule VII – at Page 1693 of 14th edition 2009, – stated that:

There can be no overlapping in the field of taxation. A tax if specifically provided for under one legislative entry, effectively narrows the fields of taxation available under other related entries. It is also natural when considering the ambit of an express power in relation to an unspecified residuary power, to give a broad interpretation to the former at the expense of the latter.

i) Godfrey Phillips India Ltd., v. State of U.P., (2005) 2 SCC 515, 544-45 (Para 59); AIR 2005 SC 1103.

3.12 Further on commenting on – Scope of the residuary power – at Page 2367 of 14th edition 2009 it is stated that:

3) Where the competition is between an Entry in list II and Entry 97 in list I, the latter cannot be so expansively interpreted as to whittle down the power of the State Legislature.

International Tourist Corpn. v. State of Haryana, AIR 1981 SC 774 (Para 7) 1981 (2) SCR 364

On the other hand, the Entry in the State list must be given a broad and plentiful interpretation.

International Tourist Corpn. v. State of Haryana, AIR 1981 SC 774 (Para 7) 1981 (2) SCR 364

5) Being aware of the dangers of allowing the residuary powers of Parliament under Entry 97 of List I of the Seventh Schedule to swamp the legislative entries in the State List, the Supreme Court interpreted Entry 54 of List II, together with Art.366 (29A) of the Constitution, without whittling down the interpretation by referring to the residuary provision.

Bharat Sanchar Nigam Ltd. v. Union of India, (2006) 3 SCC I, 40 (Para 82).

3.13 It is held in Imagic Creative Pvt. Ltd. v. Commissioner of Commercial Taxes, (2008) 12 STT 392 (SC) that:

The Court must also bear in mind that where the application of a Parliamentary and a legislative Act comes up for consideration, endeavours shall be made to see that provisions of both the Acts are made applicable (Para 27).

Payments of Service Tax as also VAT are mutually exclusive. Therefore, they should be held to be applicable having regard to the respective parameters of Service Tax and sales tax as envisaged in a composite contract as contradistinguished from an indivisible contract. It may consist of different elements providing for attracting different nature of levy. It was, therefore difficult to hold that in a case of instant nature, sales tax would be payable on the value of the entire contract, irrespective of the element of service provided – the approach of the assessing authority, thus, appeared to be correct. (Para 28)

4.0 What is value chargeable to Service Tax, if applicable?

4.01 S. 67 of the Finance Act, 1994 contains provisions for valuation of service for charging Service Tax and Rule 3 of the Valuation Rules provides Manner of determination of value of taxable service.

4.02 There are instances when some services are provided free of cost. The courts of law have held that no service Tax can be charged for free services.

i) Bharati Cellular Ltd. v. CCE, (2205) 1 STT 73 (CESTAT)

ii) Kamal & Co. v. CCE, (2007) 10 SIT 481 (CESTAT 5MB)

4.03 Indus Motor Company v. CCE, (2008) 12 SIT 112 is a case very similar to the present one. Free service provided to automobiles by authorised service station (presumably at the time of sale) for which no payment is received from anyone and when its price is included in sale price of vehicle, it cannot be subjected to Service Tax.

4.04 In Chandravadan Desai v. CCE, (2007) 11SIT 326 (CESTAT), the assessee who was a stockbroker did not charge brokerage in respect of certain transactions, it was held that S. 67 does not have any deeming provision and hence Service Tax is not levi-able.

4.05 The discussion in Builders’ Association of India v. UOI, 73 STC 370 (SC 5-Member Constitution Bench) is also relevant and is given in Point No. 3.08 above.

4.06 Very important observations are made by the Supreme Court in the case of Bharat Sanchar Nigam Ltd. v. Union of India, (2006) 3 SCC 1.

The Court observed that the definition of the word Sale in Article 366(12) was not altered and hence the same has to be understood as under the Sale of Goods Act, 1930.

Further, important test laid down by the Court in deciding a composite contract not covered by Article 366(29A), that the ‘dominant nature test’ continues to be applied.

The Court observed that after 46th Amendment to the Constitution, only 3 specific situations were chosen from several composite transactions which involve service as well as sale and out of those 3, only works contract and catering contract involve both the elements of service and sale. Therefore except these, no other sale was contemplated to be covered or bifurcated.

In para 46 it observed that:

“the test therefore for composite contracts other than those mentioned in Article 366(29A) continues to be – did the parties have in mind or intend separate rights arising out of the sale of goods. If there was no such intention, there is no sale even if the contract could be disintegrated. The test for deciding whether a contract falls into one category or the other is as to what is ‘the substance of the contract.’ We will, for want of a better phrase, call this the dominant nature test.”

In view of the above test, it can well be concluded that unless the transaction in reality contemplated two distinct contracts, a composite contract cannot be bifurcated for levy of Service Tax. One has to go by the substance of the agreement in the transaction.

5.0 Facts from the Software Sale Agreement:

5.01 The software seller normally enters into an agreement with the buyer and various terms and conditions are specified and executed by the buyer and the seller.

5.02 The Terms of Agreement normally grant a licence to use the software and the vendor thereby grants to the buyer a licence to use the said product or licensed material.

5.03 Further, there are clauses which enumerate free services provided like :

Installation of product and it normally states that the vendor undertakes to provide on-site training of the software only to the specified staff of the buyer.

The vendor also normally carries out some modifications or customisation and also takes up

Pre-installation. Requirement/GAP analysis study, conducted by vendor.
Data migration from all earlier software.
Pre- and post-installation system audits.

All the above come as an inbuilt and inseparable part of the product and necessarily required with the software and are free of cost/charge for the same. The price paid is for the licence/right to use the software.

In many cases e.g., in case of a Tally software, installation is done by the representative of the vendor and other stages i.e., migration of the data and system audit, etc. are done and carried out by the buyer at his own cost. Even if the same is arranged by the vendor, the cost is paid for the buyer to a third party and nothing is paid to the vendor.

6.0 Conclusion:

Considering all the relevant facts, and the law as discussed here in above, and relying and based on the same as mentioned above, we reach the conclusion that:

6.01 In case of the manufacturer / developer, he sells the right to use of the software.

However in case of the software dealer the position is slightly different. The software is not developed by him, but he has got the rights to sale/market/ deployment of the licence/right to use.

Except this, there is no difference between the two. It is permitted to make only minor modifications to the extent of incorporating the name, etc. as per the specific requirements/parameters of the purchaser, without changing any basic structure of the software.

The vendor is also in some cases, making requirement/GAP analysis study, data migration from all earlier software, and arranging pre- and post-installation system audit, which are either free of cost or included in the software price itself, except in case of system audit. This is normally required to be carried out by an independent third party and is paid separately by the buyer to the third party.

6.02 It is evident that the sale involves both a Sale and a Service. The grant of licence is a right to use the software, with a legal right of possession and effective control, allowing another person (purchaser) to use the goods (software).

This is done by copying the original software and then given possession and control to the buyer. The moment this is copied for Sale, it becomes goods, as defined by the Supreme Court of India.

Hence, this is a Sale of Goods under Article 366(12) of the Constitution of India, Entry C-39 of Schedules to the MVAT Act, 2002 and consequently MVAT is chargeable on sale price of the same. The position for the developer of the software and the dealer is the same.

This portion being in List-Il, i.e., State List of Schedule VII to the Constitution of India, cannot be subjected to Service Tax.

6.03 The items mentioned in Point No. 5.03 may be covered and subjected to Service Tax, if any consideration for the service is received separately in any manner.

Normally the pre-installation, installation, modifications and successful commencement of use of software, etc. are provided free of cost.

As held by the Supreme Court (para 4.06) the dominant intention of parties is to buy and sell. Hence, the sale price cannot be disintegrated for the purpose of Service Tax.

Hence, in my opinion these are not chargeable to Service Tax.

Hence, under the State Vat, the position is now amply clear.

But, there has to be suitable amendment in the Valuation Rules and a basic clarification in the definition and the scope of the service, to tax services part only under the Service Tax and not the goods part, as this is not permitted under the Constitution of India.

Nirav Shah

Changing of law through issuance of circulars ! ! !

Introduction :

Till today the law on the subject of repairing and maintenance of roads and other infrastructural facilities was clear in the minds of all stakeholders (barring a few service tax commissionerates).

There was this discussion that maintenance and/or repairing of roads may be a taxable activity, but a conclusive view came across from most corners that no such taxing is possible because the law itself was clear enough.

This view was based on a sound principle of law which says that if a service activity is specifically excluded from the purview of taxation from one service category, it cannot be included in some other category unless and until specific inclusion thereof is provided for it in that Section.

The Central Board of Excise and Customs (CBEC) has now come up with a Circular No. 110/2009, dated 23.02.2009 clarifying the doubts in respect of levy of service tax on repair/renovation/widening of roads.

The Circular has tried to give extra-judicial meaning to 2 sections involved :

1. Commercial or industrial construction service [Section 65(105) (zzq)]

2. Management, maintenance or repair service [Section 65(105) (zzg)].

Legislative Background :

I. Commercial or Industrial Construction Service :

As per Section 65(25b) of the Finance Act, 1994 (Act), ‘Commercial or industrial construction service’ means —

(a) construction of a new building or a civil structure or a part thereof; or

(b) construction of pipeline or conduit; or

(c) completion and finishing services such as glazing, plastering, painting, floor and wall tiling, wall covering and wall papering, wood and metal joinery and carpentry, fencing and railing, construction of swimming pools, acoustic applications or fittings and other similar services, in relation to building or civil structure; or

(d) repair, alteration, renovation or restoration of, or similar services in relation to, building or civil structure, pipeline or conduit,

which is —

(i) used, or to be used, primarily for; or

(ii) occupied, or to be occupied, primarily with; or

(iii) engaged, or to be engaged, primarily in,

commerce or industry, or work intended for commerce or industry, but does not include such services provided in respect of roads, airports, railways, transport terminals, bridges, tunnels and dams;

The above defining Section clearly spells out that all kinds of repairing, alteration, renovation, restoration or similar services provided in relation to any infrastructural facilities including roads is completely non-taxable. Therefore it can be safely said that there was and still exists a specific exclusion from charging of service tax on repairing and related services in respect of roads.

II. Management, Maintenance or Repair Service :

As per section 65 (64) of the Act,

“management, maintenance or repair service means any service provided by —

(i) any person under a contract or an agreement; or

(ii) a manufacturer or any person authorised by him,

in relation to,

(a) management of properties, whether immovable or not;

(b) maintenance or repair of properties, whether immovable or not; or

[Explanation : For the removal of doubts, it is hereby declared that for the purposes of this clause, —

(a) ‘goods’ includes computer software;

(b) ‘properties’ includes information technology software;]

This section puts in place a charge on management, maintenance or repair services in relation to all movable and immovable goods and properties. This Section was first amended w.e.f. 16.06.2005 to include maintenance services in respect of immovable properties and it was further amended from 1.05.2006 to include repairing services therein also.

Legal Importance of circular :

It is an accepted rule of law that an Act passed by the Parliament is supreme in authority and its provisions cannot be re-defined by issuance of Circulars. Circulars can only be guides to law and law cannot be re-defined by these instruments. Many Circulars have been struck down by Courts. In the case of Commissioner of Sales Tax vs. Indra Industries, (2001) 248 ITR 338 (SC), the apex court has opined that,

“A Circular by tax authorities is not binding on the Courts. It is not binding on the assessee.”

Hence Circulars at best are instruments in the hands of administrators to clear doubts where they exist, but unfortunately these are being used to create doubts where none exist.

Defining the Circular

Circular no. 110 is issued in response to clarification sought by the Nashik Commissionerate on the issue. The Circular has tried to clarify 2 issues —

a. Whether management, maintenance or repairs of roads is taxable under similar service head or not.

b. Segregation of activities in relation to roads into 2 distinct heads as under :

i. Maintenance & repair activities

1. Resurfacing

2. Renovation

3. Strengthening

4. Relaying

5. Filling of potholes

ii. Construction Activities

1. Laying of a new road

2. Widening of narrow road to broader road (such as conversion of a two-lane road to a four-lane road)

3. Changing road surface (gravelled road to metalled road/metalled road to black-topped/blacktopped to concrete, etc.).

In simple language, as per this Circular all activities of management, maintenance or repairing in respect of roads will be taxable with retrospective effect at least from 1.05.2006 if not earlier. It has tried to define what activities are classifiable as Maintenance or Repair services and what can be defined as Construction. As there is no legal standing of the Circulars, its impact cannot be retrospective in nature.

If we believe this Circular to be sacrosanct, then at least from 1.05.2006 all jobs of resurfacing, renovation, strengthening, relaying or filling of potholes in respect of roads will become taxable.

This can be stretched to mean that if a road is constructed once – all relaying work done on it for as many years to come – would be a taxable activity given that the quality of surface of the road is not changed from gravelled road to metalled road/metalled road to blacktopped/blacktopped to concrete, etc.

Mistake of Omission:

The Circular fails to recognise one important sub-clause of section 65 (25b) of the Act.

As explained earlier, this Section defines the words “Commercial or Industrial Construction” – wherein sub-clause (d) of Section 65 (25b) clearly includes all kinds of repair, alteration, renovation, restoration or similar services. Thereby meaning that repairs is also a sort of Construction.

The definition further has an the exclusion clause which says that,

“but does not include such services provided in respect of roads, airports, railways, transport terminals, bridges, tunnels and dams.]”

The words “Such services” – refer to sub-clause 65 (25b) (a) to (d) – which means that all repairing, renovation, etc., jobs in relation to roads are NOT TAXABLE at all.

Why was this clause not referred to before issuance of the impugned Circular is a question that only the Board can answer. It is clear that they have not considered this sub-clause and this mistake of omission would give birth to serious litigation issues for the infrastructure sector as a whole.

Conclusion:

As far as repairing jobs of roads, etc., is concerned there was no iota of doubt in the legislative intent, because infrastructure is the need of the day and upkeep of the infrastructural facilities is a core area in which the Government is working hard. Unfortunately this Circular may undo all the good intentions of law.

It is not as if the law is silent on the issue. On the contrary, the law is crystal clear and specifically excludes all kinds of repair jobs done in respect of all infrastructural facilities like roads, airports, railways, transport terminals, bridges, tunnels and dams as explained above.

This Circular must be withdrawn with immediate effect and all efforts must be taken by all stake-holders to force the Central Government into withdrawing it. The Circular, in any case according to me, is Void-ab-initio and will not stand the scrutiny of Tribunals and courts in the long run. But till that happens, it would have played the mischief it is intended to. The litigation-creating potential of this Circular is immense and immediate.

This Circular would proverbially open a Pandora’s box for the maintenance and repairing of infrastructural facilities sector as a whole, because the logic of this circular, if accepted, would mean that similar services in relation to infrastructural facilities other that roads -like airports, tunnels, dams, etc., – will also be taxable and that too retrospectively.

This Circular has all the right ingredients to do all the wrong things !

Nirav Shah

Recent issues in FDI Policy

Article

1. Introduction :

1.1 The Foreign
Direct Investment (‘FDI’) Policy has always been a contentious issue. Recently
in an attempt to simplify the FDI Policy, the Department of Industrial Policy &
Promotion (DIPP), Ministry of Commerce & Industry, has issued 3 Press Notes — PN
2 of 2009, 3 of 2009 and 4 of 2009.

1.2 Press Note
2 of 2009 seeks to bring in clarity, uniformity, consistency and homogeneity
into the methodology of calculation of the direct and indirect foreign
investment in Indian companies across sectors/activities. Press Note 3 of
2009 gives guidelines for transfer of ownership and control of Indian
companies from resident Indians to non-resident entities. Press Note 4 of 2009
lays down the policy for downstream investment by Indian companies.

1.3 Whether these
Press Notes clear the confusion or add more fuel to the fire is anyone’s guess.
This Article seeks to explain the issues which emerge as a result of this new
Policy stance adopted by the Government.

2.

Indirect Foreign Ownership
(Press Note 2 of 2009) :

2.1 Any
non-resident investment in an Indian company is FDI. However, if the domestic
investment by resident Indian entities, which have invested in the Indian
company, comprise non-resident investment, then the Indian company would have
indirect foreign investment as well. Till recently the FIPB reckoned such
indirect foreign investment on a proportionate basis in several sectors such as
telecom. For example, an Indian telecom company had 36% FDI and 64% domestic
investment and if the domestic investor had 50% FDI in it, then the indirect
foreign equity in the telecom company was 32% and the total foreign investment,
direct and indirect was 68%.

2.2

New method of calculating
foreign investment in an Indian company :

2.2.1 All
investments made directly by a Non-resident Entity into an Indian company would
be treated as Foreign Direct Investment.

2.2.2 For
reckoning the indirect foreign investment, the important factors would be the
ownership and control of the Indian investing companies. Any foreign investment
by an investing Indian company which is ‘owned and controlled’ by
resident Indian citizens and/or by Indian companies which are in turn owned and
controlled by Resident Indian citizens, would not be considered for calculation
of ‘indirect foreign investment’. Such investment would be treated as
pure domestic investment. The previous provisions (PN 7 of 2008) for
investing companies in infrastructure and service sector and the proportionate
method computation have now been deleted.

Let us understand
the meaning of the terms ‘owned’ and ‘controlled’ :

Owned :

An Indian company
would be considered as ‘owned’ by resident Indian citizens and Indian
companies if more than 50% of the equity interest in the Indian company
is beneficially owned

by resident
Indian citizens, or
by Indian
companies which are owned and controlled ultimately by resident Indian
citizens.

Controlled :

An Indian company would be
considered as
‘controlled’ by resident
Indian citizens
and Indian companies (which are owned and controlled ultimately by resident
Indian citizens) if the resident Indian citizens and Indian companies (which are
owned and controlled ultimately by resident Indian citizens) have the
power to appoint a
majority of its directors.

For example, in
Bharti Airtel, SingTel of Singapore owns a 31% stake, of which only 15.8% is
direct and the balance is through its investment in Bharti Telecom which owns
45% of Bharti Airtel. As per the new norms, only 15.8% would be treated as
SingTel’s foreign ownership in Bharti Airtel, since Bharti Telecom is a company
owned and controlled by Indians and hence, its entire investment in Bharti
Airtel is treated as a domestic investment.

2.2.4 If the
investing Indian company’s ownership and control is not directly/indirectly by a
Resident Indian Citizen, the entire investment by such company would be
considered as indirect foreign investment. For example, A Ltd. which is owned
and controlled by an NRI, has invested 40% in B Ltd. The indirect foreign
investment in B Ltd. is 40%.

An exception has
been provided for in the case of downstream investments in a wholly-owned
subsidiary of operating-cum-investing/investing companies. In such a case,
the indirect foreign investment will be limited to the foreign investment in the
operating-cum-investing/investing company. Thus, A Ltd., which is an
operating-cum-investing company has 74% FDI and if it sets up a 100% subsidiary,
B Ltd., then B Ltd., will be treated as having 74% indirect foreign investment.

The
above-mentioned methodology for computation of foreign investment does not apply
to sectors which are governed specifically by a separate statute, such as the
insurance sector. The methodology specified therein would continue.

2.2.5 The Press Note also treats foreign investment as including all FDI, FII investment (as on 31st March), FCCB, NRI/ ADR/GDR investment/Convertible Preference Shares/Convertible Debentures, etc.

2.2.6 In the case of all sectors which require FIPB approval, any shareholders’ agreement which has an effect on appointment of directors, veto rights, affirmative votes, etc., would have to be filed with the FIPB at the time of seeking approval. It will consider all such clauses and would decide whether the investor has ownership and control due to them.

2.2.7 Issues:

The recent Press Note has thrown up several issues:

(a) It is necessary to note that an Indian company must be both owned and controlled by Indian citizens. If either condition is violated, then its investment would be treated as indirect foreign investment.

(b) For determining the foreign ownership of an Indian company it should have more than 50% foreign ownership. What happens in a situation where the Indian and the foreign partner have an equal (50 : 50) stake? In several Indian JVs, the foreign partner desires one golden share (over 50%) to enable consolidation with his foreign company. If such a JV makes a down-stream investment in any company, then the entire investment would now be treated as in-direct foreign investment.

(c) For determining the foreign control, it only needs to be seen whether the foreign entity has power to appoint majority of directors. It does not address the other ways in which control can be exercised, e.g., veto rights, affirmative votes, shareholders’ agreement. In sectors where the FDI is subject to Government approval, the Indian company will need to disclose to the FIPB the details of inierse shareholder agreements which have an effect on the appointment of the Board of Directors, differential voting rights and such other matters. But a similar treatment has not been extended to the indirect foreign investment. A majority of the private equity deals have a host of special investor rights, but may not necessarily have a majority of the Board seats.

(d) What would happen if an Indian investing company with 49% FDI and which is owned and controlled by Indian citizens, invests 26% in an NBFC which already has 51% FDI? Under the new norms, 26% investment would be treated as domestic investment and hence, the NBFC would not have to comply with the minimum capitalisation norms applicable to an NBFC which has more than 75% FDI.

(e) What if the Indian investing company, which has 49% FDI and which is owned and controlled by Indian citizens, invests in a sector for which FDI is prohibited, e.g., lottery business? Sectors such as retail trading, real estate, information, defence, avaiation, etc., are expected to benefit from this Press Note. We may soon have a case where several foreign retail players may try to invest in multi-brand retailing via the indirect foreign ownership method. As per press reports, the RBI has objected to this Press Note.

(f) FII investment has been treated as foreign investment. However, to consider the same, one has to ascertain the limits as on 31st March. If one looks at the FII activity after 31st March, 2008 there are only withdrawals. Hence, even though the current position is drastically different from what it was on 31st March, 2008, yet one is required to consider the FITinvestment level as on 31st March, 2008. This provision would create a lot of problems. Further, clubbing ADR/GDR holding with foreign shareholding is also a vexed issue. The voting on ADR/GDR is by the custodian of the shares. How the custodian would vote is generally not specified. There are a few cases where it is specified in the pro-spectus. But generally, it is left open. Interestingly, Cl. 40A of the Listing Agreement, while computing the public shareholding in a listed company, excludes shares which are held by custodians and against which depository receipts are issued overseas. The logic being that the custodian would vote in unison with the promoter. If that be the case under the Listing Agreement, then the stand taken by the FIPB is diagonally opposite, i.e., the custodian would vote in unison with the foreign receipt owners.

(g) Special investor rights are the norm in the case of private equity deals and hence, if PE deals are to be done in sectors requiring FIPB approval, then the Shareholders’ Agreement would have to be filed with the FIPB. Thus, if any courier company (where FIPB approval is required) wants to get PE funding, it would also have to get the Shareholders’ Agreement approved by the FIPB. Thus, the regulator would now exercise quasi-judicial functions. This amendment is truly amazing.

3. Transfer of Ownership & Control of Indian Companies from Resident Indian Citizens to Non-Resident Entities (Press Note 3 of 2009) :

3.1 The DIPP has issued new guidelines in respect of transfers of shares in all sectors where the FIPB approval is required or sectors which have caps of FDI. These include sectors, such as defence, air transport, ground handling, asset reconstruction, private sector banking, broadcasting, commodity exchanges, credit information companies, insurance, print media, telecom and satellites.

3.2 In all such sectors, Govemment/FIPB approval would be required in the following cases:
(a) If an Indian company is being established with foreign investment and is owned or controlled by a non-resident entity, or

(b) The ownership or control of an existing Indian company, owned or controlled directly or indirectly by resident Indian citizens, is being transferred to a non-resident entity as a consequence of transfer of shares to NREs through amalgamation, merger, acquisition, etc.

3.3 The guidelines will not apply to sectors where there are no foreign investment caps, i.e., 100% foreign investment is permitted under the automatic route.

3.4 Issues:

(a) Press Note 4 of 2006 had earlier put all transfers of shares from residents to non-residents on the automatic route, including in financial services sectors, or cases where the Takeover Regulations were attracted. It is intriguing that after a period of 3 years, the Government has decided to take a step backwards and put transfers in certain sectors on the approval route. When on the one hand, the RBI is taking measures for liberalisation of the FEMA, the FIPB on the other hand has taken us back to the approval raj.

(b) The FIPB’s approval would be required even

in cases of Court-approved mergers, demergers, etc. This has increased the number of authorities whose permission would be required for a merger. Thus, if a listed company in the telecom field decides to merge with another listed company which has more than 50% foreign investment, then consider the number of approvals it would require – the High Court, BSE/NSE (under Cl. 24 of the Listing Agreement) and now the FIPB.

The FIPB’s approval would be required even for cases of acquisition of shares. This would even delay the process for takeover of listed companies. A takeover, in a sector requiring FIPB approval for FDI, which attracts the SEBI Takeover Regulations, requires the clearance of SEBI, prior approval of the RBI and now also the approval of FIPB. Thus, this step is going to increase the time it takes for corporate re-structuring.

4. Downstream Investments in Indian Companies (Press Note 4 of 2009) :

4.1 The last of the Press Notes aimed at simplifying the Rules is Press Note 4. This deals with down-stream investments by Indian companies. Down-stream investment, which refers to indirect foreign investment by one Indian company in another, was hitherto governed by Press Note 9 of 1999. This dealt with any downstream investmentby aforeignowned Indian holding company. FDI in such cases required prior FIPB approval. Recently, FIPB had taken an interesting stance that downstream investment on an automatic route was permitted only for pure investment companies and not by operating-cum-investment companies, those which have their own operations in economic activities and desired to invest in another Indian company. FIPB’s view was that this tantamounted to a change in status from operating to operating-cum-investment company and hence, required prior FIPB approval. Several renowned corp orates such as JSW Energy Ltd., Aditya Birla Nuvo Ltd., etc. were pulled up for getting FDI and making downstream investments without FIPB approval. FIPB allowed restrospective clearance subject to compounding of penalties with the RBI under FEMA. In some cases, the foreign investment was as low as 1% and yet FIPB treated it as a violation of Press Note 9 of 1999. Thus, this was one area where there was a lot of ambiguity.

4.2 Operating Companies :

The new norms state that foreign investments in operating companies would fall under the automatic approval route wherein the investing companies would have to comply with the relevant sectoral conditions on entry route, conditionalities and caps with regard to the sectors in which such companies are operating.

4.3 Operating-cum-Investing Companies:

Foreign Investments in operating-cum-investing companies would fall under the Automatic Route as explained above. Further, the Operating-cum-investing company which is making the downstream investment into the Indian Company would have to comply with the relevant sectoral caps and conditionalities which are applicable to the investee company. Thus, if Hindustan Unilever Ltd., which is a foreign-owned company, desires to invest in a retail trading company, then it would become an operating-cum-investment company and its downstream investment would need to comply with the conditions applicable to FDI in retail trading.

4.4 Investing Companies :

Foreign investments in purely Investing Companies would require FIPB approval, regardless of the extent of foreign investment. Further, as and when such Investing Companies make downstream investments in Indian companies, they would have to comply with the relevant sectoral caps and conditionalities. However, such downstream investments cannot be made for the purposes of trading of the underlying securities. The FIPB approval would be required regardless of the amount of foreign investment in such an investing company.

4.5 Shell Company :

Foreign investments into companies which are currently neither carrying on any operations nor do have any investment activities, would require FIPB approval regardless of the extent of the foreign investment. Further if and when such shell companies commence any operating/investing activity, the relevant conditionalities as explained above would have to be complied with.

4.6 Additional Conditions :

In case of Operating-cum-Investing Companies and Investing Companies, certain additional conditions have to be complied with, such as giving an intimation to FIPB regarding the downstream investment within 30 days of such investment, compliance with the Pricing Guidelines as prescribed by SEBI, etc. Further, in order to make the downstream investment, the funds must be brought in from abroad only and not borrowed domestically.

5. Conclusion:

5.1 Although Government has a noble intention of simplifying the FDI policy, it may have unwittingly opened up a few more pandora’s boxes. It has plugged a few leaks by creating new leaks. The days to come are likely to throw up new issues in respect of these Press Notes and in some of the cases, the remedy may be more serious than the ailment. One hopes that the FIPB addresses these issues and comes out with a clearer and unambiguous policy. One is reminded of the US author, Kerry Thornley’s words:

“What we imagine as Order is merely the prevailing form of Chaos !”

Nirav Shah

The Finance (No. 2) Act, 2009

Nirav Shah

Order — Order passed without jurisdiction is nullity

New Page 1

Order — Order passed without jurisdiction is nullity

[ Chandrabhai K. Bhoir & Ors. v. Krishna Arjun Bhoir &
Ors., AIR 2009 SC 1645]

The question that arose for consideration was in respect of
application filed u/s.302 of the Indian Succession Act 1925.

One Mr. K. B. Mhatre executed a will on or about 1963, the
legatee whereunder are the respondents. On his expiry an application for grant
of probate in respect of the said will was filed by the respondents. The
appellant filed a caveat pursuant to which a suit was registered. In the said
suit a compromise was entered into by and between the parties. Subsequently
the appellant cancelled the said agreement. Thereafter pursuant to certain
orders passed by the Court in Chamber Summons the matter reached the Court by
appeal filed by the appellant. The appellant contended that the contract
between the parties could not be specifically enforced by the High Court while
exercising its testamentary jurisdiction.

The Court observed that the effect of termination of such
agreement entered into by and between the parties was required to be gone into
in an independent suit and not in a proceeding u/s.302 of the Act. The
testamentary Court in exercise of its jurisdiction u/s.302 of the Act cannot
enforce a contract qua
contract only because the executor is a party thereto.

The submission of the appellant that the decision of the
High Court constitutes res judicata cannot be accepted. Thus, the issue
did not attain finality. In view of the matter, an order passed without
jurisdiction would be a nullity. It will be a coram non judice. It is
non est in the eye of law. Principles of res judicata would not
apply to such cases.

As S. 302 of the Act was not attracted in the facts and
circumstances of this case, the principles of res judicata would also
not apply. If the agreement was not a part of the will, S. 302 will have no
application.

The testamentary Court must give effect to the will and not
an agreement by and between the Executor and the third party, which would be
contrary to the wishes of the testator.

The appeal was allowed. The order of High Court was set
aside.

levitra

Nirav Shah

Life of a professional

Article

When a C.A. professional is called upon to write about his
professional life, what comes uppermost in his mind is to draw up a Balance
Sheet of Life. We Chartered Accountants, who certify financial statements, which
include Balance Sheets of our client, try to give a ‘true and fair’ view of the
state of affairs of the organisation. People judge the health of the
organisation on the basis of our opinion. We should try to prepare Balance Sheet
of our Life to find out whether it gives a ‘true and fair’ view of our actions
in life.

One of our professional colleagues had once tried to state in
a journal as to how Balance Sheet of a professional should appear. This write up
appeared somewhat as under :

Balance sheet of a professional :

Liabilities

Assets

Capital

Fixed Assets

Character of Professional

Heart of Professional

Reserves and Surplus

Goodwill

Happiness in life

Soul of professional

Liabilities

Investment

Duties to the society

Your knowledge

Bank balance

Your mind

Accrued interest

Your patience

Accumulated losses

Your sorrows

One can summarise the Balance Sheet of Life in the above
manner.

The essence of C.A. profession :

A professional commands respect in the society because his
motto is ‘Pride of service in preference to personal gain’. He is described as
one who places public good above his personal gain. This is the reason why
Government, financial institutions and members of the public rely on a CA for
his expert advice. This reliance imposes a public interest responsibility on our
members, when they render services in the field of accounting, taxation or other
fields.

For the success of any professional, it is essential that
there is a strong base provided by the regulating body to which he is
answerable. The system of education, training and examination should be such
that he is able to command the respect and confidence of the members of the
society. The users of professional services require an assurance that the member
of the profession whose services are retained is (i) a person of character and
integrity and (ii) competent and knowledgeable to render professional services.

The character and integrity of a professional will depend on
his personal qualities. This will also be guided by the environment in which he
has taken his education and training as well as the environment in which he is
working. His position can be maintained and strengthened only if the regulating
professional body is able to guide and encourage its members to live upto the
high ethical and professional standards. The prestige and confidence enjoyed by
a professional, to a great extent, depends on the strictness and scrupulous
manner in which the professional code is implemented.

Bhagavad Geeta classifies castes (not communal) on the basis of different qualities and actions of a person. According to this classification a ‘Brahmana’, in whatever community the person is born, is one whose wisdom and knowledge is in his nature. Self-restraint, purity, uprightness and wisdom are the qualities of a ‘Brahmana’, It is for this reason that in the Indian Society all professionals, such as a CAs, lawyers, doctors, etc. are considered as Brahmanas. A C.A. professional does not own a business or industry but he does act as advisor of a businessman because of his study and knowledge. For this purpose, he has to keep himself updated in his knowledge as he is in constant touch with his client during his audit, tax and other assignment year after year. In other words, he has to be a student throughout his life.

Fundamental principles:

Our Institute has identified the following fundamental principles by which any professional should be governed in the conduct of his professional relations with others.

i) Integrity:

A professional should be straightforward, honest and sincere in rendering professional services.

ii) Objectivity:

A professional should be fair and should not allow prejudice or bias, conflict of interest or influence of others to override objectivity.

iii) Independence:

When in public practice, a professional should both be and appear to be independent. Integrity and independence are the most essential characteristics of any professional. Independence implies that the judgement of a person is not subordinate to the wishes or directions of another person who might have engaged him or to his own self interest.

iv) Confidentiality:

Information acquired in the course of his professional work has to be treated as most confidential. This should not be disclosed to anyone without specific authority of the client or unless it is required to be disclosed for compliance with legal or professional requirements.

v) Technical standards:

He must discharge his duties in accordance with the technical and professional standards relevant to the work assigned to him.

vi) Professional competence:

He must maintain high level of competence throughout his professional career. He should un-dertake only such work which he or his firm is competent to handle and complete within the given time frame.

vii) Ethical behaviour:

A professional should conduct himself in a manner consistent with the good reputation of the profession and refrain from any conduct which might bring discredit to the profession.

A professional who keeps the above seven principles before him and adopts them in his day-to-day practice can achieve great success in his professional practice. One may say it is difficult to adopt all these principles in the present day environment. However, if a professional wants to have peace of mind and get inner satisfaction of having served the society and the profession, he will have no option but to follow the path identified by the above principles.

Conduct in other fields:

Our Institute strives to maintain discipline amongst our members not only on matters relating to their professional conduct but also in relation to their conduct in other fields. It is for this reason that the Institute is given power to take disciplinary action against a member if he is found guilty of ‘Other Misconduct’. This is a very wide term. The Institute has, however, taken the view that a member of the profession is expected to maintain the highest standards of integrity in his personal conduct and any deviation from this high standard, even in personal affairs, would expose him to a disciplinary action.

A professional may be holding an office in a social or service organisation in his personal capacity. He may be a member, treasurer, secretary or chainman of such organisation. He may be an arbitrator, executor, liquidator or trustee in any trust, etc. in his personal capacity. In all such situations, his actions and decisions relating to financial, legal and other matters should be above board and he should not take any personal benefit in such capacity. This is because the society expects that a professional person will render service even in his personal capacity in the same manner as he renders his professional service.

When CA. Act was amended in 2006, Part IV was added in the First Schedule to provide that a CA., whether in practice or not, will be guilty of ‘Other Misconduct’ if he is held guilty by any Civil or Criminal Court of an offence which is punishable with imprisonment for a term not exceeding six months. It also provides that, if in the opinion of the Council, an action of any CA brings disrepute to the profession or the Institute, whether or not such action is related to his professional work, he will be held to be guilty of ‘other misconduct’.

Similarly, Part III has been added to the Second Schedule to provide that if a CA., whether in practice or not, is held guilty by any civil or criminal court for an offence which is punishable with imprisonment for a term exceeding six months, he shall be considered as guilty of ‘Other Misconduct’.

Ethics in profession:

The word ‘Ethics’ is defined to mean ‘moral principles, quality of practice, a system of moral principles, the morals of individual action or practice’. Accordingly, his behaviour towards his professional brothers and sisters, his employees, articled assistants, clients, users of his service and general public should be governed by the above ethical principles. His personal conduct in a capacity other than his professional work should also be governed by these ethical principles.

The C.A. Act and Regulations provide for the Code of Ethics. Our Institute also publishes literature on the subject from time to time. As stated earlier, certain fundamental principles have been identified. Some of the Do’s and Don’ts about ethical behaviour of a c.A. professional are listed as under:

i) Cannot engage in any business or occupation without the permission of the Council.

ii) Cannot enter into partnership or share fees with a non-professional. Recently some relaxations are made about sharing of fees/partnership with other designated professionals such as Company Secretaries, Cost Accountants, Advocates, etc.

iii) Cannot solicit professional work or advertise professional attainments, subject to certain exceptions.

iv) Cannot charge fees based on percentage/ contingency.

v) Cannot allow a member who is not in practice or not his partner to sign financial statements or audit opinion on his behalf or on behalf of his firm.

vi) Cannot disclose information acquired during the course of his professional or other engage-ment without the client’s permission.

vii) Cannot express opinion on financial statements of an enterprise in which he or his relatives have substantial interest. This restriction also applies if his firm or a partner of the firm has substantial interest in the enterprise.

viii) Performs professional duties without due diligence or is grossly negligent while performing his duties.

ix) Cannot keep client’s money without opening separate bank account.

x) Contravences any of the provision of the CA Act, Regulations and directions of the Council of ICAI.

Some quotations:

It may be useful to refer to two quotations of eminent personalities about how one should conduct oneself in life.

i) Oscar Wilde has said about Meanings as under:

Standing for what you believe in,
Regardless of the odds against you,
and the pressure that tears at your resistance,

… means courage

Keeping a smile on your face,
when inside you feel like dying,
For the sake of supporting others,

… means strength

Stopping at nothing,
And doing what’s in your heart
You know is right,

… means determination

Doing more than is expected,
To make another’s life a little more bearable,
Without uttering a single complaint,

… means compassion

Helping a friend in need,
No matter the time or effort,
To the best of your ability,

… means loyalty

Giving more than you have,
And expecting nothing
But nothing in return,

… means selflessness

Holding your head high
And being the best you know you can be
When life seems to fall apart at your feet,
Facing each difficulty with the confidence
That time will bring you better tomorrows
And never giving up,

… means confidence.

ii) Late Shri 1.R.D. Tata on Guiding Principles:

Nothing worthwhile is ever achieved with-out deep thought and hard-work.

One must think for oneself and never accept at their face value slogans and catch phrases to which, unfortunately, our people are too easily susceptible.

One must forever strive for excellence or even perfection, in any task however small, and never be satisfied with the second best.

No success or achievement in material terms is worthwhile unless it serves the need or interests of the country and its people and is achieved by fair and honest means.

Good human relations not only bring great personal rewards but are essential to the success of any enterprise.

A true professional:

Late Shri Nani A. Palkhiwala has explained as to who can be called a True Professional, as under:

First a man must have the courage of his convictions.
He must not be coward.
He must honestly believe certain things and he must say publicity what he believes privately.
Secondly he must have integrity

-Not only financial integrity

But

– Intellectual integrity also.

He must have intellectual honesty which makes him say what he believes to be right.
So, if a Chartered Accountant or a Lawyer has intellectual integrity, he will never give an opinion merely to suit the client.
The professional man must have that ideal before him, when he advises his clients.
Lastly, humility is just as important as courage and intellectual integrity.

The higher the man goes in life the humbler he should-be.

In this context a Bhajan by Narsingh Mehta is most appropriate.

Vaishnav Jan :

– Who is vaishnav – A person who is nearer to Lord Vishnu.

– He who knows difficulties of others.

– He who will help the needy person but will not boast about the same.

– He who is humble to all and will never speak ill of others.

– He who is upright in his

– Speech

– Hearing others

– Mind

– He who will always speak truth.

– He who will never touch monies belonging to others.

– He who is never greedy.

– He who is detached and never angry.

If a person can imbibe these qualifies of a true vaishnav he can be a ‘true professional’.

In this article an attempt has been made to explain what qualities a professional has to have in his life.

When a person wants to choose his career and take a decision whether to join a business or profession, he should be ready to make a sacrifice if he selects to join a profession. He will have to keep in mind that motto of a profession is ‘Pride of Service in preference to personal gain’. He has to place public good above his personal gain. He cannot mix profession with business as there will be conflict of interest. As stated earlier, a professional has to keep the fundamental principles enunciated by professional bodies uppermost in his mind while performing his duties. He has to follow these principles even in his personal actions not connected with his professional duties. In short, he has to act as a ‘Vaishnav’ to be a true professional. He has to draw up Balance Sheet of his life at periodical intervals and determine whether it gives a ‘true and fair view’ of his behaviour and actions.

Nirav Shah

Medical services — State cannot avoid its constitutional obligation to provide medical services on account of financial constraints — Constitution of India, Art : 47.

New Page 1

Medical services — State cannot avoid its constitutional
obligation to provide medical services on account of financial constraints —
Constitution of India, Art : 47.

[ B. Krishna Bhat v. State of Karnataka & Ors., AIR
2009 (NOC) 1787 (Kar.)]

Maintenance and improvement of public health is joint
obligation of Central as well as State for which they have to provide medical
services. State cannot avoid its constitutional obligation in that regard on
account of financial constraints. Govt. hospitals or public hospitals (run by
local authorities) are ill-equipped as they lack infrastructure both in terms
of buildings, medical equipments, adequate drugs, etc., and adequate manpower.
It is irrational, unjustifiable, unethical, unhygienic and antisocial to plan
a slum colony inside a hospital. All efforts to curb corruption in hospitals
be made. The Court suggests facilities required to be provided in hospital.

Nirav Shah

Liability for delayed delivery by post office : Post Office Act 1898 S. 6.

New Page 1

Liability for delayed delivery by post office : Post Office
Act 1898 S. 6.

[Branch Post Master, Village & Post Jaipur PS Bhagwanpur
& Ors., v. Chandra Shekhar Pandey, AIR 2009 (NOC) 1670 (NCC)]

The Post Office was held liable to pay compensation of
Rs.25,000 for delay in delivery of the letter. The plea taken that addressee
was not found available on given address was not accepted as there was no
endorsement on day-to-day basis on the envelope about non-availability of the
addressee. It was held to be a clear case of negligence.

levitra

Nirav Shah

Power of attorney executed by owner of property for executing sale : Such power of attorney cannot be treated as conveyance for consideration for the purpose of stamp duty : Stamp Act 1899, and Power of Attorney Act, 2(21).

New Page 1

Power of attorney executed by owner of property for
executing sale : Such power of attorney cannot be treated as conveyance for
consideration for the purpose of stamp duty : Stamp Act 1899, and Power
of Attorney Act, 2(21).

[ Suman Kumar Sinha v. The State of Jharkhand & Ors.,
AIR 2009 Jharkhand 53]

A registered power of attorney was executed by the owner of
plot in favour of petitioner authorising the petitioner to manage, sell, to
defend, or file any case including transfer of the said property by executing
sale deed in the name of and on behalf of the executant and receive the
consideration amount and pay the same to the executant i.e., the owner.

The petitioner being the power of attorney holder beside
doing other things in respect of the said property executed various sale deeds
in favour of different persons. However, the petitioner received the impugned
notice issued by the District Sub-Registrar, Hazaribagh, whereby the
petitioner was directed to pay a sum of Rs.82,112 being the stamp duty payable
on the said power of attorney treating the same as an instrument of sale.

S. 2(21) of the Power of Attorney Act, 1822 defines the
word ‘Power of Attorney’ which reads as :

“(21) Power-of –attorney — Power-of-attorney “includes
any instrument (not chargeable with a fee under the law relating to court
fees for the time being in force) empowering a specified person to act for
and in the name of the person executing it.”

The Court observed that Power of Attorney is a formal
document whereby one person authorises another to represent him and act in his
name in relation to any transaction or a number of transactions.

In case the power of attorney was given for consideration
authorising the attorney to sell any immovable property, then the same duty
was payable in respect of conveyance for a consideration on the market value
equal to the amount of consideration.

From the contents of the power of attorney, it was clear
that the executant has authorised the donee, in whom he has full faith, to
look after and manage his property as he was not in a position to look after
the property because of his preoccupation. The executant, therefore, inter
alia, authorised the donee to enter into an agreement to sell or sell the
property in his name and on his behalf. It was specifically mentioned in the
instrument that whatever consideration for sale of the property is received by
the donee shall be paid to the executant.

It was therefore, held that the power of attorney was
without any consideration.

Further there was much difference between the general power
of attorney and an irrevocable power of attorney. Where the authority of an
agent was required to be conferred by a deed, or where an agent was appointed
to formally act for the principal in one transaction or a series of
transactions, or to manage the affair of the principal generally, such
document was known as power of attorney. Such an instrument confers a right to
the donee to use the name of the principal. Whereas an agreement is entered
into on sufficient consideration for the purpose of securing some benefits to
the donee of the authority, such an authority is irrevocable and was known as
irrevocable power of attorney.

In the instant case, there was no consideration for the
power of attorney executed by the executant in favour of the petitioner, nor
any benefit is derived in favour of the petitioner. There was no consideration
for the authority given to the petitioner.

Conveyance of sale is, therefore, an instrument whereby any
property is legally or equitably transferred or vested in the purchaser.

As the power of attorney in question was not a conveyance
by which executant transferred or alienated the property in favour of the
petitioner for valuable consideration, rather it authorises the donee,
inter alia, to initiate for sale and to sell the property and to pay the
consideration amount so received to the executant. Such power of attorney
cannot be treated as conveyance for consideration. Hence, no fresh stamp duty
was payable on such document.

The impugned notice issued by the Sub-Registrar was
palpably illegal, arbitrary, mala fide and without jurisdiction.

levitra

Nirav Shah

Reference to Larger Bench : In all Larger Bench matters registry should provide copies of appeal papers and issue notice of hearing to Bar Association : S. 129C(5) of the Customs Act, 1962.

New Page 1

Reference to Larger Bench : In all Larger Bench matters
registry should provide copies of appeal papers and issue notice of hearing to
Bar Association : S. 129C(5) of the Customs Act, 1962.

[ Amit Sales v. Commissioner of Central Excise, Japipur-I,
2009 (238) ELT 467 (Trib. L.B.)]

A Division Bench taking into account the submission made by
the appellant referred the matter to Larger Bench.

On behalf of Bar it was submitted that in respect of Larger
Bench cases as per direction of the Hon’ble President, copies of appeal papers
as well as referral orders along with hearing notice were required to be given
to Bar Association. This practice was being followed generally in all Larger
Bench matters. However, in this particular case, the Bar Association has not
been given a copy of these papers.

The Tribunal observed that the issues considered by the
Larger Bench has wide implication and if there is a decision already taken to
enlist the views of the members of the Bar and that if this practice was being
followed, the registry should follow the same in this case also. The registry
was directed to do the needful in this regard. The notice was to be given to
the appellants as well as to the Bar Association for the next date of hearing.

levitra

Nirav Shah

Authorised representative : Counsel appearing without Vakalatnama : Directed to file memo of appearance and client with NOC if any : CESTAT Rules, 1982.

New Page 1

Authorised representative : Counsel appearing without
Vakalatnama : Directed to file memo of appearance and client with NOC if any :
CESTAT Rules, 1982.

[Pneumatic Power Tools & Co. v. Commissioner of C.Ex,
Raipur, (2009) (238) ELT 605 (Trib. Del)]

In a case before the CESTAT New Delhi the Tribunal found
that the counsel had not filed the Vakalatnama. The Tribunal directed him to
file a memo of appearance in support of his appearance and also Vakalatnama
duly executed by his client with no objection from the previous counsel who
appeared on the previous occasions. The Court noticed that Counsel Shri N. K.
Choudhary appeared on 28-1-2008. Counsel Shri Hargun Jaggi appeared on
2-4-2008, Counsel Shri Hargun Jaggi and Shri C. N. Kali appeared on 11-4-2008.
Counsel Shri A. K. Panikar appeared on 19-5-2008. Counsel Shri A. K. Panigrahi
appeared on 7-8-2008. Similarly on 15-9-2008 Counsel Shri A. K. Panigrahi also
appeared. Counsel Shri Raja Chaterjee appeared on 17-3-2009. The Tribunal
directed the counsel to explain by way of a memo whether all the previous
learned counsels who had appeared in the matter were signatory to the
Vakalatnama and also whether he was signatory to the Vakalatnama. The Registry
was directed to place a report to the Bench getting compliance by way of memo
from the ld. counsel Shri Choudhary appearing in the matter.

levitra

Nirav Shah

Section 50C of the Income tax Act — a tool to tackle menace of black money

The Government has been rightly concerned about the component of black money in real estate transactions and consequent evasion of tax. With a view to curb the said menace and to tax the unaccounted money, the Government has time and again made amendments in the Income-tax Act (Act) by introducing different provisions to tackle the issue.

Under the Act of 1922 , we had the first proviso to Section 12B(2), which entitled the Assessing Officer to ignore the actual consideration received for the transfer and to substitute a notional or artificial consideration based on the fair market value of the asset on the date of transfer in such cases where the transfer was to a person directly or indirectly connected with the assessee and the Income-tax officer had reason to believe that the transfer was effected with the object of avoidance or reduction of the liability of the assessee to capital gains tax. With the enactment of the 1961 Act, the said provision found place in Section 52 of the said Act. It provided that only when both the conditions specified in the said Section were satisfied, viz. (1) the transfer was effected with the object of avoidance or reduction of the liability of the assessee under Section 45 and (2) the fair market value exceeded the amount of declared consideration by more than 15%, that the difference between the agreed consideration and market value could be subjected to tax. The scope of the said provision was thus restricted. The said provision was found unworkable as the Assessing Officers found it difficult to establish that the consideration had been understated with the object of avoidance or reduction of the capital gains tax liability. The vires of this Section was examined by the famous decision of the Apex Court in K. P. Varghese’s case 131 ITR 597 (SC) and the provisions were made virtually inapplicable.

Thereupon in the year 1982, Chapter XXA was inserted in the Act, providing for compulsory acquisition of immovable properties. As the provisions of the said Chapter too were not successful in arresting the proliferation of black money in the transfer of immovable properties, the said Chapter was replaced by a new Chapter XXC by the Finance Act, 1986. Under the provisions contained in the said Chapter XXC any person intending to transfer immovable property in specified areas at values exceeding specified amounts was required to file a statement in Form 37-I before the appropriate authority within the prescribed time before the intended date of transfer. The transfer could be effected, only if the appropriate authority did not pass an order of pre- emptive purchase of the property and a ‘No Objection Certificate’ was issued by the said authority. As compared to Chapter XXA, the said Chapter XXC did not provide for compulsory acquisition of immovable properties, but enabled the Central Government to purchase the property which had already been offered for sale. The said Chapter was found to be creating procedural delay in registration of transfers. The provisions of the said Chapter were read down by the Apex Court in C. B. Gautam’s case 199 ITR 530 (SC) and were finally abandoned with a view to remove the source of hardship to the taxpayers and instead Section 50C was introduced by the Finance Act, 2002.

The said Section provides that where the consideration received or accruing as a result of the transfer of land or building or both is less than the value adopted or assessed by any authority of a State Government for the purpose of payment of stamp duty in respect of such transfer, the value so adopted or assessed shall be deemed to be the full value of the consideration and capital gains shall be computed accordingly. The said provision has been enacted notwithstanding adverse observations that had been made by the various courts of law against the reliance on stamp duty valuations for the purpose of computation of capital gains. The Gujarat High Court in the case of New Kalindi Kamavati Co-op. Housing Society Ltd. vs. State of Gujarat & Ors. (2006)(2) Guj. L. R. Vol. XLVII(2) has observed that the valuation adopted by the Stamp authorities cannot be considered conclusive. The Court while observing that : Sole reliance was placed on ‘jantri’ by Dy. Collector for determination of market value for stamp duty held that ‘jantri’; i.e., market valuation record book maintained by the Stamp Valuation authorities reflects probable market value and the same was not a conclusive evidence.

The Allahabad High Court in the matter of Dinesh Kumar Mittal vs. ITO & Ors., 193 ITR 770 (All) has observed : We are of the opinion that we cannot recognise any rule of law to the effect that the value determined for the purpose of stamp duty is the actual consideration passing between the parties to a sale. The actual consideration may be more or may be less. What is the actual consideration that passed between the parties is a question of fact to be determined in each case having regard to the fact and circumstances of the case.

The Madras High Court in the case of Hindustan Motors Ltd. vs. Members, Appropriate Authority, (2001) 249 ITR 424 (Mad.) while dealing with the provisions of Chapter XX-C of the Income-tax Act has observed : Guideline values are fixed by registering authorities for purposes of collection of stamp duty and therefore, those guidelines can have no application for determining market value under Chapter XX-C . . . . Valuation depends on the location of property, the purpose for which the property is used, the nature of the property, and the time when the agreement is entered into and similar other objective factors. The valuation therefore has to be done by a method, which is more objective and can furnish reliable data to arrive at a just conclusion. The market rates notified by the Sub Registrar for the purpose of registration cannot be proper guide for valuation in respect of pre-emptive purchase.

The constitutional validity of the provisions of Section 50C was challenged before the Madras High Court in the case of K. R. Palanisamy vs. UOI, 306 ITR 61 (Mad). The provisions of the Section were attacked on the following grounds :

(i) lack of legislative competence — It was urged that while under Entry 82 List I of Schedule VII of the Constitution of India, tax could be levied on income other than agricultural income, Section 50C seeks to charge tax on artificial or deemed income, which is neither received nor is accrued;

ii) provisions of Section SOC are arbitrary in nature due to adoption of guideline values and thus being violative of Article 14 of the Constitution – It was urged that the provisions contained in the said Section fail to take cognizance of genuine cases, where actual sale consideration passing between the parties for various valid reasons could be lower than the guideline values, which it was further urged are normally fixed for survey numbers or particular area and it fails to take into account that within the particular area the value of the property may differ widely depending upon various locational advantages and disadvantages;

iii) the provisions of the Section are discretionary inasmuch as it covers only the transfer of the property in the nature of ‘capital asset’ leaving out of its ambit the transfer of land and building held as trading asset/stock-in-trade, as there is no deeming provision that could apply to the determination of income under the head ‘profits and gains of business or profession’;

iv) the provisions being beyond the legislative competence and violative of Articles 14 and 265 of the Constitution should be read down.

The Court while upholding constitutional validity of the provisions of Section SOCobserved that these provisions are directed only to check and prevent the evasion of tax by undervaluing the consideration of the transfer of capital assets and held that when there is a factual avoidance of tax in terms of law, the Legislature is justified in enacting the impugned provisions and it is not hit by the legislative incompetence of the Central Legislature. The Court while referring to the provisions contained in Section 47A of the Indian Stamp Act, 1989, pointed out that every safeguard has been provided allowing the aggrieved assessees to establish before the authorities the real value for which the capital asset has been transferred. The Collector is empowered to determine the market value of the property after giving an opportunity of being heard. The Court further ruled that sub-sections 2 and 3 of Section SOC further provide safeguard to the assessees in the sense that if the assessee claims before the Assessing Officer that the value adopted by the stamp duty authorities exceeds the fair market value and the value adopted by the stamp duty authorities has not been disputed in any appeal or revision before any authority, the Assessing Officer may refer the valuation of the capital asset to the Department Valuation Officer and if the value determined by the DVO be more than the value adopted by the stamp duty authority, the AO shall adopt the market value as determined by the stamp duty authorities. The Court thus held that the contention that Section 50C is arbitrary and violative of Article 14 cannot be accepted. In the context of the contention that the impugned provision is discriminatory, the Court while relying on a number of juridical pronouncements of the Apex Court ruled that: There exists intelligible differentia between the categories of assets, which had a rational nexus with the object of plugging the leakage of tax on income from the capital asset by undervaluation of the document. Thus holding that ‘differentiation is not always discriminatory’ it held that the contention that the impugned provision is discriminatory cannot be accepted. As regards the last contention, the Court ruled that in view of sufficient opportunity being available to the assessees under the Stamp Act to dislodge the value adopted by the stamp authorities the provision is not hit by legislative incompetence.

In the context of the safeguard available to the assessees under sub-Section (2) of Section 50C for reference being made to D.V.O. for determining the value of the property, it may, with due respect to the Hon’ble High Court, be pointed out that the word ‘may’ occurring in the said sub-Section suggests that the option in this regard is vested in the Assessing Officer, who may choose to refer the valuation to DVO or not.

The said question came up for consideration before the Jodhpur Bench of the Income-tax Appellate Tribunal in the case of Meghraj Baid vs. ITO, (2008) 4 DTR 509. The Tribunal in that case took the view that in case the AO did not agree with the explanation of the assessee with regard to lower consideration disclosed by him, then the Assessing Officer should refer the matter to DVO for determination of the fair market value. The Tribunal observed that if the provision was read to mean that if the AO was not satisfied with the explanation of the assessee, then he has a discretion to not send the matter to DVO, the provision would then be rendered redundant. Since the Courts of law, as discussed hereinabove have observed that the value determined for the purpose of stamp duty is not conclusive evidence of the actual consideration passing between the parties to a sale, the principles of natural justice demand that in all such cases, where there is a difference between the agreed consideration and the value assessed for the purpose of stamp duty, the AO should refer the matter to DVO for determination of fair market value for the purpose of computing capital gains, instead of placing sole reliance on the value determined for stamp duty in all cases where the assessee has computed capital gains on the basis of agreement value.

The Income-tax Appellate Tribunal in the case of Navneet Kumar Thakkar vs. ITO, (2007) 112 TIJ 76 (Jd) held that unless the property transferred has become the subject matter of registration and for that purpose has been assessed by the stamp duty authorities at a value higher than the amount of agreed consideration, the provisions of Section 50C cannot come into operation. This decision seems to provide for a release from the stringent clutches of S.50c. It is seen that quite often than not the parties do not register the sale deeds. In such cases, the onus would be upon the revenue to establish that the sale consideration declared by the assessee was understated and in such event as observed by the Tribunal, the ratio of the decisions of the Apex Court in the matter of K. P. Varghese vs. ITO, 131 ITR 597 and CIT vs. Shivakarni Co. Pvt. Ltd. (1986) 159 ITR 71 would be applicable. The Supreme Court in the case of Varghese was concerned with the provisions of Section 52(2) of the Act, which was in force at the relevant time and had remained on the statute till 31.3.1987. The said Section provided that where in the opinion of the Assessing Officer the fair market value (FMV) of the capital asset on the date of its transfer exceeded the sale consideration by not less than 15 per cent, the Assessing Officer with the previous approval of the Inspecting Asst. Commissioner can adopt FMV as the full consideration received by the assessee. It was held by the Apex Court that Section 52(2) can be invoked only where the consideration for the transfer has been understated by the assessee or in other words, the consideration actually received by the assessee is more than what is declared or disclosed by him and the burden of proving such an understatement is on the Revenue. It was also observed that the said Section has no application in the case of an honest and bona fide transaction, where the consideration in respect of transfer has been correctly declared or disclosed by the assessee even if the condition of 15 per cent difference between the FMV of the capital asset as on the date of transfer exceeds full value of the consideration declared by the assessee. If, therefore, the Revenue seeks to bring a case within sub-Section (1), it must show not only that the fair market value of the capital asset as on the date of transfer exceeds the full value of the consideration declared by the assessee by not less 15 per cent of the value so declared but also that the consideration has been understated and the assessee has actually received more than what is declared by him. These are two conditions which have to be satisfied before sub-Section (2) can be invoked by the Revenue and the burden of showing that these two conditions are satisfied rests upon the Revenue.

It may further be pointed out that Section 50C targets the vendor or transferor of the property and not the purchaser or transferee. It is an accepted position in law that the legal fiction cannot be extended beyond the purpose for which it is enacted. Section sac embodies the legal fiction by which the value assessed by the stamp duty authorities is considered as the full value of consideration for the property transferred. It cannot thus be extended to rope in the purchasers on the ground of undisclosed investment. It may nonetheless be pointed out that in the case of Dinesh Kumar Mittal vs. ITa and Ors., (1992) 193 ITR 770 (All) the Income-tax officer in the course of proceedings relating to AY 1984-85 had invoked the provisions of Section 69 of the Act in the hands of purchaser by holding that the purchase consideration declared was less than the value determined for the purpose of stamp duty and had made an addition of 50 per cent of the difference in his hands. The said addition was upheld by AAC and the revision petition moved by the assessee was rejected by the CIT. The Allahabad High Court while holding that there was no rule of law to the effect that the value determined for the purpose of stamp duty was the actual consideration passing between the parties to a sale had eventually quashed all the three orders and had remanded the matter to the ITO for determination of actual consideration, which was paid by the assessee.

Section 69 does not embody the legal fiction by which the value assessed by stamp authorities could be considered to be the actual consideration paid by the purchaser of the property. In fact in Section 69 the word ‘may’ has been deliberately used. It may be recalled that when the Bill was introduced for insertion of S.69, in the Parliament the draft provision required that the value of investment ‘shall’ be deemed to be the income of the assessee for such financial year. However at the suggestion of the Select Committee of the Parliament, the word ‘may’ was substituted for the word ‘shall’ and has been finally adopted in the Act. It indicates that there is no presumption that unexplained investment must necessarily be added to the assessee’s income. It vests substantial amount of discretion unto the Income-tax authorities. The Courts have ruled that even ‘the unsatisfactoriness of the explanation need and did not automatically result in deeming the value of investment to be the income of the assesee’. That is still a matter within the discretion of the officer and therefore of the Tribunal as has been held in [(1980) 123 ITR 3 (Ker) and, (1995) 216 ITR 301 (AP)]. Thus it may be concluded that the scope of Section sac is limited to the extent that it cannot be utilised as a tool for additions in the hands of a purchaser.

Nirav Shah

Amount of tax sought to be evaded

1.0 Facts :

1.1 ABC Pvt. Ltd. filed its return of income for A.Y. 2005-06 showing the following position :

Statement of Loss to be carried forward u/s.72 of the Income-tax Act, 1961 (the Act) :

1.2 On assessment, the AO disallowed certain expenses and the assessed income and the revised Statement of Loss stood as under :

Revised Statement of Loss to be carried forward u/s.72 of the Act :

1.2 The AO worked out penalty u/s.271(1)(c) of the Act as under :

2.0 Assessee’s submission to the AO:

2.1 The company contended that the final tax payable as per the return of income and as per the assessment order was nil, and therefore, there was no ‘amount of tax sought to be evaded’ as the phrase was explained in Explanation 4 to S. 271(1) of the Act. The AO did not accept the argument and referred to the amendment made to clause (a) of Ex-planation 4 to S. 271(1) of the Act by the Finance Act, 2002, with effect from A.Y. 2003-04. According to the AO, the aforementioned amendment had put paid to all arguments in such cases made on the basis of the ratio of ClT v. Priihipal Singh & Co., 249 ITR 670 (SC) and Virtual Soft Systems Ltd. v. ClT,289 ITR 83 (SC). Moreover, the AO held that the ratio of Virtual Soft had no application after the amendment of 2002, as was observed in that case also.

2.2 The company tried to distinguish the facts in Virtual Soft’s case (supra) from its own facts by stating that in Virtual Soft the return was one of loss and the assessment was made at a reduced loss, whereas in its own case the return was one of nil income and the assessment was also one of nil income. Effectively, the company contended that as the term ‘the amount of tax sought to be evaded’ was explained in Explanation 4 to S. 271(1) of the Act there was no such amount. This argument was rejected.

3.0 The assessee seeks your advice on the above aspect with a view to deciding on the advisability of going in appeal.

4.0 Opinion:

4.1 Before embarking upon giving opinion, one must admit that the issue involved here has a long history. The matter relates to penalty, and therefore, in construing penal provisions, as the Honourable SC said in Virtual Soft (supra), the statute creating penalty is the first and last consideration and must be construed within the term and language of the particular statute.

4.2 It is true that the ratio of Virtual Soft may not apply to cases post 1st April, 2003. However, what is necessary is to see whether the company’s case here solely rests on the ratio of Virtual Soft or it can stand on its own. The point involved in Virtual Soft is succinctly brought out by the Honourable SC in the following words at page 92 of the Report: “The point involved before the High Court was, as to whether penalty was leviable u/s.271(1)(c)(iii) read with Explanation 4 thereto which came on the statute book with effect from April 1,1976, in a case where the return filed was one of loss and the assessment made by the Assessing Officer was at a reduced amount of loss.”

Thus, one may see that there was a loss declared in the return of income which was reduced on assessment. This fact is material for later part of this opinion.

4.3 In order that penalty can be imposed u/s. 271(1)(c) of the Act, there must be an ‘amount of tax sought to be evaded’, because this amount forms the basis of quantum of penalty. If it is discovered in a given case that there is no such amount, or that such amount cannot be worked out, then one can say that though the substantive provisions may apply, the machinery provisions fail. If that is the case, one may infer that the substantive provisions are not intended to apply to a given case. Support for these propositions can be found in the Supreme Court decision in the case of Cl’T v. B. C. Srinivasa Setty, 128 ITR 294. In fact, this proposition is clearly accepted in Virtual Soft (supra) also.

4.4 Therefore, it is necessary for us to find out whether there is any ‘amount of tax sought to be evaded’ in terms of the language of Explanation 4 to S. 271(1) of the Act. Let us examine the individual clauses of the said Explanation.

4.4.1 Clause (a) of the said Explanation reads as under:

“(a) in any case where the amount of income in respect of which particulars have been concealed or inaccurate particulars have been furnished has the effect of reducing the loss declared in the return or converting that loss into income, means the tax that would have been chargeable on the income in respect of which particulars have been concealed or inaccurate particulars have been furnished had such income been the total income;”

4.4.1.1 As per this clause, it applies in a situation when the income alleged to be concealed has the effect of reducing the loss declared in the return of income or converting that loss into income. If this is not the case, one need not look beyond.

4.4.1.2 In the present case, there was no loss declared in the return, as the return declared nil income. Therefore, the question of the concealed income reducing that loss declared in the return of income does not arise. One may, here, argue that the balance of the carried forward loss of Rs.90,00,000 was a loss declared in the return of income (such losses have to be stated in the form of return of income) and since this loss got reduced from Rs.90,00,000to Rs.85,00,000, the condition of ‘the concealed income reducing the loss declared in the return of income’ is fulfilled. The question is : Is it to the brought forward loss or to the current year’s loss that the reference is made in the first limb of clause (a) of Explanation 4 ? The second limb of the sentence, which reads as, “…. or converting that loss into income” holds the key to that question. The word ‘that’ used in the second limb of the sentence explains, or rather qualifies, the term ‘loss’ referred to in the first limb of the sentence. It says that the ‘loss’ referred to in clause (a) is such loss as is also capable of being converted into income. Viewed thus, one may agree that brought forward losses can be reduced, but in any assessment, they cannot be converted into income. Such losses, can at best, be reduced to nil. Therefore, one may further argue that the reference to the word ‘loss’ in this clause is to the loss of the current year which alone is capable of being converted into income on additions or disallowances made in the assessment. Since there is no loss in the current year (there is income of Rs.10,00,000 from business), clause (a) of Explanation 4 to S. 271(1) of the Act does not apply to the facts of the case.

4.4.2 Clause (b) of Explanation 4 to S. 271(1)) of the Act, being applicable only in certain special cases of search and non-filing of returns, does not apply to the facts of this case.

4.4.3 Let us examine the applicability of the residuary clause (c) of the said Explanation to the facts of this case. Clause (c) reads as under:

“(c) in any other case, means the difference between the tax on the total income assessed and the tax that would have been chargeable had such total income been reduced by the amount of income in respect of which particulars have been concealed or inaccurate particulars have been furnished.”

4.4.3.1 In order to find out the quantum of penalty under this clause, one has to find out the difference between the tax on the total income assessed and the tax that would have been chargeable had such total income been reduced by the amount of income alleged to be concealed (Rs.5,00,000 in this case).

4.4.3.2 The tax on the total income as returned and assessed, both, in this case, is nil, and as such, there is no difference between the two. Thus, no amount of penalty can be worked out under this clause.

4.4.3.3 One may argue here that Rs.I0,00,000 and Rs.15,00,000 being the returned income and the assessed income from business, respectively, should be taken as ‘the total income’ and the difference between the notional tax on such total income, returned and assessed, should form the basis of quantum of penalty. In other words, what needs to be decided is: what is the meaning of ‘total Income’, the phrase used in clause (c) of Explanation 4 ? Does the term ‘total income’ here means the one as ar-rived at before setting off of brought forward losses or the one as arrived at after such set-off?

4.4.3.4 The ‘total income’ has been defined in S. 2(45) of the Act as, ” ‘Total Income’ means the total amount of income referred to in S. 5 computed in the manner laid down in this Act”. S. 5 of the Act lays down the scope of total income, but S. 15 to S. 59 lay down provisions relating to computation of income under various heads. The question is : Is S. 72 dealing with carry forward and set-off of business losses part of computational machinery? The issue is addressed by the Supreme Court in Cambay Electric Supply Industrial Co. Ltd. v. CIT, 113 ITR 84.

At page 97 of the Report, Tulzapurkar T., speaking for the Court, said “that it was not possible to accept the view that S. 72 had no bearing on, or was unconnected with, the computation of the total income of the assessee under the head.” Following the decision in Cambay Electric, the Gujarat High Court has adopted a similar reason in Monogram Mills Co. Ltd. v. CIT, 135 ITR 122. In other words, the correct figure of total income cannot be arrived at without working out the net result of computation under the head ‘Profits and gains of business or profession’ and income under this head cannot be determined without taking into account S. 72 of the Act. Similar views are also expressed by the Supreme Court in CIT v. Shirke Construction Equipment Ltd., 291 ITR 380.

4.4.3.5 Therefore, it can be said that the term ‘total income’ used in clause (c) of Explanation 4 to S. 271(1) means the total income computed under the head ‘Profits and gains of business or profession’ taking into account the brought forward business losses. If this proposition is accepted, the total income, returned as well as assessed, in this case is nil, and the tax thereon is also nil. No amount of penalty can be worked out. It is true that the definition of the term ‘total income’ as contained in S. 2(45) is to not be followed if the context requires otherwise. However, it is submitted that there is nothing is clause (c) of Explanation 4 to S. 271(1) of the Act to suggest that the context requires a different meaning of the term ‘total income’, for any different meaning would be to stretch the language and, as the Supreme Court said in Virtual Soft (supra), it is not competent for the Court to stretch the meaning of an expression to carry out the intention of the Legislature.

In view of the above, it is submitted that though concealment might be established in the case, it is not possible to quantity the amount of penalty. The machinery provisions fail. Therefore, penalty is not leviable.

Author’s Note:

The author only expresses his views. Readers may write in to discuss a different viewpoint since the matter discussed here is controversial and may require one to act with caution.

Nirav Shah

Sue the accountant

Introduction :

The role of modern day accounting professionals has come a long way, from a core accounting function to that of being viewed as a corporate gatekeeper. Today’s professionals are not just auditors, certifying routine book of accounts, but also on the boards of companies as directors. This multi disciplinary role puts emphasis on “always taking the correct decisions and doing everything right”. While accountants look to successfully achieve the set standards, they are increasingly exposed to being targets for easy lawsuits, bought against them by third parties. A series of lawsuits filed against some of the reputed accounting firms and professionals is a beginning of the trend.

These third parties could be regulators, customers, shareholders and creditors, to name a few. Own employees cannot be excluded from the list. The list of reputed professionals, who have developed skill in what they do, over the years, but are yet, in the midst of proving their innocence in the court of law, will get longer. This will be fuelled by the arrival of the specialised litigation firms, who have been trained to gather claimants and win lawsuits in more litigious territories like Europe and US.

The Government is drafting regulations to ease Foreign Direct Investment and opening up of the Indian legal sector to overseas law firms. The local shops of the foreign firms will derive encouragement for local claimants to sue for miniscule failure by professionals to carry out diligence and care.

In most courts, the lawsuit may drag for long, cutting into the pockets and personal assets of professionals. The professionals may have acted in good faith and will have the best of the counsel defending them in the court of law, yet, the process may not only be expensive, but, time consuming, complex and lengthy. This adds to the agony.

A dent to reputation and financial condition with this situation is inevitable.

Recent cases in highlight involving accountants :

In the recent times, India has been a witness to a few incidents, where accounting professionals have been in the face of legal action.

Depositors in Nagarjuna Finance v. Mr. Nimesh Kampani & others

Source : Rediff business desk, 13-4-2009

The Supreme Court on Monday quashed a petition filed by financial industry magnate Nimesh Kampani to stop proceeding initiated against him in the Nagarjuna Finance Corp case, thus clearing the way for his arrest.

Nagarjuna Finance, the Hyderabad-based non-banking finance company has been charged with defaulting on repayment of deposits worth Rs.100 crore (Rs.1 billion).

Kampani was a director of Nagarjuna Finance when the alleged default took place. He had resigned as a non-executive director in 1999. He was, however, on the board when the NBFC raised deposits from the public.

Kampani, however, had earlier told APO police that he was in no way involved with the matter, having resigned as a non-executive director in 1999. The apex court had on April 2 stayed the arrest of investment banker Kampani.

Satyam ADR purchasers v. M/s. Pricewaterhouse Coopers

Source : Financial Express, 8-1-2009

The ADR purchasers of the Satyam Computers stock, represented by law firm Pomerantz Haudek Block Grossman & Gross LLP, have filed a lawsuit against the multinational audit firm Pricewater-house Coopers (PWC). The lawsuit alleges that PWC breached the duty towards shareholders, causing undue losses, by committing grossly negligent audits, overlooked internal control mechanisms. The lawsuit further alleges that PwC ignored red flags that should have alerted it to the fraud and that PWC failed to perform its audits in accordance with the requisite accounting principles.

The Indian unit of the global audit major, has been maintaining that it followed all the standard accounting principles while auditing the books of Satyam Computers. While two partners of the firm have been arrested for abetting the fraud, PWC also said that its auditing on Satyam could be construed invalid, if the statements made by promoter Raju, in his admission letter about the fraud were correct.

In the Satyam case, the audit firm is defending the allegations filed against it and incurring substantial legal expenses, while independent probe is under way by the Serious Fraud Investigation Office (SFIO).

Institute of Chartered Accountants of India v. Auditors of Global Trust Bank

Source : livemint.com

ICAI disciplinary committee has held two Global Trust Bank (GTB) auditors guilty of professional misconduct. In 2003, Global Trust Bank had collapsed. It was alleged that the GTB auditors had failed to adequately point out in its audit report about the high levels of NPA. Four partners at the firm had been made respondents in this case for their audit work spanning over three years. Reserve Bank of India had stepped in at that time and speedily restored normalcy for the bank’s customers, by approving its merger with Oriental Bank of Commerce.

As per the latest media reports, ICAI has conducted disciplinary proceedings and the case has been referred to the high level committee of the monitoring body. The partners of the audit firm have been hauled up and had to present themselves in front of the monitoring body to explain the alleged professional misconduct.

Liability under Indian Law :

In India, a civil liability for negligence can be attached when it is proved that an auditor’s client suffered a financial loss due to the auditor’s professional negligence. The basis of pointing the finger and establishment of the liability would be through two simple steps :

1. There was a professional negligence by the auditor in the performance of his duty

2. This professional negligence resulted in a loss or damage to the client

This process is simple and easy to allege. Professional negligence is generally held to imply “any action by an auditor that is careless or is not in consonance with the performance of his duty”.

Most accounting professionals are also directors on the boards of various listed and non listed companies. Error, omission or negligence on their part, can impact the performance of the company and erode its value. They could be sued for breach of their duty towards shareholders, even while the breach may not be willful. They would still have to defend themselves, in case a lawsuit is filed.

Once in court, the legal expense, may mount and end up being quite Significant. Subsequently, huge settlements may follow out of a court verdict or even a settlement may be negotiated out of court. All these are definitely likely to dent the bottom line of the audit firm held negligent, while there will also be a loss of reputation and goodwill of the firm, built over several years of hard work.

Risk mitigation through Insurance for Accountants:

Apart from relying on their own pocket to churn out expenses towards legal costs and litigation settlements, there are two specialised insurance policies which becomes a pertinent and reliable mechanism, for risk mitigation:

1. Accountants Professional Liability Insurance

2. Directors and Officers Liability Insurance

The insurance policies are carved to pay for defence expenses and settlements, broadly.

Accountants Professional Liability Insurance:

Sample policy coverage:

An Accountants Professional Liability insurance policy covers legal liability arising out of professional negligence and error or omission of the accounting/ audit firms. The key highlights of a typical insurance policy are:

Provides protection against wrongful acts arising out of negligence, error or omission, of the insured firm, partners, employees.

Responds towards defense costs and settlements, within the policy terms and conditions.

Responds to acts taking place after the appended retroactive date in the policy. A retroactive date stands incorporated when a firm buys the insurance policy for the first time and usually remains constant over many years, thus giving continuity in the coverage of acts occurring after that date.

Claims on the policy have to be made and reported within the policy period and covered within the retroactive date in the insurance policy.

Every policy has a deductible, which is the minimum amount the insured has to bear on each claim. Depending on the firm, the deductible varies between 10% to 12% of the limit of liability opted for.

Can be taken by firms into multiple professions like accounts preparation, book keeping, audit, tax compliance, liquidation, valuation, mergers and acquisition work etc. Usually, the insurance company would request for exhaustive information on the activities of the firm and extend policy coverage.

Can be extended to include retroactive acts, provided they are unknown, when the policy is procured.

Can be extended to include coverage for costs incurred towards documents destroyed, damaged, lost or mislaid, as a small portion of the liability limit of the insurance policy.

Directors and Officers Liability Insurance:

Sample policy coverage:

A Directors and Officers Liability insurance policy covers legal liability arising out of wrongful acts of the Directors and Officers of the company. The key highlights of a typical insurance policy are:

Provides coverage for liability of :

Directors and Officers who cannot be indemnified by the company
Directors and Officers who can be indemnified by the company

Responds towards defense costs and settlements, within the policy terms and conditions

Responds to acts taking place after the appended retroactive date in the policy.

Claims on the policy have to be made and reported within the policy period and covered within the retroactive date in the insurance policy.

Every policy has a deductible, which is the minimum amount the insured has to bear on each claim. The deductible is smaller as compared to the Accountants Professional Liability insurance and usually has a fixed value.

Coverage territory and jurisdiction is incorporated in the policy. Can be issued on a world-wide basis or only for India.

Defense costs include attorney’s fees, reasonable expenses towards court attendance, administrative expenses, legal representation expenses and investigative costs.

Policy has advancements on current basis, towards defense costs.

Premium computation and limits of liability :

The underwriters of this specialised nature of insurance policy, can structure and design coverage which could respond to individual firm’s business requirement. This involves an exchange of information with the underwriter, like profile of the firm, nature of services, partners’ profile. The size of the firm in terms of employees and revenue, financials, type of clients, contracts, geographical area of operation, incidents reported previously etc. are also studied.

This dialogue and information is processed to provide premium estimation to the firm seeking insurance. Depending on these parameters and the coverages opted for; the premium varies from firm to firm. Option is available with the insured, for volunteering for higher deductibles, which helps in bringing down the premium for the policies.

In conclusion:

In light of the increased emphasis on certifications to firms, whether it is in an audit or as a director on the board of listed and unlisted companies, it is recommended that all small, medium and large firms, purchase adequate level of insurance protection. In a dynamic economic and legal environment, the insurance policy will come handy as a risk mitigation tool.

Most of the leading underwriters of liability insurance offer these insurance policies. To get the best underwriter to be a part of one’s valued insurance program, the firm should ideally seek the assistance of an insurance broker. The insurance broker is licensed by the Insurance Regulatory and Development Authority (IRDA), to structure policy coverage, give informed advice and seek quotes from various insurers towards the finalisation of the best cover for their client.

Nirav Shah

Accounting for financial instruments and derivatives

In Parts One and Two, we discussed definition, recognition, classification and measurement principles of financial assets and financial liabilities. In this part, we will discuss the definition and accounting for derivatives including principles of hedge definition, recognition and accounting.

Derivatives

A derivative is a financial instrument or other contract which has all the following 3 characteristics (para 8.1 of AS-30) :

· Its value changes in response to changes in an underlying (the underlying could be a specified interest rate, a financial instrument, a commodity, a currency, an index, a credit rating or index, or other variable).

· It requires no or small initial net investment (than the investment that would be required if an entity were to enter into other contracts that would be expected to have a similar response to changes in the price of the underlying).

· It is settled at a future date.

Common examples of derivatives are forwards, futures, calls, puts and swaps. Derivatives may be exchanged, traded or over-the-counter contracts. If the underlying is a non-financial variable, the standard specifies that the variable should not be specific to a party to the contract. Derivative contracts may be net settled or gross settled. The definition and accounting of a derivative does not depend upon the method of settlement. In both settlement systems, the accounting remains the same.

If a company buys crude oil futures on a commodity exchange, it typically pays a small initial margin that may range from 5 to 20%. The company is exposed to risk arising from movements in the price of crude oil, which will impact prices of crude oil futures resulting in gains or losses. The contract will be settled at a future date. In practice, most futures contracts are net settled. If the company bought futures at a price of $ 41 per barrel and on the date of expiry the price of spot and futures (which will converge on expiry) is $ 47, the company would have gained $ 6 per barrel, which would be paid to the company on expiry in a net settlement framework. In a gross settlement framework, the company would pay $ 41 and receive delivery of crude oil.

Recognition and Measurement

A derivative instrument is by default classified as a financial asset or a financial liability held for trading. Derivatives which are financial guarantees or designated as hedging instruments are exceptions. Assets and liabilities held for trading fall under the broader category ‘Financial Assets and Li-abilities held at fair value through Profit and Loss’.

Accordingly, derivatives (other than exceptions above) are initially recognised at fair value on the date of acquisition or issue (para 47 of AS-30). Transaction costs are recognised as expenses. Subsequently, they continue to be carried at fair value without deduction for transaction costs that may be incurred on sale or disposal (para 51 and 52 of AS-30).

As a consequence of continuous fair valuation of derivative positions, corporates will be exposed to earnings volatility. Derivative fair values are known to fluctuate substantially and a high exposure to derivatives which do not qualify for hedge accounting treatment is a major challenge that corporates need to manage well.

Example of a Forward Contract

The accounting community will be familiar with recognition and measurement of forward dollar contracts under the AS-11 framework. The principles of AS-30 are quite different and it may be useful to compare the two methodologies.

Corporate XYZ Ltd. buys a three-month forward dollar contract for $ 1 on May 1, 2009 at a forward rate of Rs. 50.25. The spot rate on that day was Rs. 49.65 and the premium paid on the forward was Rs. 0.60. The contract was entered into to hedge an import payment that is due three months later.

Let us assume that the spot rate on June 30, 2009 was Rs. 51 and the forward rate of a one month forward on June 30, 2009 was Rs. 51.12.

AS 11 Framework

The premium of Rs. 0.60 will be amortised over three months. The June quarter financials will therefore recognise an expense of Rs. 0.40 (two months proportionate amortisation). On June 30, 2009, the forward contract will be revalued to spot Rs. 51.00. However, the underlying payable will also be revalued to Rs. 51.00. The impact of revaluing the underlying payable and the long forward will offset each other so that the impact on the profit would be zero.

AS-30 Framework

There is no concept of amortisation of forward premium. The derivative contract would be recognised at fair value on the date of inception. A typical on-market forward would have a fair value of zero on the date of inception. In other words, if the corporate were to turn around and square up the contract immediately after inception, it would be able to do so at the same forward rate as it contracted.

At quarter end, the derivative contract will be fair valued. If the contracted forward rate was Rs. 50.25 and the forward rate on June 30, 2009 was Rs. 51.12, the corporate has generated a gain of Rs. 0.87. This will be present valued (discounted) as there is one month left for expiry. Suppose the present value comes to Rs. 0.86. This is the fair value of the derivative to be recognised as an Asset in the Balance Sheet as at June 30, 2009. Please note that the spot rate of the dollar on June 30, 2009 is not relevant for fair valuing the forward contract, but would be relevant for revaluing the underlying payable.

The second effect of this fair valuation could either be recorded as a gain in the Profit and Loss account or could be carried to Hedging Reserves, depending upon whether the derivative contract qualifies as a hedge and the type of hedge definition.

Hedge Accounting

Hedge Accounting is a choice of accounting policy which corporates mayor may not exercise. Hedge accounting allows the corporate to offset the volatility which earnings are exposed to as a consequence of derivative fair valuation at the end of every reporting period. It allows the corporate to either recognise an offsetting gain or loss in the profit and loss itself (and thus negate the derivatives impact) or to recognise the derivative gains or losses
directly in reserves. While it is common to hedge using derivative instruments, it is possible to use regular financial non-derivative instruments for hedging.

The AS-30 framework envisages primarily two types of hedged risks:

(a) those arising from changes in fair values of existing assets, existing liabilities or unrecognised firm commitments (Fair Value Hedging), and

(b) those arising from changes in future cash flows (which could emanate from existing assets, existing liabilities, as well as from highly probable forecasted transactions) (Cash Flow Hedging).

Both risks should affect profit and loss of the entity in order to qualify for hedge accounting treatment. Some examples of underlyings, risks, classification for the purpose of hedging and type of hedge are provided below. The type of hedge indicated here is the one most commonly designated, but it is possible to argue that a cash flow hedge also exposes a corporate to a fair value risk and vice versa and hence such designations need to be effected with care.

Hedge Definitions and Effectiveness

Each hedge should be formally documented in an elaborate manner. The documentation will include a formal risk management policy, the hedging instrument, the hedged item, the hedged risk, effectiveness testing methodology to be adopted by the corporate and approval processes. This area needs involvement of non-accounting managers from the corporate, including the top management, operations and treasury.

Effectiveness testing is required on a prospective basis to establish that the hedge is expected to be effective in managing the risk which it seeks to mitigate. At each reporting period end, the hedge needs to be retrospectively tested to establish whether it was de facto effective in its stated objective. The standard specifies that the change in the fair value of the hedging instrument should retrospectively fall between 80% to 125% of the change in the value of the hedged item attributable to the hedged risk. If the hedge is not effective, hedge accounting principles cannot be applied.

Accounting for Fair Value Hedges

In fair value hedges, gains and losses arising from both instruments, viz., the hedged item and the hedging instrument are recognised in the statement of profit and loss, thus creating an offset such that the net gains or losses impact the reported profit. In more formal terms, the following treatment is adopted:

Gain or loss arising from re-measuring the hedging instrument at fair value is recognised in the statement of profit and loss.

Gain or loss arising from the hedged item attributable to the hedged risk is recognised in the statement of profit and loss.

Example – Export Receivables

Corporate XYZ has exported merchandise for $ 100,000 recognised at spot rate of Rs. 50 on the day of export. The corporate sold 3-month forward dollars at Rs. 50.60 on the same day. At the quarter end, the spot rate was Rs. 50.75 and forward rate (of an equivalent tenor as that outstanding on that forward) was Rs. 51.02.

The corporate needs to designate the risk sought to be hedged in a precise manner. This risk can be defined in two ways (a) risk of the volatility of the spot dollar (b) risk of the volatility of the forward dollar. Each designation will lead to difference in hedge accounting measurements as well as effectiveness.

Risk of Spot Volatility

The spot has moved by Rs. 0.75 while the forward has moved by Rs. 0.42 between the date of export and the period end. The forward would be discounted to present value as the realisability of the forward is expected only on its final settlement. Let us assume the present value of the forward gain is Rs. 0.41. Hedge effectiveness percentage would come to 55% and the hedge would fail. The derivative fair value will be charged to the profit and loss statement while the receivable would be revalued under AS-l1 and the restatement gain taken to the profit and loss statement.

Risk of Forward Volatility

The forward element of the receivable has hypothetically moved by Rs. 0.41 (when fair valued) and the forward contract has also moved by Rs. 0.41 (when fair valued). Thus the hedge is effective. This loss on the forward would be recognised in the statement of profit and loss, while the movement in the spot would be recognised under AS-II in the profit and loss.

The final impact on the net profit is the same in this illustration, irrespective of whether the hedge is effective or otherwise. However, the line item classification within the statement of profit and loss may differ. Hedged items related gains and losses are commonly classified along with the underlying transactions while gains and losses on ineffective hedges are classified as derivative losses, which, if material, would merit a separate line item disclosure in the statement of profit and loss.

Cash Flow Hedge Accounting

Gains and losses on hedging instruments designated as cash flow hedges, if effective, are recognised directly in equity (generally in Hedging Reserves). These gains and losses are recycled into the statement of profit and loss when the underlying transaction impacts the statement of profit and loss.

Example – Forecasted Revenue

Corporate ABC forecasts dollar revenues of $ 10mio for the year to end March 2010. These sales relate to the month of January 2010. It faces a risk of dollar volatility and has sold forward dollars for each month in this financial year so as to hedge itself at Rs. 51.27 today, when the spot dollar was Rs. 50. At the end of the June quarter, spot dollar was Rs. 50.65 while the forward dollar of equivalent tenor was Rs. 51.75.

The corporate needs to designate the hedged risk in a precise manner. In particular, the hedged risk may be defined as (a) the risk of volatility in the spot or (b) the risk of volatility in the forward.

If the spot risk is designated, hedge effectiveness will be tested as under. Change in the value of the hedging instrument (based on forward dollar) is Rs 0.48, while the change in the value of the hedged item (i.e., forecasted revenues based on spot dollar) is Rs. 0.65. The hedge effectiveness ratio will work out to 74% and the hedge will be considered ineffective. Please note that the forward dollar will need to be present valued to arrive at the fair value, but that process will make the hedge further ineffective.

The loss on the forward will be recognised in the statement of profit and loss as the hedge is ineffective.

If the forward risk is designated, hedge effectiveness will be computed at 100% (as both the hedging instrument and the hedged item will change by the same amount of the present value of Rs. 0.48). The loss on the forward will therefore be recognised in equity. This accounting process will shield the present earnings from derivative volatility.

In the quarter in which the revenue forecasted actually happens (in our example the Jan.-March 2010 quarter), the cumulative gains or losses parked in reserves will be recycled into the statement of
profit and loss.

Conclusion
Derivative accounting and hedge accounting are complex areas which need a deep understanding of economic hedging, derivative instruments, risk management concepts as well as the accounting standard requirements. Systemic challenges around hedge definitions and accounting are stringent and corporates need to plan in advance to establish these systems well. In many cases, a committed involvement of operational managers as well as information technology is required to implement hedge accounting successfully.

Nirav Shah

Carry forward and set off of MAT credit u/s.115JAA — Allowability in the hands of amalgamated company — A case study

Facts :

As on 31-3-2009 X Ltd. is entitled to carry forward MAT credit u/s.115JAA of the Income-tax Act, 1961 amounting to Rs. one million. X Ltd. is amalgamated with Y Ltd. with effect from 1-4-2009.

Issue :

In the light of the above facts the question for consideration is whether Y Ltd. is entitled to carry forward and set off MAT credit of X Ltd. ?

Analysis of S. 115JAA:

S. 115JAA of the Income-tax Act, 1961 allows credit in respect of tax paid u/s.115JA or u/s.115JB. Credit in respect of tax paid u/s.115JB is allowed only if such tax is paid for the A.Y. 2006-07 or any subsequent assessment year. The difference between the amount of tax paid u/s.115JA or u/s.115JB, as the case may be, and the amount of tax payable on total income, computed in accordance with the regular provisions of the Act, would be the amount of tax credit allowable u/s.115JAA. The credit in relation to tax paid u/s.115JA can be carried forward for a period of 5 assessment years succeeding the assessment year in which such tax credit becomes allowable. On the other hand, the credit in relation to tax paid u/s.115JB can be carried forward for a period of 10 assessment years succeeding the assessment year in which such tax credit becomes allowable. The Finance (No. 2) Act, 2009, by amending S. 115JAA(3A), has increased the period of carry forward of MAT credit from 7 assessment years to 10 assessment years.

The tax credit determined u/s.115JAA of the Income-tax Act, 1961 is allowed as a set off in a year in which tax is payable on the total income computed in accordance with the normal provisions of the Act. Set off of MAT credit brought forward is allowed to the extent of the difference between tax on total income and tax which would have been payable u/s.115JA or u/s.115JB as the case may be.

S. 115JAA does not expressly provide for set off of MAT credit of the transferor Company by the transferee Company. In other words, the said section does not specifically state that the MAT credit of the amalgamating Company can be carried forward and set off by the amalgamated Company. The said section also does not contain any express or specific prohibition with regard to carry forward and set off of the MAT credit of amalgamating or transferor Company by the amalgamated or transferee Company. In such a situation, the issue as to whether MAT credit of amalgamating or transferor Company can be carried forward and set off by the amalgamated or transferee company could be discussed under two alternatives.

Alternative 1 — Adverse view :

The proposition under this view is that the amalgamated or transferee company is not entitled to carry forward and set off the MAT credit of the amalgamating or transferor Company. The reasons for the same are as follows :

1. S. 115JAA does not specifically provide for the carry forward and set off of MAT credit of amalgamating company in the hands of the amalgamated company.

(a) The legislature has enacted specific provisions allowing the amalgamated company to continue to claim exemption/deduction to which the amalgamating company was entitled. For ex :

u/s.10A(7A), u/s.10B(7A) and u/s.10AA(5) where the eligible unit is transferred in a scheme of amalgamation, the amalgamated company is entitled to claim deduction for the unexpired period of tax holiday under the respective sections;

as per 5th proviso to S. 32(1), the deduction in respect of depreciation allowance is apportioned between amalgamating and amalgamated company based on the number of days for which the assets were used by them;

amalgamated company was entitled to claim the ‘investment allowance’/‘development rebate’/‘development allowance’ of the amalgamating company as per S. 32A(6), S. 33(3) and S. 33A(5) respectively;

u/s.35AB(3), the amalgamated company is entitled to claim deduction in respect of expenditure on know how for the residual period;

the amalgamated company is entitled to claim deduction u/s.35ABB(6) in respect of the expenditure incurred to obtain licence to operate telecommunication service for the unexpired period of the license;

the deduction allowable u/s.35D in respect of amortisation of certain preliminary expenses over a period of 5 years can be claimed by an amalgamated company for the unexpired period;

as per S. 35DDA(2) the amalgamated company is entitled to claim deduction in respect of the expenditure incurred under voluntary retirement scheme and eligible for amortisation for the remaining number of years;

u/s.35E(7), the amalgamated company is eligible to claim deduction in respect of expenditure on prospecting for, or extraction or production of, any mineral for the unexpired period;

S. 44DB allows amalgamating co-operative bank and amalgamated co-operative bank to claim proportionate deduction u/s.32, u/s.35D, u/s.35DD and u/s.35DDA based on the periods comprised in the financial year before and after the date of amalgamation.

As per S. 72A, the amalgamated company is eligible to carry forward and set off brought forward business loss and unabsorbed depreciation allowance of amalgamating company on fulfillment of the conditions/requirements of the said section;

U / s.72AA, the amalgamated banking company is eligible to carry forward and set off the accumulated loss and unabsorbed depreciation allowance of amalgamating banking company on fulfillment of the requirements/ conditions of the said section. Regarding S. 72AA, the Memorandum explaining the provisions of Finance Bill 2005 [273 ITR (St.) 60] stated that the said section is being introduced with a view to provide for carry forward and set off of accumulated loss and unabsorbed depreciation allowance of a banking company against the profits of a banking institution under a scheme of amalgamation sanctioned by the Central Government.

S. 72AB allows an amalgamated co-operative bank to carry forward and set off accumulated loss and unabsorbed depreciation allowance of amalgamating co-operative bank if the conditions/requirements of the said section are satisfied.

11,.. S. 80lA(12) allows the amalgamated company to claim deduction under the said section for the unexpired period. However, as per Ss.12A of S. 80IA the amalgamated company would not be entitled to claim deduction under the said section for the unexpired period of tax holiday if amalgamation or demerger happens on or after 1-4-2007.

By virtue of Ss.3 of S. 80IAB, Ss.7 of S. 80lC and Ss.6 of S. 80lE, the amalgamated company is entitled to claim deduction under the above sections for the unexpired period of tax holiday.

As per S. 80IB(12)where an undertaking which is entitled to claim deduction under the said section is transferred before the expiry of the tax holiday period in a scheme of amalgamation, the amalgamated company is entitled to claim deduction under the said section for the unexpired period of tax holiday.

As may be seen from the above, there are specific provisions in the Act allowing the amalgamated company to claim deduction or to carry forward and set off the accumulated loss and unabsorbed depreciation allowance of the amalgamating company.

As already noticed, there is a specific provision [80lA(12A)] denying the deduction under the said section to the amalgamated company. Further, S. 80lD allowing deduction in respect of profits and gains from business of hotels and convention centres in specified areas is silent as to whether amal-gamated company could claim deduction under the said section for the unexpired period of tax holiday.

S. 115JAA does not contain specific provision as to whether the amalgamated company can carry forward and set off the MAT credit of amalgamating company. One may contend that if the legislature had thought of permitting carry forward and set off of MAT credit to the amalgamated company it would have inserted specific provision to that effect in S. 115JAA. In the absence of a specific provision allowing the amalgamated company to carry forward and set off MAT credit of amalgamating company, Y Ltd. may not be eligible to carry forward and claim MAT credit of X Ltd.

2. Ss.lA of S. 115JAA reads as under:

“(lA) Where any amount of tax is paid U/ss.(l) of S. 115JBby an assessee, being a company for the assessment year commencing on the 1st day of April, 2006 and any subsequent assessment year, then, credit in respect of tax so paid shall be allowed to him in accordance with the provisions of this section.”

On a literal reading of the above provision, one could argue that only the company which has paid tax u/s.115JB is entitled to carry forward and set off the MAT credit.

S. 115JAA was inserted by the Finance Act 1997. Para 99 of the Budget speech of the Finance Minister [224 ITR (St.) 9] for the year 1997 and the memorandum explaining the provisions of Finance Bill 1997 [224 ITR (St.) 26] do not specifically state that the amalgamated company can set off the MAT credit of the amalgamating company.

3. Where the language of a provision is clear and unambiguous, the plain and natural meaning of the words should be supplied to the language used and no word should be ignored while interpreting a provision of a statute. [Keshavji Ravji and Co. v. CIT, [1990] 183 ITR 1 (SC)]. As stated earlier, the language of S. 115JAA(lA) allows carry forward and set off of MAT credit only to the company which has paid tax u/s.115JB. As a result, MAT credit of X Ltd. may not be available for carry forward and set off in the hands of Y Ltd.

4. The Finance Act, 2006 extended the period of carry forward and set off of MAT credit from 5 years to 7 years. The memorandum explaining the provisions of Finance Bill 2006 [2006] 281 ITR (St.) 61 and Para 26.2 of the CBDT Circular No. 14/2006 dated 28-12-2006 [2007] 288 ITR (St.) 9 stated as follows:

“To provide relief to assessees, being companies, who are required to pay MAT u/s.115JB for any assessment year commencing on or after 1st April, 2006, the provisions of S. 115JAA have been amended to provide that the amount’ of tax credit determined shall be allowed to be carried forward and set off for seven assessment years immediately succeeding the assessment year in which the tax credit becomes allowable under the said section.”

As stated earlier, Finance (No. 2) Act, 2009 [314 ITR (St.) 57] has extended the period of carry forward and set off of MAT credit from 7 years to 10 years. In this connection, the memorandum explaining the provisions of Finance (No. 2) Bill 2009 [314 ITR (St.) 183] also states that the above amendment is proposed with a view to provide relief to the asses sees being companies who pay MAT u/s.115JB for any assessment year beginning on or after the 1st day of April 2006.

From a plain reading of the above, it would be manifest that carry forward and set off of MAT credit is intended to provide relief to companies who have paid MAT. Thus, the benefit of MAT credit could be claimed only by a company which has paid MAT for AY 2006-07 or subsequent years and not by any other company. As a result, the amalgamated company may not be able to carry forward and set off MAT credit earlier belonging to amalgamating company.

In the year in which a company is liable to pay tax under regular provisions of the Act, MAT credit is allowed as a set off against the tax payable. The provisions of S. 140A, S. 234A, S. 234B and S. 234C allow reduction of MAT credit in the process of determining the tax/interest payable under the said sections. In other words, the amount of MAT credit is adjusted/reduced in the process of determining the tax payable u/s.140A and interest payable u/ s.234A, u/ s.234B, u/ s.234C. Finance Act 2006 amended the provisions of S. 140A, S. 234A, S. 234B and S. 234C so as to allow the adjustment/reduction of MAT credit while determining the tax/interest payable under these sections.

The memorandum explaining the provisions of Finance Bill 2006 [281 ITR (St.) 61] and para 38.2 of CBDT Circular No. 14/2006 dated 28-12-2006 explaining the provisions of Finance Act, 2006 state that tax credit allowed u/s.115JAA is no different from the tax paid in advance and credit for having paid the MAT should be allowed against the tax liability determined on assessment.

Similar is the view taken in CIT v. Jindal Exports Ltd., [2009] 314 ITR 137 (Del.) wherein it was held as follows:

“Minimum alternate tax credit represents that portion of minimum alternate tax which was not actually payable by the company but has all the same been collected by the government. It represents the tax paid before it is due. Minimum alternate tax credit which is available for set off in a year falls within the meaning of “advance tax” because the context requires it be given such a purposive meaning.”

S. 219 of the Act deals with credit for advance tax. As per the said section, advance tax paid by an assessee shall be treated as a payment of tax in respect of the income of the assessment year relevant to the previous year in which advance tax was payable and credit therefor shall be given to the assessee in the regular assessment.

On a reading of the above section, one may argue that credit for advance tax payment is given to the person who has paid such tax.

When MAT credit and advance tax are treated equally or when MAT credit is considered as advance tax, the principle underlying S. 219 could be held applicable even to MAT credit. As credit for advance tax is allowed to the person who makes payment of such tax, similarly, set off of MAT credit should be allowed only to that company which pays MAT.

6. Rule 37BA read with S. 199 generally provides for allowing credit for tax deducted at source to the deductee. However, in certain cases, it also provides for allowing credit of TDS to a different person (other than the deductee) if the income on which tax is deducted at source is assessable in the hands of a person other than the deductee.

In the absence of guidelines or circumstances under which a company can set off MAT credit of other company u/s.115JAA or under any rule, the amalgamated company may not be eligible to carry forward and set off MAT credit of the amalgamating company.

7. As per the maxim ‘Expressio unius est exclusio alterius’ which is a rule of prohibition by necessary implication, mention of one or more things of a particular class may be regarded as silently excluding all other members of the class; ‘expressum facit cessare tacitum’. Further, where a statute uses two words or expressions, one of which generally includes the other, the more general term is taken in a sense excluding the less general one; otherwise there would have been little point in using the latter as well as the former.

As detailed above, various provisions of the Act allow the amalgamated company to continue to claim deduction or to carry forward and set off the accumulated loss and unabsorbed depreciation of the amalgamating company. S. 115JAA does not specifically provide for carry forward and set off of MAT credit of amalgamating company by amalgamated company.

Applying the above rule of interpretation one could argue that in the absence of a specific provision, the amalgamated company would not be entitled to carry forward and set off MAT credit of the amal-gamating company.

Alternative II- Favourable view:
The proposition under this view is that the amal-gamated company is entitled to carry forward and set off the MAT credit of the amalgamating Company. The reasons for the same are as follows:

1. Amalgamation is a process wherein one or more companies merge into another company or two or more companies merge together to form a new company. All the property of the amalgamating company before amalgamation becomes the property of the amalgamated company by virtue of the amalgamation. Similarly, all liabilities of the amalgamating company before amalgamation become the liabilities of the amalgamated company by virtue of the amalgamation. The definition of the term ‘amalgamation’ ul s.2(1B) of the Act also envisages the above requirement. It is a settled law that the term ‘property’ as employed in S. 2(lB) is a term of the widest import and, subject to any limitation which the context may require, signifies every possible interest which a person can clearly hold and enjoy. MAT credit which can be carried forward and set off has the potential of reducing the tax liability during subsequent years and therefore it possesses the characteristics of being considered as a ‘property’. Guidance note on accounting of MAT credit issued by lCAl also recognises that MAT credit has expected future economic benefits in the form of its adjustment against the discharge of the normal tax liability in future years and therefore is an ‘asset’. The said Guidance note also permits the accounting and recognition of MAT credit as an ‘asset’ in the financial statements. Thus, MAT credit of the amalgamating company, which would be considered as a property, becomes the property of the amalgamated company by virtue of the amalgamation.

AS-14 – Accounting for amalgamation in the books of amalgamated company issued by ICAI and notified by Central Government in the form of Companies (Accounting Standard) Rules 2006 envisages two types of amalgamation viz., amalgamation in the nature of merger (pooling of interest method) and amalgamation in the nature of purchase (purchase method).

If the amalgamation is that of type one i.e., amal-gamation in the nature of merger, all the assets and liabilities of amalgamating company are recognised in the books of amalgamated company at their book value. Under this method, if MAT credit is recog-nised as an asset in the balance sheet of the amal-gamating company, the amalgamated company is also required to recognise the same in its balance sheet.

Under type two amalgamation i.e., the purchase method, the amalgamated company accounts for the amalgamation either by incorporating the assets and liabilities at their existing carrying amounts or by allocating the consideration to individual identifi-able assets and liabilities of the amalgamating company on the basis of their fair values at the date of amalgamation. The identifiable assets and liabilities may include assets and liabilities not recorded in the financial statements of the amalgamating company. [para 12 of AS-14]

Under this method, if MAT credit of amalgamating company (irrespective of whether such credit is recognised as an asset in the balance sheet of amalgamating company or not) is taken over by the amalgamated company or if the consideration in respect of amalgamation includes consideration for taking over MAT credit in the scheme of amalgamation, the latter company recognises the same in its balance sheet.

Thus, under both the types of amalgamation, the MAT credit of amalgamating company could be recognised as an asset in the balance sheet of the amalgamated company. MAT credit is thus an accounting derivative. It could be regarded as a ‘capital asset’ u/s.2(14). On transfer of such capital asset in a scheme of amalgamation, it could be said that the amalgamated company becomes the owner, enabling it to carry forward and set off MAT credit. The principle underlying some of the provisions wherein deduction is attached to the undertaking and not to the owner thereof could also be extended to MAT credit. Therefore, it could be said that on amalgamation the amalgamated company gets the right to carry forward and set off the MAT credit.

2. Various amendments were made to the Income-tax Act, 1961 by the Finance Act 1999 concerning tax implications of business reorganisations by way of amalgamation and demerger. The Finance Minister’s speech in Budget 1999 [236 ITR (St.) 1] stated that a comprehensive set of amendments is being proposed to make business re-organisations fully tax neutral. In the speech the following was stated “it is proposed that all fiscal concessions will survive for the unexpired period in the case of amal-gamation and de-mergers.” It may be noted that MAT credit in respect of tax paid u/s.115JA was already on the statute books when the provisions of Finance Act 1999 were introduced. The intention of the legislature appears to be that the benefits/reliefs available to the amalgamating company should vest in the amalgamated company so that the latter company can claim such benefits/reliefs for the unexpired period, on a premise that the amalgam-ation had not been effected.

3. There is no prohibition or restriction in S. 115JAA with regard to carry forward and set off of MAT credit belonging to the amalgamating company by the amalgamated company. The memorandum explaining the provisions of Finance Bill, 2005 [273 ITR (St.) 60] and Circular no. 3 of 2006, dated 27-2-2006 [(2006) 281 ITR (St.) 222] explaining the provisions of Finance Act 2005 also do not state that carry forward and set off of MAT credit is allowable only to the company which has paid tax u/s.115JB. In an amalgamation, one company is subsumed into another. The amalgamated company becomes the ‘alter ego’ of the amalgamating company. Tax provisions desire that the benefits available to the amal-gamating company survive and continue to be effective in the amalgamated company. The benefits are to remain unhindered despite the assumption of new legal garb. As a result, the amalgamated company may carry forward and set off MAT credit belonging to the amalgamating company.

4. In DCIT v. Beck India Ltd., (2008) 26 SOT 141 (Mum.) the High Court vide order dated 20-9-2001 approved the merger of a company with the respondent company with effect from the appointed date of amalgamation being 1-1-2001. The financial statements presented in the annual general meeting did not consider the unabsorbed losses of the amalgamating company since the said meeting was conducted before the date of the order of the High Court approving the merger. For the same reason, the original return filed by the respondent on 30-10-2001 did not consider the unabsorbed losses of amalgamating company in the process of computation of book profits u/s.115JB. After the approval of merger by the High Court, the respondent assessee revised its financial statements so as to consider the effect of amalgamation. The respondent assessee also filed a revised return wherein the unabsorbed losses of amalgamating company remaining after setting off the same with the surplus of the assessee company was reduced in the process of computation of book profits u/s.115JB. The Tribunal held that the assessee is eligible for set off based on the revised accounts.

Considering the above decision wherein losses of amalgamating company were allowed to be set off by the amalgamated company in computing book profits u/s.115JB, one could contend that MAT credit of amalgamating company could also be carry forward and set off by the amalgamated company u/s.115JAA.

In VST Tillers and Tractors Ltd. v. CIT, ITA No. 588/Bang./2008, a decision of the Bangalore ITAT, VST Precision Components Ltd. (‘VPCL or the amal-gamating company’), a subsidiary of VST Tillers & Tractors Ltd. (‘the assessee’) amalgamated with the assessee under a scheme of amalgamation sanctioned by the Karnataka High Court. As per the sanctioned scheme, pursuant to the amalgamation, all assets and liabilities of VPCL would vest with the assessee. The sanctioned scheme inter alia provided that the unabsorbed .losses and depreciation of VPCL shall be deemed to be losses and depreciation of the assessee as provided u/ s.72 of the Act. The assessee in computing the MAT liability u/s.115JB reduced unabsorbed losses of VPCL (which was less than the unabsorbed depreciation of VPCL) from book profits. The CIT passed order u/ s.263 holding that unabsorbed losses reduced were not as per books of account of the assessee but were as per books of accounts of VPCL and therefore the same cannot be reduced from the book profits of the assessee. On appeal, the Tribunal apart from relying on S. 72 also relied on S. 72A of the Act. It was observed that the sanctioned scheme also provided that the unabsorbed losses and depreciation of VPCL shall be deemed to be losses and depreciation of the assessee as provided u/ s.72 of the Act. It was therefore held that the assessee has rightly reduced the unabsorbed losses of VPCL from its book prof-its in computing MAT liability u/s.115JB.

6. In ITO v. Mahyco Vegetable Seeds Ltd., (2009)314 ITR (AT) 37 ITAT (Mum.) it was held that the resulting company is entitled to carry forward unabsorbed scientific research expenditure allocated to it in the process of demerger by the demerged company. The Tribunal held that the amount representing the unabsorbed capital expenditure on scientific research u/s.35(4) was not different from the unabsorbed depreciation for the purposes of S. 72A(7). The respondent company was therefore allowed to carry forward unabsorbed scientific research expenditure of the demerged company even though there is no specific provision in S. 72A allowing amalgamated or resulting company to carry forward and set off unabsorbed scientific research expenditure of amalgamating or demerged company.

7. In SKOL Breweries Ltd. v. ACIT, 28 ITAT India 998 (Mum.) ITA No. 313/Mum./07 A.Y. 2003-04 decision dated 15-5-2008 the Tribunal allowed set off of MAT credit of amalgamating company in the hands of the appellant assessee being the amalgamated company. The Tribunal observed:

“We have duly considered the rival contentions and gone through the record carefully. The Ld. CIT(A) while denying the benefit of taxes paid by M/s .. Charrninar Breweries Ltd. (CBL) u/s.115JA has observed that M/ s.. CBL was amalgamated with erstwhile SKOL and ceased to exist. Once the company ceases to exist then any benefit available to the company would not devolve upon the transferee company. For the above view CIT(A) has relied upon the decision of Hon’ble SC in the case of Sarawati Industries Syndicate 186 ITR 278. In our opinion Ld. first appellate authority has referred to this decision without context. The facts of that case are quite different. In that case, an assessee ‘A’ has paid certain amount to ‘B’ towards sales tax liability. ‘B’ who collected the sales tax from’ A’ disputed the liability before the Sales tax Tribunal. During the pendency of the litigation’ A’ ceased to exist and its business was taken over by ‘C’. The Sales tax Tribunal decided the issue in favour of ‘B’ and held that no sales tax is payable. Accordingly ‘B’ returned the money to ‘C’. This amount was sought to be taxed u/s.41(1) of the Act according to the provision as it existed in AY 1965 – 66. In the context the Hon’ble Supreme court has held that this amount is not taxable in the hands of ‘C’. The ingredients provided in the definition of amal-gamation is altogether different from the condition provided in S. 41(1) in A.Y. 1965-66. The assets and liabilities on the date of amalgamation of the amalgamating company would become assets and liabilities of the amalgamated company. If M/ s. Charminar Breweries has paid tax u/s.115JA of the Act in earlier assessment years and that benefit is permissible u/s.115JA of the Act then that cannot be denied to the assessee simply for the reason that M/s. Charminar Breweries is not in existence. The Ld. CIT(A) has erred in placing his implicit reliance upon the judgment of Hon’ble Supreme court. In principle we allow this ground of appeal of the assessee, set aside the issue to the file of A.O for verification of the taxes paid by M/ s. Charminar Breweries and how that benefit would devolve upon the assessee. The AO shall verify the details and then grant the benefit to the assessee.”

8. The rationale for allowing credit in respect of taxes paid under MAT, as per the memorandum explaining the provisions of Finance Bill, 1997 [224 ITR (St.) 26] and as per Para 45.4 of CBDT Circular No. 763, dated 18-2-1998 [230 ITR (St.) 54] is that a company should always pay a minimum tax even while offsetting the MAT credit against regular tax. The objective of the said provision is to allow relief in respect of tax paid under MAT regime. It is a settled law that provisions granting exemptions and relief should be interpreted liberally so as to advance the objective and not to frustrate it. [Bajaj Tempo Ltd. v. cit, [199] 196 ITR 188 (SC)]. Thus, MAT credit of X Ltd., on amalgamation with Y Ltd., should be available for carry forward and set off in the hands of the fatter company.

9. It is also a settled law that when there is any genuine doubt about the interpretation of a fiscal statute or where two opinions are capable of being formed then, that rule of interpretation which is favourable to the assessee is to be preferred. [CIT v. Vegetable Products Ltd., [1973] 88 ITR 192 (SC)]

10. Going by the rationale of S. 115 JAA, one could contend that the MAT credit of amalgamating company can be set off by the amalgamated company. One could contend that in the process of amalgamation, one company loses its identity and would be merged with the other company. It could be contended that MAT credit, if utilised by the amalgamated company, would not result in any excessive relief.

11. Denial of carry forward and set off of MAT credit of an amalgamating company to an amalgamated company would be against the legislative intention and reasonable or purposive interpretation of S. 115JB and S. 115JAA. There would be no excessive relief or double deduction if amalgamated company is allowed to carry forward and set off MAT credit of amalgamating company. As explained earlier, MAT credit represents that portion of tax which was not actually payable by the company but has all the same been collected by the Government. [CIT v. [indal Exports Ltd., [2009] 314 ITR 137 (Del.)] If amalgamated company is denied the benefit of carry forward and set off of MAT credit of amalgamating company, it could be termed unauthorised collection of taxes by the Government. Reliance may be placed on the decision in Escorts Ltd. v. DCIT, (2007) 15 SOT 368 (Del.) wherein it was observed that if no credit of TDS is to be given to the payee/ deductee, the Government would have no authority to treat the same as tax and Article 265 does not empower the Government to make any levy or collection of tax not authorised by law.

It is settled law that where strict literal construction leads to injustice or a result not intended to be subserved by the object of the legislation, then an equitable construction should be preferred over the strict literal construction. Where the plain literal interpretation of a statutory provision produces a manifestly unjust result which could never have been intended by the legislature, the court might modify the language used by the legislature so as to achieve the intention of the legislature and produce a rational result.

The task of interpretation of a statutory provision is an attempt to discover the intention of the legislature from the language used. Language is an imper-fect instrument for the expression of human intention. Statutes always have some purpose or object to accomplish and a sympathetic and imaginative discovery is the surest guide to their meaning.

Though equity and taxation are often strangers, attempts should be made that these do not remain always so and if a construction results in equity rather than in injustice, then such construction should be preferred to the literal construction. [CIT v. Gotla, (J.H) [1985] 156 ITR 323 (SC); K. P. Varghese v. ITO, [1981] 131 ITR 597 (SC)]

12. In the process of interpretation of statutes, the maxim ‘Expressio unius est exclusio alterius’ is a valuable servant but a dangerous master. [Smith’s Judicial review of Administrative Action, Fourth edition page 187; Colquhoun v. Brooks, [1888] 21 QBD 52 (CA); Devidas v. UOI, (1993) 200 ITR 697 (Born.); Kirloskar Pneumatic Co. Ltd. v. CIT(A), (1994) 210 ITR 0485 (Born.); CWT v. Dungarmal Tainwala, (1991) 191 ITR 0445 (PAT); Nathuram Weljibhai Vyas v. Mrs. Laxmibai Lunkaranji Chandak, (1983) 139 ITR 0948 (Born);ACCE v. National TobaccoCo. of India Ltd., AIR 1972 SC 2563.] The exclusion (in a legislature) is often the result of inadvertence or accident, and the maxim ought not to be applied, when its application, having regard to the subject-matter to which it is to be applied, leads to inconsistency or injustice. [Devidas v. UOI, (1993) 200 ITR 697 (Born.)] In ACCE v. National Tobacco Co. of India Ltd., AIR 1972 SC 2563 [decision referred to in 139 ITR 0948 (supra)] it was observed that the rule of ‘Expressio unius est exclusio alterius’ is subservient to the basic principle that courts must endeavour to ascertain the legislative intent and purpose, and then adopt a rule of construction which effectuates rather than one that defeats these principles.

In view of the above, the maxim ‘Expressio unius est exclusio alterius’ should not be considered for denying the benefit of carry forward and set off of MAT credit of amalgamating company to amalgamated company.

Conclusion:
The reasons in support of and also against the issue under consideration have been set out above. The reasons in support of the argument that, amal-gamated company can claim MAT credit of amal-gamating company after merger, appears to be reasonable. Such conclusion would also be in accord with the purposive interpretation of the relevant provision. However, the tax authorities may be reluctant to allow MAT credit of the amalgamating company to amalgamated company. This may entail a tax demand and other consequences such as levy of interest and penalty on the amalgamated company. To avoid the levy of interest, one may take a pro-revenue stand while paying taxes, but adopt the liberal view while filing returns.

It may be noted that Para 13.10 of the discussion paper on Direct Taxes Code Bill, 2009 states that under the proposed code, MAT will be a final tax and therefore it will not be allowed to be carried forward for claiming tax credit in subsequent years.

Nirav Shah

Registration — Gift deed in respect of immovable property requires registration — Registration Act S. 17

New Page 5

Registration — Gift deed in respect of immovable property
requires registration — Registration Act S. 17

[ Naranji Bhimji Family Trust v. Sub-divisional Officer,
Ramtek & Ors., AIR 2009 (NOC) 1934 (Bom.)]

The petitioner claimed to be owner and landlord of the suit
premises. The property originally belonged to one Shamji Naranji and in the
year 1962, by order of the Charity Commissioner, the said property was
included in Naranji Bhimji Family Trust and accordingly entry was also taken
in the city survey record in the year 1969. The petitioner-trust allowed
respondent No. 2 & 3 in the year 1980-81 to occupy the suit premises
consisting of five rooms and two verandahs, etc. as licensee. Respondent no. 3
had filed Regular Civil Suit seeking declaration that he was owner of the
property on the basis of oral gift. That suit came to be dismissed on
8-2-2005. According to the petitioner, they had repeatedly asked the
respondent nos. 2 and 3 to vacate the premises but they avoided.

The petitioner filed application u/s.43 of the Maharashtra
Rent Control Act, 1999 for eviction. The competent authority granted the
respondent leave to appear and contest the above application. The said order
was challenged, wherein the Court held that S. 123 of the Transfer of Property
Act clearly provides that for the purpose of making gift of immovable
property, the transfer must be effected by registered instrument signed by or
on behalf of the donor and attested by at least two witnesses. A gift of
movable property may be made either by registered instrument or by delivery.
Thus immovable property cannot be transferred unless a gift of the same was
made by a registered instrument. Oral gift of immovable property is not
permitted u/s.123 of the Transfer of Property Act. Similarly, S. 17 of the
Registration Act, 1908 makes registration of an instrument of gift of any
immovable property compulsory, irrespective of value of the property. Other
non-testamentary instruments, which purport or operate to create, declare,
assign, limit or extinguish any right, title or interest in immovable
property, the value of which is Rs.100 or upwards are required to be
registered compulsorily. It means that if the value of the property is less
than Rs.100, in case of such documents, they are not compulsorily required to
be registered. However, exception on the basis of the value of the immovable
property is not made in respect of instrument of gift of immovable property.
Thus, it was clear that S. 123 of the Transfer Property Act as well as S. 17
of the Regis-tration Act make registration of the instrument of gift deed of
an immovable property, irrespective of the value, to be compulsory. In view of
this, the ground taken by the respondents in defence of the application for
eviction was not permitted to be raised and proved. In view of this, the order
of competent authority granting leave to defend was set aside.

levitra

Nirav Shah

Registration — Registration of sale deed pending — Purchaser cannot project himself as owner — Registration Act S. 17 and S. 49.

New Page 5

Registration — Registration of sale deed pending —
Purchaser cannot project himself as owner — Registration Act S. 17 and S. 49.

[ Arun Bhusan Guha & Ors v. Amal Roy & Anr., AIR
2009 Calcutta 182]

The plaintiff executed the deed of conveyance for conveying
his right, title and interest in the suit property in favour of the opposite
party No. 2 on 14-11-2002. The registration of the said deed of conveyance was
kept in abeyance till March, 2006 due to non-payment of deficit stamp duty.
The registration of the said deed was completed in March, 2006 on payment of
deficit stamp duty. The question that arose for consideration was what is the
position in law about the title of the property during the interregnum period
between the date of execution of the deed and the date of completion of
Registration of the said deed as per the Registration Act ? Can the purchaser
project himself as owner of the said property during this interregnum.

The Court held that S. 17 read with S. 49 of the
Registration Act provides that title of the property was conveyed only on
registration of the said deed where registration was compulsory; therefore it
was difficult to hold that the purchaser can project himself as the owner of
the said property prior to the completion of registration of the deed of sale
as per the Registration Act.

So long as the registration was not completed, the
purchaser cannot project himself as the owner of the property in question,
though it was true that all trappings of ownership were traceable from the
date of execution of the deed after its registration was completed. So long as
the sale deed was not registered or in other words the registration of the
sale deed was not completed, it was not a valid document. Therefore, no one
could claim title on the basis of such invalid document before completion of
its registration. However, once the invalid documents gain validity on
completion of registration upon fulfilment of the requirement required for
registration thereof, the title of the purchaser would relate back to the date
of execution of the document by operation of law, but during this interregnum
period i.e., between the date of execution of the document and the
completion of registration thereof, the purchaser cannot project himself as
the owner of the said property though his title will relate back to the date
of execution of the said deed immediately on completion of registration of the
said document.

Since the vendor executed the said deed of transfer with an
expressed intention to convey his title in the property in favour of its
purchaser from the very date of its execution, either upon receipt of the
consideration money for such sale or upon receipt of the consideration money
in part with a promise made by the purchaser to pay the balance amount in
future, the vendor has a legal and moral obligation to protect the title and
possession of the property in question until registration of the deed of
transfer was completed, so that on completion of such registration, the
purchaser can enjoy the fruits of such transfer with retrospective effect from
the date of execution of the deed of sale.

Nirav Shah

Sureties — Co-sureties are liable to pay each an equal share of whole debt — Contract Act S. 146.

New Page 5

Sureties — Co-sureties are liable to pay each an equal
share of whole debt — Contract Act S. 146.

[ Krushna Chandra Mallick v. Chief General Manager, SBI
and Ors., AIR 2009 Orissa 99]

The petitioner had filed a petition challenging the
impugned notice wherein the petitioner has been shown as one of three
guarantors for one principal borrower. The notice was issued pursuant to the
decree of the DRT providing for the joint and several liability of all the
three guarantors. The petitioner apprehended that his property would be put to
auction without touching the properties of other two guarantors who are family
members of the borrowers.

The Court held that liability u/s.128 of the Contract Act
is co-extensive to that of the borrower. S. 146 of the Contract Act provides
that co-sureties are liable to pay each an equal share of the whole debt. The
Court directed the Tribunal to dispose of the petitioner application after
hearing the legal and factual issues regarding application of the provision of
S. 146 of Contract Act and Rule 8(5) of the Security Interest (Enforcement)
Rule, 2002.

levitra

Nirav Shah

Recovery — Directors of Pvt. Ltd company who were not co-borrowers nor guarantors not liable — Recovery of Debts due to Banks and Financial Institutions Act 1993.

New Page 1

Recovery — Directors of Pvt. Ltd company who were not
co-borrowers nor guarantors not liable — Recovery of Debts due to Banks and
Financial Institutions Act 1993.

[Vijay Dashika Char v. Bank of Maharashtra, AIR 2009
(NOC) 2260 (Bom.)]

The plaintiff bank filed a suit for a monetary claim
against the defendants. The original defendant was a private ltd company who
had taken financial assistance from the plaintiff bank of Rs.2.50 lacs. In
security the defendant company had executed a demand promissory note.

The bank had contended that the managing director and
director had executed bond and were guarantors, however no such bond was ever
produced by the bank before the Court.

The Court observed that merely because the directors had
put their signatures on the credit note, would not render the promise made a
personal promise on part of directors. It was admitted position that the cash
credit facility was given only to the company. There was no personal cash
credit facility granted to any of the directors. Thus it was clear that there
was no personal facility granted in favour of any individual director. Thus,
the bank has no case against the directors, but was only for recovery from the
company. The plaintiff’s suit as against the directors’ was therefore
dismissed.

levitra

Nirav Shah

Gift — Gift deed of immovable property should be attested by two witness — Transfer of Property Act S. 123.

New Page 1

Gift — Gift deed of immovable property should be attested
by two witness — Transfer of Property Act S. 123.

[Lankeswar Malakar & Ors. v. Harendra Nath Deka (Dead) &
Ors., AIR 2009 (NOC) 2462 (Gau.)]

As per S. 123 of Transfer of Property Act, a document
whereby a gift of immovable property is made should be attested by two
witness. The document if not proved as required u/s.68 of Evidence Act, the
donee cannot claim title over suit land by means of such a Gift deed.

Nirav Shah

Inheritance — Children of void marriage would be treated as legitimate children of their father for purpose of inheriting separate property of father — Hindu Succession Act 1956.

New Page 1

Inheritance — Children of void marriage would be treated as
legitimate children of their father for purpose of inheriting separate
property of father — Hindu Succession Act 1956.

[Govind Manohar Jadhav & Ors. v. Smt. Rukhminibai
Manohar Jadhav & Anr., AIR 2009 (NOC) 2366 (Bom.)]

One Mr. Manohar Jadhav married respondent No.1 Rukminibai.
During the subsistence of the said marriage, he married appellant No. 3
Popatbai. From the second marriage appellant No. 1 & 2 were born. One person
had purchased some property from Respondent No. 1 (i.e. first wife).
Mr. Manohar had received his share of property on partition from his brother.

The issue that arose for consideration was whether the
property received by Mr. Manohar on family partition was his separate property
and therefore whether the illegitimate children were entitled to inherit
share.

The Court observed that as per S. 314 of the Principles of
Hindu Law by Mulla, Volume I, 20h Edition, a wife cannot herself demand
partition, but if a partition does take place between her husband and his
sons, she is entitled to receive a share equal to that of a son. It does not
appear that in absence of any child, male or female, wife automatically
be-comes sharer in the property of husband during his life time. So, it cannot
be said that 1st wife-respondent No. 1 Rukminibai has more than
3 share in
the property of Manohar. The case would have been different if respondent No.
1, Rukminibai had a son, in that case such son would have been coparcener and
such son, Rukminibai and Manohar each would have
ard share
and property available for partition amongst heirs would have been
a share. The
2nd wife would not be entitled to any share. On partition between brothers,
the mother would have equal share with sons.

The Court held that the 2 children from the 2nd wife were
entitled to share in the property of their father, Manohar, though the second
wife had no such right.

levitra

Nirav Shah

Hindu Undivided Family — Sale of coparcenaries property for legal necessity — Hindu Succession Act 1956.

New Page 1

Hindu Undivided Family — Sale of coparcenaries property for
legal necessity — Hindu Succession Act 1956.

[Shankarlal Ramprasad Ladha (deceased by L.Rs.) v.
Vasnat Chandidasrao Deshmukh & Ors., AIR 2009 (NOC) 2367 (Bom.)]

The ancestral agricultural properties were kept undivided.
The respondent No. 4 was the karta of the family as he was the eldest male
member. He used to manage affairs of the joint family including cultivation of
the family lands. He was required to maintain himself and the other members of
the joint Hindu family. It was subsequently learnt that the Karta alienated
the suit houses.

The issue arose as to whether there was existence of legal
necessity for alienation of the suit house.

Concept of legal necessity as illustrated under Article 243
of the Hindu Law [By Mulla — 20th Edition (Vol. I) page 371]. It is well
settled that ‘legal necessity’ does imply pressure on the resources of the
joint Hindu family. So, if it is proved that there was considerable strain on
financial resources of the joint Hindu family at the relevant time, then the
sale transaction may be justified. The alienation by Manager of the joint
Hindu family may be permissible if it is for the benefit of the estate.
Article 244 of the Hindu Law (By Mulla) would make it manifest that purchaser
of the joint Hindu family property is under obligation to discharge burden of
proof to prove existence of the legal necessity or that his having made proper
and bonafide inquiry as to the existence of such necessity.

The Karta alienated the suit properties for improvement of
the lands, for maintenance of himself and education of the minors and for
meeting out his own marriage expenditure. It had come on record that in the
proximity of time of the sale deed, the karta got married.

It is explicit in view of Article 243(c) of the Hindu Law
(By Mulla) that marriage expenses of male coparceners can be regarded as
incidents of legal necessity. The marriage expenditure required for the
purpose of marriage of the Karta appears to be the reason for which the house
property was alienated by him.

The house property was sold by the Karta on account of
legal necessity, namely, to meet out expenditure of his own marriage. However,
the sale transaction of the other house property is not proved to be for the
purpose of legal necessity nor it could be for the benefit of the estate of
the joint family. Which is therefore held to be not on account of legal
necessity.

In the result, the appeal was partly allowed.

levitra

Nirav Shah

Affidavit — Evidence — Sworn before Notaries can be accepted by the Civil Court — Civil Procedure Code S. 139 Order 18 Rule 4.

New Page 1

Affidavit — Evidence — Sworn before Notaries can be
accepted by the Civil Court — Civil Procedure Code S. 139 Order 18 Rule 4.

[ Prashant Chandrashekhar Gundawar & Ors. v. Municipal
Council, Bhadrawati & Anr., AIR 2009 Bombay 144]

The issue which arose for consideration was whether
affidavits which are to be filed in the Court, can be sworn by on
administering the oath to the deponents, by any notary appointed under the
Notaries Act.

It was observed that notaries have power to administer oath
under the Notaries Act. In absence of statutory provision, the courts were
refusing to accept the affidavits sworn before the notary. S. 139 of CPC, was
amended to include a specific provision permitting the swearing of such
affidavits before the Notaries. The deponents are to be the persons who are
authorised u/s.139 of CPC to do so. Therefore, the result is obvious that the
notaries are authorised to administer oath to the deponents. The affidavits
which are to be under the Code, can be sworn by on administering the oath to
the deponents, by any notary appointed under the Notaries Act and under Order
18, Rule 4 of the CPC there is no bar requiring to exclude the affidavits
sworn before the Notaries for taking them on record as an examination in
chief. Thus, such affidavit sworn before Notaries can be accepted as evidence
by the Civil Court.

levitra

Nirav Shah

Deficiency in service — person — includes company : Consumer Protection Act S. 2(1)(m).

New Page 1

7. Deficiency in service — person — includes company :
Consumer Protection Act S. 2(1)(m).

[ Karnataka Power Transmission Corporation Ltd. & Anr.
v. Ashok Iron Works P. Ltd. with Ors., AIR 2009 SC 1905]

The definition of term person was never intended to exclude
a juristic person like company. The definition u/s.2(1)(m) is inclusive and
not exhaustive.

The Court held that non supply of electricity to consumer
by transmission company within time agreed upon even if the consumer is a
manufacturing unit, amounts to deficiency in service as per the definition of
consumer as it stood before 2002 Amendment. Therefore the complaint against
transmission company is maintainable before Consumer Forum.

The Court further observed that u/s.2(1)(o) ‘service’ means
service of any description which is made available to potential users and
includes the provision of facilities in connection with supply of electrical
or other energy. ‘Deficiency’ u/s.2(1)(g) means any fault, imperfection,
shortcoming or inadequacy in the quality, nature and manner of performance
which is required to be maintained by or under any law for the time being in
force or has been undertaken to be performed by a person in pursuance of a
contract or otherwise in relation to any service. As indicated in the
definition of ‘service’, the provision of facilities in connection with supply
of electrical energy is a service. Supply of electricity by the Board or for
that matter KPTC to a consumer would be covered u/s.2(1)(o) being ‘service’
and if the supply of electrical energy to a consumer is not provided in time
as is agreed upon, then u/s.2(1)(g), there may be a case for deficiency in
service.

levitra

Nirav Shah

A step towards decoding the complex IFRS

Article

A shift from country-specific Generally Accepted Accounting
Principles (GAAP) to International Financial Reporting Standards (IFRS) is
proving to be an inevitable move virtually for all organisations around the
world. It is imperative to be prepared to contend the extensive impact of this
regulatory change on business practices, accounting practices and organisation
as whole.

The paragraphs below give a bird’s-eye view of the
following :

What is
IFRS ?

Indian
initiative

Process of
conversion

Overview of
key difference

Challenges
under IFRS

Impact and
considerations out of IFRS

What are accounting standards ?

Accounting standards are authoritative statement on how
transactions should be recorded and disclosed in the financial statements. They
ensure uniformity amongst the various entities of the readers of financial
statements. The compliance to standards is mandatory to ensure that the accounts
are true and fair. This uniformity is now proposed to be spread from local
boundaries to across the world with the advent of single global accounting
standard, namely, IFRS.

Introduction to IFRS :

IFRSs are adopted by the International Accounting Standards
Board (IASB), the independent standard-setting body of the International
Accounting Standards Committee Foundation (IASC Foundation).

More than 100 countries now require or permit the use of
IFRSs or are converging with the International Accounting Standards Board’s (IASB)
standards. EU recognised IFRS in 2005 and the SEC has in its announcement on
November 2007 permitted IFRS without reconciliation with US GAAP for non-US
companies.

Many of the accounting standards forming part of the IFRS are
known by the earlier name of International Accounting Standards (IAS), which
were issued between 1973 and 2001 by the board of International Accounting
Standards Committee (IASC). In April 2001, IASB adopted all IAS and continued
their development calling new standards as IFRS which consist of :

IFRS
standards issued after 2001

IAS
standards issued before 2001

Interpretations originated from International financial Reporting
Interpretations Committee (IFRIC)

Standing
Committee Interpretations (SIC) issued before 2001

Indian initiative towards IFRS :

The Institute of Chartered Accountants of India (ICAI), the
apex accounting body in India has issued a ‘Concept paper on convergence
with IFRS in India’ in October 2007. The document lays down the
convergence strategy. All public interest entities would have to adopt IFRS from
1st April 2011.

Financial statements under IFRS :

Generally in India we have the following as financial
statements :

Balance
Sheet

Profit &
Loss Account

Cash Flow

Significant
Accounting Polices and Notes to Accounts

Under IFRS the financial statements would comprise :

Statement
of financial position as at end of the period

Statement
of comprehensive income for the period

Statement
of changes in equity for the period

Statement
of cash flow for the period

Notes,
comprising a summary of significant accounting policies and other explanatory
information

Statement
of financial position as at the beginning of the earliest comparative period
when an equity applies an accounting policy retrospectively or makes a
retrospective restatement of items in its financial statements, or when it
reclassifies items in its financial statement.

The old format as per Schedule VI of the Indian Companies Act
would not be relevant and the financial statements would have to reflect items
as prescribed by the relevant IFRS.

Key differences between IFRS and Indian GAAP :

The adoption of IFRS affects more than a company’s accounting
policies, processes, and people. Ultimately, most aspects of a company’s
business and operations are affected potentially.

IFRS is a principle-based approach to standard-setting. It is
less reliant on bright lines and detailed rules as compared to the US GAAP.

At various places IFRS provides scope of judgment and
requires information to be presented on the basis of substance rather than rule.
For example, redeemable preference shares may be treated as liability and
convertible debentures as equity.

While applying IFRS, usage by an investor is kept in mind and
requirement of the law and management takes a backseat. For example, in
case of the business combination the acquirer under IFRS could be different than
the legal acquirer (like in case of reverse merger for tax benefit or other
purposes).

Financial statements under IFRS place more reliance on the
management estimate. For example, in case of depreciation of assets
which, under IFRS, would have to be based on estimated useful life as against
the present Indian requirement to follow Schedule XIV of the Companies Act,
1956.

The fair value concept is embodied in many of the IFRS (like
IAS 30 on Financial Instruments, IAS 40 Investment Property, etc.). The concept
of fair value poses several issues on valuation, valuation models and accuracy
and reliability of the same for the purpose of accounting and presentation of
financial statements.

A few other examples where there is departure from Indian Accounting Standards are:

Major overhauling cost for fixed assets which can be capitalised under IFRS (provided it meets certain criteria) as against the present requirement to expense out the same

Inventory for service organisation for work which is in progress (already covered by proposed Indian Accounting Standard)

Prior period items to be given effect retrospectively in opening equity

Proposed dividend is not required to be reflected in financial statements under IFRS

Under IFRS, provision made for dismantling of asset or for site closure can be capitalised

Under IFRS, EPS to be disclosed separately for continuing and discontinuing operations

Challenges under IFRS :

Joint ventures: Consolidation proportionate or otherwise may become an issue. Consolidation method may impact the structure of new arrangements

Debt/equity: Possible reclassification of preference shares as liabilities

Subsidiaries and associates: Different rules may impact the current treatment

Valuation: Greater use of fair value

Detailed hedge documentation, and ongoing effectiveness testing is required to achieve hedge accounting under IFRS

Embedded derivatives: Possible requirement to fair value components of other instruments, including long-term contracts

Contracting: Different rules will present different opportunities, challenges, management and accounting issues

Financial communications will have to address changes in presentation of financial information as well as fundamental change towards fair value accounting and its impacts on traditional ratios and performance indicators

Systems and processes

– Data requirements

– Calculation methodologies

– Integration

Uncertainly about Income-tax Dept. response

Requires multi-disciplinary participation

Aiming at a moving target

– Uncertain timetable for implementation

– Uncertainty about final form of IFRS

Conversion/convergence to IFRS :

The conversion to IFRS will have to be managed like any other large-scale project. Sufficient time must be incorporated into project plan, proper resources must be secured and all key players must be in-volved in critical decision-making.

IFRS is more than an exercise for the accounting and finance department. Its impact is far reaching, affect-ing areas from internal control and sales to research and development.

Typically the following three phases will be involved in convergence/conversion to IFRS :

Impact and considerations out of IFRS :

First-time adoption could be a mammoth task and hence it is essential to ensure that proper care and diligence is exercised so that there are no spill-over impacts in subsequent periods. IFRS 1 deals exhaustively with the first-time adoption.

To ensure that the judgment, estimated and fair valuation concepts are not misused by the Management, lot of reliance would have to be placed on independent valuers.

Proper planning is required for transition to IFRS and hence to ensure that the company must have a proper road map / strategy and resources to migrate to IFRS.

Emphasis on transparent and exhaustive disclosure which would mean that the source of data, compilation process and methodology are more robust.

To ensure that the commercial colour of the transaction is correctly reflected in the accounting of the same. For example, Spy to park non-performing assets may be required to be consolidated.

More data analysis, narrative accounting and hence more qualitative accountants and more time will be required to review.

The taxation team will have to work closely with the accounts teams to examine IFRS impact on the new financing structures implemented within the group. Further there is also uncertainty regarding the response to the Income-tax Department regarding change to IFRS.

Under income-tax based on view that the Tax Department may take, there could be cash flow related implication which would have to be understood/ captured and addressed appropriately.

The CFO will need to focus on the underlying commercial nature of transactions and events. Other areas where more judgment is required include property, leases, revenue recognition, provisions and consolidation policy.

Convergence to IFRS will have an impact on the processes which lead to recording of a specific transaction and necessitate re-engineering of those process and related internal controls.

IFRS would benefit all the users of financial statements. It would take accounting and financial reporting to a new level. However, it would in the initial years put too much burden on the preparers and reviewers of financial statements.

Lot of research and development is still under progress for various items like fair value, etc. and the evolved version would lead to better and more narrative financial statements. IFRS for SME is yet to be released; the same is expected to reduce the compliance requirement and the cost for ‘private entities’ /’non-publicly accountable entities’.

IFRS in India is an opportunity for Indian enterprises to be in line with the global companies and would in turn help raise finances globally. It would be a boon to the accounting fraternity as it would expose them to international arena and would help service the global accounting market.

Nirav Shah

Analysis and comments on New Form 704 under MVAT Rules, 2005

Nirav Shah

Finding the Sweet Spot

Accounting Standards

Accounting standards are becoming increasingly complicated.
Though the standard-setters have their heart in the right place, and would want
to simplify the standards, the end result is that accounting standards are
becoming incomprehensible. The more the standard-setters try to simplify, the
worse it gets. One reason may very well be that businesses are getting
complicated, and transactions are not as simple as they used to be. A few years
ago, Indian GAAP had only 15 accounting standards; now that number has more than
doubled. Even International Financial Reporting Standards (IFRSs) would soon
cross 3000 plus pages.

Indian standards are inspired by IFRS. Therefore it would be
more appropriate to look at the development of IFRSs. These standards were
written over several years and with the assistance of different national
standard-setters. Consequently the lay out of the standards, the manner of
drafting and the use of English differ substantially. Recent IFRSs are drafted
more methodically, with a clear segregation of scope, definitions, recognition
and measurement, measurement after recognition, retirement and disposal,
disclosures, basis of conclusion, implementation guidance, etc. Therefore it is
of utmost importance that all old IFRS be drafted afresh, to make them
consistent with the recently issued standards.

There are a number of terms (see box) that have been used
frequently throughout the standards, which could mean different things to
different people; particularly given the fact that IFRSs would be used worldwide
and English in different countries is influenced by local culture. Therefore, a
term such as ‘may be accounted for in the following manner’ may be
interpreted in India as providing an alternative, though that may not be the
intention of the standard-setters. So also terms such as near term, current
period, short term, foreseeable future, long term, etc. or probable terms such
as probable of recovery, possible that it would be recovered, likely that it
would be recovered, highly unlikely that it would not be recovered, certain that
it would be recovered, etc. can create confusion. Firstly, these terms should be
reduced to a few standard terms and they should be used consistently across the
standards. Also, it would be more preferable to put some mathematical threshold
to these terms so that when it is being said that it is probable of recovery, it
should be known whether a 51%, 75% or 95% chance of recovery is applicable. In
India, we have already struggled with these terms, a prime example being the
requirement of virtual certainty with regards to recognition of deferred tax
assets in situations of unabsorbed losses and unabsorbed depreciation. Quite
clearly there is a lot that can be done in this area to clear the clutter.

Another debate is whether standards should be principle-based
or rule-based. It may be noted that though US GAAP is called rule-based
standards, it has a number of principles which are not translated
into detailed rules. So also though IFRS are principle-based, standards on
financial instruments almost read like a detailed rule book. In my view, the
whole argument of whether standards should be rule-based or principle-based is
futile. What we need is to hit that sweet spot where standards can be understood
easily and consistently.

Easier said than done, but with some hard work this can be achieved. Take for example, the accounting of multiple element contracts. Consider an example, where along with sale of software licence, post-contract customer support (PCS) will be provided over the next 6 months to a customer under a single contract. There are many accounting possibilities in this case. If there is price evidence for PCS, the price for software licence could be derived. This is known as the residual method. Alternatively, if there is price evidence for the software licence, the price for the PCS could be derived. This is known as the reverse residual method. Alternatively, the price for both elements may be known, and consequently the over-all discount on the contract may be allocated to the two elements, based on their relative fair values. A fourth possibility is the determination of revenue for the two elements by adding a uniform margin on their respective cost. The fifth possibility would be to keep the margin on the two elements different, to reflect their relative value and pricing in the market place. As can be seen, IFRS lends itself to multiple interpretations. Under US CAAP, the only method that is permitted is the residual method. Therefore under US CAAP, if there is no vendor-specific objective evidence (VSOE) of the undelivered element (in this case the PCS), no revenue can be recognised on the sale of licence. In such circumstances, the entire licence fee revenue is recognised ratably over the period during which the PCS is to be provided, rather than on delivery of the licence. As can be seen from the above example, US CAAP is very harsh and extensively rules-driven in this area. IFRS, takes the other extreme, is nebulous and lends itself to multiple interpretations. Quite clearly, this is an example where the sweet spot can be found and a common ground found between the two extreme approaches. US CAAP’s rule-based approach is founded by the fear that there would be abuse of standards if they are not fairly detailed. However, experience suggests otherwise – those who want to abuse the standards, would abuse them irrespective of whether those are based on principles or rules. Besides in many cases it is easier to abuse rules, by structuring the transaction in a desired manner. This is clearly seen in the area of leases, where lessees structure deals to escape finance lease classification. Another area which needs serious attention is the availability of too many accounting choices under IFRS. For example, fixed assets, intangibles, investment properties can be accounted using either the fair value model or cost model, actuarial differences in the case of employee benefits can be accounted for in a number of ways. Similarly choices are available in the case of government grants, impairment, financial instruments, etc. Too many choices result in inconsistency, lack of comparability and put to question the ability of standard-setters to make up their mind on the appropriate basis of accounting. Accounting is an art, not a pure science, and it should remain that way. Therefore, what is being suggested is not the elimination of judgment in the application of the standards. Nor is it being suggested that standards should be reading like rule books with too many bright line tests. What is being suggested is the use of appropriate and standard terminologies that should be used consistently, the removal of too many accounting choices, and principles that are not only easily understood, but tell you how the accounting should be done.

Adios to the Abyss.

Nirav Shah

GAPs in GAAP – Accounting for joint ventures Proportionate consolidation v. equity method

Accounting Standards

Under Indian GAAP (AS-27 Financial Reporting of Interests
in Joint Ventures), an interest in a joint venture (jointly controlled
entity — JCE) is accounted for using the proportionate consolidation method.
Under this method the venturers report their respective proportion of the JCE’s
assets, liabilities, income and expenses in its consolidated financial
statements.

Under IFRS, IAS-31 requires the application of proportionate
consolidation method for joint ventures but also allows the application of
equity method as an alternative method. Under the equity method an interest in a
JCE is initially recorded at cost and adjusted thereafter for the
post-acquisition change in the venturer’s share of net assets of the JCE. The
profit or loss of the venturer includes the venturer’s share of the profit or
loss of the JCE.

The International Accounting Standards Board (IASB) issued an
Exposure Draft (ED) 9 Joint Arrangements which is intended to replace
current IAS-31. Unlike IAS-31, the ED proposes that a joint venture shall be
accounted using the equity method only. In other words, proportionate
consolidation method which is the preferred method under current IAS-31 will no
longer be available and the alternative method, i.e., equity method in
current IAS-31 becomes the only method to be followed.

The IASB is of the view that the removal of options from IFRS
will reduce the possibility of similar transactions being accounted for in
different ways. Further, the IASB believes that the proportionate consolidation
method has certain technical flaws and is not consistent with the Framework
for the Preparation and Presentation of Financial Statements. When a party
to an arrangement has joint control of an entity, it shares control of the
activities of the entity. It does not, however, control each asset, nor does it
have a present obligation for each liability of the JCE. Rather, each party has
control over its investment in the entity. If the party uses proportionate
consolidation to account for its interest in a JCE, it recognises as assets and
liabilities a proportion of items that it does not control or for which it has
no obligation. These supposed assets and liabilities do not meet the definition
of assets and liabilities in the Framework.

A number of respondents to the ED have questioned the IASB’s
decision to require only equity method for joint ventures. At the time of
issuance of current IAS-31, the same Framework was applicable. At that
time, the IASB has clearly recognised that proportionate consolidation better
reflects the substance and economic reality of a venturer’s interest in a JCE.
Against this background, the ED does not offer any compelling arguments for
removal of proportionate consolidation method.

While the IASB has indicated that proportionate consolidation
has technical flaws and is not consistent with the Framework, it does not
explain as to why the equity method is considered more appropriate to account
for interests in a JCE ? How does the application of the equity method enhance
the faithful representation of joint ventures in the financial statements of the
venturer ? Further, the removal of proportionate consolidation will lead to the
same accounting treatment for ‘joint control’ and ‘significant influence,’ which
is inappropriate.

Significant impact on Indian entities :

In India, a number of entities in sectors such as real
estate, infrastructure development, oil and gas, etc. carry out significant
activities through joint ventures. For example, KSK Power or GMR Infrastructure
carry out significant activities through joint ventures. If such entities need
to apply equity method to their interests in joint ventures, it is possible that
their financial statements will not reflect any significant economic activity.
If equity accounting is to be used, the infrastructure holding company will not
be able to present proportionately the activities and revenues of its various
joint ventures. This may have several consequential implications on matters such
as borrowing capacity, satisfaction of debt covenants, performance evaluation of
key executives, key ratios, explaining performance to investors and analysts,
etc. In certain cases, these entities may even have to reconsider their overall
business strategy and significant contracts.

IASB’s view is that the enhanced disclosure requirements of
the proposed IFRS would provide better information about the assets and
liabilities of a joint venture than is provided by using proportionate
consolidation. The exposure draft proposes the disclosure of summarised
financial information for all individually material joint ventures to help meet
the needs of users of financial statements. In the author’s view, this line of
argument is inappropriate and disclosures cannot justify equity accounting of
joint venture. Besides in many cases, disclosures on their own may not provide
any solution, for example, in the case of project bidding where qualification
requirements are linked to the revenues recorded in the financial statements of
the bidding entity.

As IFRS would eventually apply to Indian entities, it is high
time that Indian companies and local standard-setters started paying more
attention to IFRS exposure drafts. Companies that would be significantly
impacted should make suitable representations to the IASB along with the local
standard-setters.

levitra

Nirav Shah

Bing — the new kid on the block

Nirav Shah

Internet Browsers — Part II

Nirav Shah

Journal

Brieficles

Resources

About

Reach Us