Year: 2026

The taxation of contingent consideration (earn-outs) remains legally unsettled under the Income-tax Act, 2025. Indian courts maintain that contingent amounts do not accrue in the transfer year because no enforceable right yet exists. Drawing from the UK’s Marren v. Inglis ruling, this contingent right could be treated as a separate capital asset taxed upfront at fair market value, with subsequent gains taxed upon crystallization. Alternatively, taxpayers may argue it is a non-taxable capital receipt if the acquisition cost is indeterminable, despite recent legislative amendments. Additionally, earn-outs tied to continued employment risk being recharacterized and taxed as salary. Legislative clarity is ultimately required to resolve these ambiguities.

In the first part of this article¹, the discussion focused on consideration placed in escrow and the difficulties that arise under the Income-tax Act, 2025 (IT Act) where a portion of the sale consideration does not accrue to the seller in the year of transfer, but only becomes receivable later upon fulfillment of stipulated conditions. The present part turns to a related, but conceptually distinct, issue: contingent consideration.

Unlike escrow, which ordinarily involves a retained portion of an already agreed consideration being held back as a risk-allocation mechanism, contingent consideration is typically an additional amount that itself becomes payable only upon the occurrence of uncertain future events (i.e., to say the quantum of the consideration itself depends on the future event). In modern M&A transactions, such earn-out structures are frequently used to bridge valuation gaps and align post-closing incentives. Their tax treatment, however, remains doctrinally unsettled. The issues do not concern timing alone. They extend to the character of the seller’s contractual right, the possible relevance of the English decision in Marren (Inspector of Taxes) v. Inglis², the implications of the amendment to Section 55(2)(a) of the Income-tax Act, 1961 (ITA 1961) by the Finance Act, 2023, and the risk that what is labelled as contingent consideration may, in substance, be recast as salary or business income where it is linked to continued employment or post-closing services.

1 Published in BCAJ 58 (2026) 255.

2 [1980] 1 WLR 983 (HL) cited by HMRC in their capital gains manual, 
available at CG14950 -https://www.gov.uk/hmrc-internal-manuals/capital-gains manual/cg14950 (Last accessed 12th July 2026).

This distinction also assumes practical significance at the drafting stage. In a share purchase agreement (SPA), the precise manner in which the earn-out is documented may materially affect its eventual tax treatment. For instance, language that more clearly evidences that the earn-out is part of the negotiated capital value for the shares—rather than compensation for future services—may support capital gains treatment. Similarly, the formulation of the contingency, the length of the earn-out period, and the extent to which the payout is linked to post-closing employment or managerial functions may significantly influence the characterization analysis. These practical aspects are revisited later in this article.

The concept of accrual, relevance of Section 5 and its interplay was discussed in the first part of this article.³ This principle—that contingent consideration does not accrue in the year of transfer if the contingency has not materialized—was clearly articulated by the Bombay High Court in CIT v. Mrs. Hemal Raju Shete⁴. In this case, consideration for the sale of shares was capped at a maximum of INR 20 crores, but the actual amount payable was dependent on future profits. The Revenue sought to tax the entire INR 20 crores in the year of transfer.

The High Court rejected this view, observing that the consideration was not assured but was merely the maximum that could be received. The Court held that since the amount was contingent upon future profits, no right to claim any particular amount had vested in the assessee during the assessment year. Consequently, the amount could not be said to have accrued.

This view—that the test of accrual is whether there is a legally enforceable right to receive the amount—has been followed in subsequent decisions.⁵

3 BCAJ 58 (2026) 256, 257.

4 [2016] 239 Taxman 176 (Bom.).

5 Dinesh Vazirani v. PCIT [2022] 445 ITR 110 (Bom.); Modi Rubber Ltd v. DCIT [TS-81-ITAT-2024(DEL)]. 
Cf. Ajay Gulia v ACIT [2012] 209 Taxman 295 (Delhi), wherein it was held that capital gains are chargeable
 in the year of transfer and, therefore, contingent consideration was includible in the full value of consideration,
 even though it had not accrued. It was further observed that Section 48 could not curtail the operation of Section 45(1).
 These observations, particularly regarding the interplay between Sections 45(1) and 48, may warrant reconsideration. 
It is well settled that any income sought to be taxed must first fall within the ambit of Section 5. Although, 
a solitary reading of Section 67(1), a conclusion may be drawn that once the contingent consideration accrues, 
the gains are referable to and thus taxable in the year of transfer, the reasoning adopted in the judgment may nonetheless 
invite closer scrutiny given that Section 5 covers only accruals during the year. The referability condition of Section 2(108)
 would not be met in the year of transfer.

THE LACUNA: TAXATION UPON CRYSTALLIZATION

The current framework of Section 5, Section 67(1)⁶, and Section 72⁷ does not specifically provide for the taxability of contingent consideration in the year in which the contingency is fulfilled and the additional amount becomes payable.

More specifically, should the additional consideration be subjected to tax as capital gains, retaining the character of the original transfer, but in the year of realization? If so, would this approach conflict with Section 67(1), which mandates that capital gains be charged to tax in the year in which the transfer takes place? Alternatively, should the gain be characterized independently at the time the contingent consideration crystallizes? It may also be argued that the amount received as contingent consideration constitutes a capital receipt falling outside the ambit of Section 67(1), since there is no separate transfer of a capital asset upon the crystallization of the contingency.

At this juncture, it is apposite to acknowledge the prevailing market practice: taxpayers generally offer contingent consideration to tax in the year of its accrual, characterizing it as capital gains of the same nature as the original transfer⁸ (i.e., if the original gains were long term (LTCG), contingent consideration is also treated as long term, though not in the year of transfer, but in the year of accrual).

The issue, therefore, is not whether the market has adopted a pragmatic convention, but whether that convention is supported by the statute on a strict construction. In addressing this question, one may refer to Section 2(108) of the IT Act,⁹ which defines “total income”¹⁰ to mean the total amount of income referred to in Section 5, computed in the manner as laid down in the IT Act. Accordingly, it is not sufficient that the referability requirement under Section 5—whether by way of accrual or receipt—is satisfied. The computation of such income must also be possible in the manner contemplated by the IT Act.

The objective of the discussion that follows is to examine whether a more technically coherent framework may be derived from English jurisprudence, particularly from the decision in Marren v. Inglis, and whether an alternative argument remains available that the receipt may, in certain circumstances, not be chargeable to tax at all.

6 Section 45(1) of ITA 1961

7 Section 48 of ITA 1961


8 See Footnote 11 on BCAJ 58 (2026) 258.

9 Section 2(45) of ITA 1961.

10 On which Section 4 of the IT Act creates the charge. 
Section 4(1) provides that where any Central Act enacts that income-tax shall
 be charged for any tax year at any rate or rates, income-tax for such tax year 
shall be charged at that rate or those rates in accordance with and subject to 
the provisions of the IT Act. Section 4(2) further provides that the charge of
 income-tax under sub-section (1) shall be on the total income of the tax year of 
every person as determined in accordance with the provisions of the IT Act.

THE ENGLISH POSITION: MARREN V. INGLIS

In the absence of direct Supreme Court / High Court rulings¹¹ on the subsequent taxability of crystallized contingent consideration, the House of Lords decision in Marren (Inspector of Taxes) v. Inglis (supra) could provide instructive guidance.

In Marren, the taxpayer, Inglis, transferred 69 shares of J. L. Inglis (Holdings) Ltd. to Industrial and Commercial Finance Corporation Ltd. (ICFC) under a share sale agreement dated 15 September, 1970. The consideration was structured in two parts: (i) For 41 shares, a fixed consideration of £1,500 per share was paid upfront; and (ii) For the remaining 28 shares, the consideration comprised an immediate cash payment of £750 per share, plus a deferred and contingent amount described as “one-half of the profit”. This deferred amount was contingent upon the flotation of the Company on a recognized stock exchange by 31 December 31, 1975. The Company was floated in November 1972, and the deferred consideration was quantified at £2,825 per share. The Revenue argued that the right to receive the future consideration was a distinct asset (a chose in action) acquired at the time of the original share transfer, and the subsequent receipt of money in 1972 was as a result disposal of that separate asset.

The House of Lords held that the right to receive contingent consideration constituted “property” and therefore an “asset” under the UK Finance Act, 1965 (1965 Act).¹² Consequently, the transaction involved the acquisition of this separate asset at the time of the original sale. When the contingency materialized and funds were received, it constituted a disposal of this right, attracting capital gains tax.¹³ The Court rejected the argument that the receipt was merely the realization of a debt, noting that a contingent right to an unascertainable sum is not a debt until crystallized.¹⁴

Lord Fraser noted that the correct approach was to value the contingent right (the chose in action) as of the date of the original transfer and tax that value as part of the initial consideration. Any subsequent gain upon the realization of that right would be a separate taxable event.¹⁵

11 See also discussion on Sunil’s decision (infra).

12 The House of Lords referred to Section 22(1) of the 1965 Act which defined asset as 
“All forms of property shall be assets for the purposes of this Part of this Act... 
including— (a) options, debts and incorporeal property generally...”. 
One may note the similarities between this definition and the definition of 
capital asset under Section 2(22) of the IT Act [erstwhile Section 2(14)].

13 The House of Lords referred to Section 22(3) which provided that there is 
disposal of assets by their owner where any capital sum is derived from assets 
notwithstanding that no asset is acquired by the person paying the capital sum. 
One may draw parallels to the concept of extinguishment of rights in the capital asset
 under Section 2(109)(b) of the IT Act [erstwhile Section 2(47)(ii)].

14 For context, Para 11(1) of Schedule 7 of the 1965 Act provided that where a person incurs a debt to another
... no chargeable gain shall accrue to that (that is the original) creditor... on a disposal of the debt...” 
It was held that no debt existed at the time of the initial transfer because a contingent right to an 
unascertainable sum could not be regarded as a debt. When the contingency materialized, while a debt
 may then have arisen, the sum received was “derived from” the asset (the chose in action) that crystallized, 
and was chargeable on that basis. Full text of the 1965 Act can be accessed at https://www.legislation.gov.uk/ukpga/1965/25/contents/enacted, 
Part III therein dealt with capital gains (Last accessed 12th July 2026).

15 Marren v. Inglis (supra), at p. 988. Basis the question raised before the House of Lords 
(as noted on p. 984 and 985), these observations should be regarded as an obiter dictum and not the ratio decidendi.

APPLICABILITY TO INDIA

Given the similarities between the 1965 Act and the IT Act regarding the definitions of “capital asset” and “transfer”, the ratio in Marren v. Inglis may have significant persuasive value in India.¹⁶ If this principle is applied, the “right to receive” contingent consideration should be treated as a separate capital asset distinct from the shares originally transferred.

16 Sampath Iyengar’s Law of Income Tax (13th Ed., Vol. 1, p. 207) notes 
“English statutes may appear superficially to be similar but on deeper scrutiny may reveal differences... 
In some matters, however... the Indian law is in no way different from the English law and 
English decisions can be of assistance in interpretation... English decisions are continued 
to be cited and even followed in Indian Law.” Recently, the Supreme Court, in Jindal Equipment 
Leasing Consultancy Service Ltd v. CIT [2026] 484 ITR 641 (SC), relied on an English precedent
 while examining the taxability of shares received in an amalgamated company in exchange for shares 
held as stock-in-trade in the amalgamating company. In this context, the Court referred to
 Royal Insurance Co Ltd v Stephen [1928] 14 TC 22 (KB), which addressed a comparable issue (see para 19 on p.680).

PROPOSED APPROACH FOR TAXATION

A technically sustainable approach under the IT Act, aligned with Marren v. Inglis, is as follows:

1. Year of Transfer: The full value of consideration should include the initial cash consideration, the deferred consideration (at full value), and the Fair Market Value (FMV) of the contingent right (the separate asset);

2. Valuation: The FMV of the contingent right can be determined using Scenario-Based Methods (for simple structures) or Option Pricing Models such as Black–Scholes (for complex, non-linear structures).¹⁷ If the FMV is indeterminable, Section 80¹⁸ of the IT Act may be invoked to deem the FMV of the transferred shares as the full value of consideration. As no specific rules are prescribed for the determination of FMV under Section 80, the term must be understood in the context of Section 2(44)¹⁹ of the IT Act—i.e., the price that the asset would ordinarily fetch if sold in the open market on the relevant date. In the absence of specific statutory guidance under the IT Act, the valuation could be determined based on a reasonably acceptable date (such as within 180 days prior to the date of transfer, drawing parallels from FEMA pricing guidelines and Rule 15(8)(l) of the Income-tax Rules, 2026)²⁰. Furthermore, the method of valuation should align with generally accepted valuation principles, and reliance may be placed on the valuation standards issued by the ICAI;

• The valuation of the contingent right for the purposes of Section 72, or the underlying shares for the purposes of Section 80, may be carried out by a Chartered Accountant, a Registered Valuer, or a Merchant Banker. It is pertinent to note that, in both instances, there is no strict statutory prescription regarding the specific method, the exact valuation date, or the designated professional required to conduct the valuation²¹;

• Lord Fraser in Marren (supra)²² also observed that there is a suggestion that it may be impossible to assess the value of the right and nothing that he said was intended to indicate any opinion on the valuation of the right as at the date of transfer of shares; and

3. Year of Crystallization: When the contingency is met and money is received, capital gains should be computed as the difference between the amount received and the cost of acquisition of the right (i.e., the FMV taxed in the year of transfer).

This approach resolves the difficulty of taxing an unknown future sum in the year of transfer while ensuring the income does not escape the tax net. It also addresses the characterization of the gain. If the right is held for more than 24 months before the contingency materializes, the subsequent gain should be long term; otherwise, it is short term.

17 See Grant Thornton, Valuation of Complex Financial Instruments. 
https://www.grantthornton.in/globalassets/1.-member firms/india/assets /pdfs/valuation_and_accounting_complex_fin_instruments.pdf
 (Last accessed on 12th July 2026).

18 Section 50D of ITA 1961.

19 Section 2(22B) of ITA 1961.

20 Rule 3(8) of the Income-tax Rules, 1962.

21 It may not be out of context to quote Viscount Simon from Gold Coast 
Selection Trust Ltd v Humphrey (Inspector of Taxes) [1949] 17 ITR(Supp.) 19 (HL) 
wherein he observed that “valuation is an art, not an exact science. Mathematical 
certainty is not demanded, nor indeed it is possible”. Valuation thus is a subjective issue which cannot be quantified or narrowed down.

22 On p. 988(E).

AN ALTERNATIVE PERSPECTIVE: COULD CONTINGENT CONSIDERATION BE A CAPITAL RECEIPT NOT CHARGEABLE TO TAX?

For the sake of brevity, the discussion around definition of income, requirement of strict construction, sine qua non for Section 67(1) and the statutory lacunae in the IT Act are not discussed in this article.²³ These arguments could very well apply even in the context of contingent consideration. The discussion that follows proceeds in the alternative, assuming that the dictum of the House of Lords in Marren v. Inglis (supra) were to apply.

Notwithstanding the conceptual attractiveness of Marren, a substantial line of argument remains available that contingent consideration may, in some cases, constitute a capital receipt not chargeable to tax. This argument may be approached in stages.

23 See BCAJ 58(2026) 258, 259, 260 and 261 for discussion on the same.

CHARACTERIZATION OF THE CONTRACTUAL RIGHT AS A “CAPITAL ASSET”

Section 2(22) of the IT Act defines a capital asset to mean “property of any kind held by an assessee.” The expression “property” is not defined in the IT Act and must, therefore, be understood in its ordinary legal sense and in light of judicial authority. The term is one of the widest amplitude. It is commonly understood as a thing or aggregate of rights belonging to a person, and is often described as a “bundle of rights”.²⁴ Property is nomen generalissimum, and extends to every species of valuable right and interest including real and personal property, easements, franchises, and other incorporeal hereditaments.²⁵ Judicially too, the Supreme Court in CWT v. Ahmed G. Arif²⁶ recognized that “property” is a term of the widest import and, subject to contextual limitations, signifies every possible interest which a person can clearly hold or enjoy.

At first principle, therefore, a right under an agreement to receive additional money in future may readily answer the description of “property”. The real difficulty lies not in the width of the word “property”, but in determining whether an earn-out right, while still contingent and inchoate, is sufficiently vested in law to qualify as a distinct capital asset at the time of the original transfer. This question assumes significance because, if the right itself constitutes a separate capital asset, the subsequent receipt upon crystallization may be analyzed as consideration derived from, or on extinguishment of, that asset rather than merely as a delayed fragment of the original sale price.²⁷

In this regard, the Bombay High Court’s reasoning in CIT v. Abbasbhoy A. Dehgamwalla is relevant. The Court held, in the context of Section 2(14) of the ITA 1961, that an item incapable of transfer under Section 6 of the Transfer of Property Act, 1882 (TOPA) may fall outside the conception of a capital asset.²⁸ Section 6(e) of the TOPA specifically prohibits the transfer of a “mere right to sue”. Drawing from this reasoning, it may be argued that a purely contingent and unenforceable right to receive earn-out consideration, prior to fulfilment of the stipulated conditions, is analogous to a right that lacks present transferability and therefore does not yet attain the status of a capital asset.

Certain allied concepts help illustrate the point. A legacy before the death of the testator (spes successionis), an unvested employee stock option, or a mere right to sue all involve a form of expectation or contingent entitlement; yet these are not treated as capital assets for the lack of transferability, no present enforceable right or on account of the restriction contained in TOPA. On this line of reasoning, one may contend that, until the contingency is satisfied, the seller has no more than a contractual expectancy and not “property” in the capital asset sense. A similar argument may also be sought to be drawn, by analogy, from the escrow discussion—namely, that some contractual stipulations may be better viewed as part of the mechanics of the bargain rather than as giving rise to an independent asset in the hands of the seller.²⁹

That said, this argument faces substantial difficulty in light of Marren v. Inglis. The House of Lords unanimously treated the seller’s right under the agreement to receive contingent consideration as a distinct chose in action and therefore as “property”. Lord Fraser expressly observed that incorporeal rights to money’s worth can constitute property and further noted that such rights could, in principle, be assigned or otherwise disposed of.³⁰ Given the breadth of the expression “property of any kind” in Section 2(22), and absent any express statutory exclusion, the reasoning in Marren offers a strong basis to regard the earn-out right itself as a separate capital asset, notwithstanding that the amount receivable is uncertain and conditional.

In the author’s view, therefore, while the transferability objection provides an argument at the inception stage, it is ultimately difficult—especially after Marren and the wide judicial understanding of “property”—to maintain that the earn-out right is merely a contractual promise and not an asset at all.³¹ The utility of this discussion lies elsewhere. It helps frame the argument that, until crystallization, the right may not appropriately be brought to tax upfront as part of the full value of consideration; and, more importantly, it provides a conceptual basis for examining whether, upon a later waiver, cancellation, or mutual surrender of that right (prior to crystallization), there is an extinguishment of rights in a capital asset capable of having independent tax consequences.³² Once the contingency is fulfilled, the right ceases to be inchoate; at that stage, it much more clearly answers the description of “property”, and the argument that no capital asset exists becomes materially harder to sustain.

24  Concise Oxford English Dictionary, 12th edition, p. 1150, Black’s Law Dictionary, 12th Edition, p. 1472.

25 Advanced Law Lexicon by P. Ramanatha Aiyar, Seventh Edition, Volume 3, pp. 5085-5097.

26 [1970] 76 ITR 471 (SC).

27 See discussion on the possible treatment of contingent consideration upon crystallization 
and the relevance of analyzing the right itself as a distinct asset in Marren v. Inglis (supra).

28 CIT v. Abbasbhoy A. Dehgamwalla [1992] 195 ITR 28 (Bom.).

29 See BCAJ 58(2026) 259, 260 where this was discussed.

30 Marren v Inglis (supra) at p. 988.

31 See paragraph 4 of Sunil’s decision (infra). 
This records the reasoning of the CIT(A) as part of the factual background 
leading up to the lis before the Court. In the author’s view, however, 
the treatment of the asset as a short-term capital asset, without granting the
 benefit of the holding period from the date of receipt of such right, may not be
 correct and is not free from doubt. In this regard, one may refer to the observations
 of Bangalore ITAT in N.R. Ravikrishnan v ACIT [2018] 68 ITR(T) 457 (paras 4.4.1-4.4.4).

32 See Section 2(109)(b) of the IT Act [corresponding to Section 2(47)(ii) of the ITA 1961],
 which includes the extinguishment of rights in a capital asset within the ambit of “transfer”.

EXCLUSION FROM THE “FULL VALUE OF CONSIDERATION” UPFRONT

Foregoing analysis gives a robust defense for taxpayers to argue that the FMV of the right to receive contingent consideration should not be included in the full value of consideration accruing or received as a result of the initial transfer of shares or business. Since the contractual right is contingent and unenforceable on the date of the primary transfer, treating it as “consideration” would amount to taxing notional income—income that has neither accrued to nor been received by the taxpayer. This could assist the taxpayer in not paying taxes on the FMV of the right in the year of transfer and overcome the obiter dictum of Lord Fraser.³³ It is reiterated that the issue for consideration before the House of Lords was the taxability in the year of receipt of contingent consideration and not the year of transfer of shares. Hence, the observation of Lord Fraser should be understood in that context.

33 Marren v Inglis (supra) at p. 988.

THE “TRANSFER” ELEMENT AND THE TRANSFER OF PROPERTY ACT

The next aspect for consideration is whether the assessee “transfers” any capital asset upon the receipt of the contingent consideration. Section 2(109) of the IT Act defines “transfer” in the widest possible manner, explicitly including the “extinguishment of any rights therein.” Accordingly, the Revenue may argue that the assessee realizes the contingent consideration as a direct result of the extinguishment of their contractual right under the agreement.

MUTUAL EXTINGUISHMENT OF RIGHTS AND GAAR IMPLICATIONS

The practical benefit of the above discussion (with regard to requirement of transferability element for existence of a capital asset) may be evaluated in instances where a taxpayer mutually agrees with the buyer to give up or cancel their right to receive the contingent consideration prior to the achievement of the performance conditions.

However, a strong note of caution is warranted: this mechanism should not be utilized as a colourable device to avoid tax where there is no genuine commercial rationale for cancelling the right. In such scenarios, the tax authorities are highly likely to invoke the General Anti-Avoidance Rules (GAAR) under Chapter XI of the IT Act to scrutinize the transaction. The Revenue may recharacterize the purported capital receipt as a revenue receipt and contend that the income should be taxed as “Income from Other Sources” (IFOS) under Section 92(1) of the IT Act³⁴, thereby attracting the highest applicable tax rates and denying the benefit of lower capital gains rates. It is pertinent to note that substantive jurisprudence on GAAR recharacterization remains nascent; currently, the reported cases stem from writ petitions filed against the directions of the Approving Panel rather than final appellate rulings on the merits of recharacterization.³⁵

34 Section 56(1) of ITA 1961.

35 See Ayodhya Rami Reddy Alla v. PCIT [2024] 466 ITR 497 (Telangana) and Anvida Bandi v. DCIT [2025] 177 taxmann.com 726 (Telangana)
 on the issue of bonus stripping and the applicability of GAAR (prior to the amendment to Section 94(8) of the ITA 1961, 
extending its scope to shares). Subject to one factual distinction—the shares were listed in the latter case—the decisions are diametrically opposed.
 While the former held that GAAR was applicable, the latter ruled that GAAR did not apply.
 Further, in Anvida Bandi, the Court does not appear to have been informed of the 2019 bonus issue, 
as the judgment contains no discussion of that fact. It will be interesting to see whether the Court provides
 an exposition on GAAR and its applicability in Hinduja Global Solutions Limited v. PCIT [WP No. 4867 of 2025 (Bom.)].

FAILURE OF THE COMPUTATION MECHANISM: COST OF ACQUISITION AND THE FINANCE ACT, 2023 AMENDMENT

The final, and perhaps most critical, argument against the taxability of contingent consideration rests on the inability to determine the cost of acquisition. It is crucial to note that the cost of acquisition of this contractual right is not nil. The taxpayer surely incurs a cost to acquire this right (though inchoate / contingent as on the date of transfer, and later getting vested on satisfaction of the conditions / veracity of the promises made), which may include a commercial discount on the initial upfront consideration (accepting a price lower than the FMV of the shares / business on the date of transfer) or the ongoing efforts of the shareholder in assisting the company to achieve the performance thresholds. Therefore, the contractual right is acquired for a cost, but such cost is inherently incapable of precise mathematical determination.

Prior to the amendment of Section 55(2)(a) by the Finance Act, 2023, taxpayers could successfully rely on the Supreme Court judgment in B.C. Srinivasa Setty.³⁶ The Court held that the charging section (Section 45 of ITA 1961) and the computation section (Section 48 of ITA 1961) constitute an integrated code. If the cost of acquisition cannot be determined, the computation mechanism fails and, consequently, the charge under Section 67(1) must also fail.

To counter this, specific amendments were made by successive Finance Acts to gradually expand the scope of assets specified in Section 55(2)(a) of the ITA 1961, with the recent amendment being made by the Finance Act, 2023 to deem the cost of acquisition even in case of “other intangibles” or “other rights”. The amended provision reads as follows:³⁷

“2) For the purposes of sections 48 and 49, ‘cost of acquisition’,-

(a) in relation to a capital asset, being goodwill of a business or profession, or a trade mark or brand name associated with a business or profession, or any other intangible asset or right to manufacture, produce or process any article or thing, or right to carry on any business or profession, or tenancy rights, or stage carriage permits, or loom hours, or any other right.”
(emphasis supplied)

To determine if the position discussed above would still continue post the Finance Act, 2023 amendment, it would be apposite to understand the connotation of the words “any other intangible asset” or “any other right”. The denotation of ‘intangible asset’ and ‘right’ is as under:

A. Intangible asset

Not constituting or represented by a physical object and not precisely measurable in value.³⁸

Any non-physical asset or resource that can be amortized or converted to cash, such as patents, goodwill, and computer programs, or a right to something, such as services paid for in advance. ³⁹

An item of value whose true worth is hard or almost impossible to determine, such as goodwill, reputation, patents and so on.⁴⁰

B. Right

A moral or legal entitlement to have or do something. ⁴¹

The term “right”, in a civil society, is defined to mean that which a man is entitled to have or to do, or to receive from others, within the limits prescribed by law. ‘Right’ is an interest recognized and protected by moral or legal rules. Such right may be a vested right or accrued right or an acquired right. The nature of such right would depend upon and also vary from statute to statute.⁴²

Something that is due to a person by just claim, legal guarantee, or moral principle. A legally enforceable claim that another will do or will not do a given act; a recognized and protected interest the violation of which is wrong. The interest, claim, or ownership that one has in tangible or intangible property. ⁴³

The dictionary meaning of the term “intangible asset” and “right” is sufficiently broad enough to cover the rights under the SPA / Business Transfer Agreement (BTA) (as held in Marren v Inglis) and, accordingly, the cost may be deemed to be nil under Section 90(3) of the IT Act⁴⁴, thereby making the computation mechanism workable.

However, the terms, viewed in context, may assist in discerning that their scope could be interpreted ejusdem generis. Essentially, the terms “any other intangible asset” and “any other right” should be understood based on the terms that precede them.

The rule of ejusdem generis has been explained thus:⁴⁵ when particular words pertaining to a class, category or genus are followed by general words, the general words are construed as limited to things of the same kind as those specified. This rule, known as the rule of ejusdem generis, reflects an attempt to reconcile incompatibility between the specific and general words in view of the other rules of interpretation: that all words in a statute are to be given effect if possible, that a statute is to be construed as a whole, and that no words in a statute are presumed to be superfluous.

The rule applies when (1) the statute contains an enumeration of specific words; (2) the subjects of enumeration constitute a class or category; (3) that class or category is not exhausted by the enumeration; (4) the general terms follow the enumeration; and (5) there is no indication of a different legislative intent. If the subjects of enumeration belong to a broad-based genus as also to a narrower genus, there is no principle that the general words should be confined to the narrower genus.

The rule of ejusdem generis dictates that where general words follow specific words in a statute, the general words must be construed as taking their meaning and colour from the specific words preceding them. The specific assets listed in Section 90(3)—goodwill, trademarks, brand name, right to manufacture, tenancy rights, stage carriage permits, loom hours—are all distinct, commercial, business-related intangible assets or rights (except tenancy, which may be acquired for non-business purposes also). Tenancy rights are also acquired pursuant to a rental agreement / lease agreement, which has an element of continuity. A mere contractual right to receive contingent consideration does not share the same genus or commercial character as the specified business intangibles or rights. Therefore, the phrase “any other intangible asset” and “any other right” should be read down to exclude such contractual rights. If this interpretation holds, the cost of acquisition remains indeterminable (and not statutorily nil), meaning the B.C. Srinivasa Setty principle continues to apply, rendering the contingent consideration not chargeable to capital gains tax.

The author wishes to acknowledge that two views are reasonably possible here.⁴⁶ The interpretation of the above terms may be contended to be wide by applying the mischief rule of interpretation as propounded by Lord Coke in Heydon’s case.⁴⁷ The Memorandum explaining the provisions of the Finance Bill, 2023 provides as follows:⁴⁸

“The existing provisions of the section 55 of the Act, inter alia, defines the ‘cost of any improvement’ and ‘cost of acquisition’ for the purposes of computing capital gains. However, there are certain assets like intangible assets or any sort of right for which no consideration has been paid for acquisition. The cost of acquisition of such assets is not clearly defined as ‘nil’ in the present provision. This has led to many legal disputes and the courts have held that for taxability under capital gains there has to be a definite cost of acquisition or it should be deemed to be nil under the Act. Since there is no specific provision which states that the cost of such assets is nil, the chargeability of capital gains from transfer of such assets has not found favour with the Courts.”

(emphasis supplied)

While the usage of “any other right” after specified rights and similarly “any other intangible asset” after specified intangible assets may, if the memorandum, CBDT circular explaining the amendment and the mischief rule were not considered, have reasonably invited the application of the rule of ejusdem generis to determine the scope of the amendment, the legislative intent would have been put beyond doubt if the words “any other right whatsoever” or “any sort of right” had been used in the statute itself rather than such words being employed only in the memorandum and circular explaining the amendment.

However, the Explanatory Memorandum to the Finance Bill, 2023 specifically uses the words “any sort of right” while explaining the legislative intent underlying the introduction of the expression “any other right” in the aforesaid provisions. Thus, the introduction of “any other right” in context may be understood as expressly meant to widen the concept and, therefore, suggests a somewhat contrary intention to the application of the ejusdem generis rule. If this interpretation were to hold good, the amendment would be understood broadly and, hence, the cost of acquisition of the right to receive contingent consideration would be deemed to be nil and capital gains tax would be payable as per the dictum of Marren v Inglis (supra).

For the sake of completeness, if the receipt of contingent consideration escapes the charge of capital gains tax (for the reasons discussed above), the Revenue may attempt to tax such receipts under the residuary head, “Income from Other Sources”. This approach should not be tenable. For the sake of brevity, the reasons supporting this conclusion are not elaborated upon in this section, as they have already been discussed in detail in the first part of this article.⁴⁹ Additionally, it may be contended that the contingent sum received is a composite payment for the satisfaction and extinguishment of the seller’s rights under the contract, which constitutes consideration for the purposes of Section 92(2)(m).⁵⁰

To conclude on this branch, the non-taxability position primarily hinges upon the applicability of the ratio of Marren v Inglis (supra) in India. If the ‘right to receive contingent consideration’ is not considered a capital asset, the receipts thereunder would be capital receipts not liable to tax in the absence of a specific fiction to tax the same. However, if it is considered a distinct capital asset, one may have to argue on the non-applicability of Section 90(3) to these rights in order to defend the non-taxability position. It will have to be seen how the Courts would address this line of argument when raised in future.

Given the above discussion, it is pertinent to draw attention to the recent judgment of the Bombay High Court in Sunil Pran Sikand, on an issue akin to contingent consideration.⁵¹ In Sunil, the assessee along with his two sons had entered into a development agreement in 1992, under which the property was agreed to be developed by the builder. On the same date, the developer also issued a letter of commitment stating that, if it was able to obtain and load additional transferable development rights (TDR) on the property, it would pay further compensation to the assessee at the agreed rate. During the course of development, the builder obtained TDRs and paid the additional consideration in the previous year relevant to AY 1997-98. Such sums were offered to tax as LTCG in AY 1997-98.

The AO rejected this position and taxed the amount as IFOS on the basis that the original property had already been transferred under the 1992 development agreement and, therefore, no capital asset belonging to the assessee existed when the additional sum was received. In appeal, the Commissioner (Appeals), while substantially agreeing with the Assessing Officer’s reasoning, held that the amount was taxable instead as short-term capital gains, on the footing that the enforceable right arose only when the contingency materialized. The Income-tax Appellate Tribunal (ITAT), however, restored the characterization as income from other sources, inter alia, on the basis that the commitment letter was unilateral and could not be read as part of the original development agreement.

The lis before the High Court was threefold: (i) whether the ITAT was justified in holding that, upon receipt of consideration under the development agreement, the assessee had ceased to be the owner of the property; (ii) without prejudice, whether the additional compensation was a capital receipt not liable to tax; and (iii) whether, if no cost had been incurred to acquire the additional FSI / TDR-related entitlement, the amount could at all be brought to tax, essentially on the applicability of the principle in B.C. Srinivasa Setty. The Court held that the development agreement and the letter of commitment, both dated 29 September 1992, ought to be read as one composite arrangement and that the additional amount paid upon loading of TDR was to be regarded as payment under the development agreement itself. Accordingly, the Court held that the ITAT was not correct in treating the sum as IFOS and accepted the assessee’s stand that the amount was taxable as LTCG in the year of receipt. Further, in view of the Court’s answer to question (i), the assessee did not press question nos. (ii) and (iii) pertaining to the capital receipt plea and the no-cost-of-acquisition argument.⁵²

Essentially, it should be borne in mind that the Court never had an occasion to analyze the plea that the additional compensation constituted a capital receipt not chargeable to tax, since that contention was expressly not pressed and the fact that “A case is only an authority for what it actually decides and not what may come to follow logically from it”.⁵³ Equally, one may still contend that the taxability of such additional compensation as LTCG in the year of receipt is not free from difficulty having regard to the definition of “total income” under section 2(108). As discussed in the first part of this article, such consideration could not have been included in the full value of consideration in the year of transfer because, at that stage, the right to receive the same had not accrued and the referability requirement under section 5 was therefore not satisfied. Conversely, in the year of accrual or receipt, the difficulty arises from the charging provision itself, namely section 67(1), under which capital gains are taxable only in the year in which the transfer of the capital asset takes place. Where, as the Court itself recognized, there is no separate transfer of a distinct capital asset at the stage of receipt of the additional amount, the computation in the manner laid down in the IT Act also becomes problematic. In that sense, one limb fails in the year of transfer for want of accrual, while the other fails in the year of receipt for want of a transfer in that year. This statutory lacuna was discussed in detail in the first part of the article and is not reproduced here for the sake of brevity.⁵⁴ Reference is also drawn to the observations made in Decoding Section 5 (pp. 151-152), wherein it is noted that:

“The same [contingent consideration] cannot be taxed under Section 45(1) as no transfer is taking place in the year of receipt. It is not possible to revisit the taxation for the year of transfer as this part of the consideration did not accrue at all in the year of transfer. Therefore, there appears to be a legislative gap in dealing with this type of situation.”

36 CIT v B.C. Srinivasa Setty [1981] 128 ITR 294 (SC).

37 Section 90(3) of the IT Act corresponds to Section 55(2)(a) of ITA 1961.

38 Concise Oxford English Dictionary, 12th edition, p. 737.

39 Black’s Law Dictionary, 12th Edition, p. 144.

40 Advanced Law Lexicon by P. Ramanatha Aiyar, Seventh Edition, Volume 2, pp. 3248-3249.

41 Concise Oxford English Dictionary, 12th edition, p. 1238.

42 Advanced Law Lexicon by P. Ramanatha Aiyar, Seventh Edition, Volume 4, pp. 5601-5603.

43 Black’s Law Dictionary, 12th Edition, p. 1584.

46 “Such is the character of human language, 
that no word conveys to the mind, in all situations, 
one single definite idea…” per CJ Marshall in McCulloch v Maryland, 17 U.S. (4 Wheat.) 316, 414 (1819).

47 [1584] 76 ER 637. For the sure and true interpretation of all statutes in general, 
be they penal or beneficial, restrictive or enlarging of the common law, four things are to be discerned and considered, 
(a) what was the common law before the making of the Act (in context of statutes, understood as the law before the amendment), 
(b) what was the mischief and defect for which the common law (in context of statutes, understood as the pre-amended law) did not provide, 
(c) what remedy Parliament hath resolved and appointed to cure the disease of the Commonwealth (in context of statutes, understood as the pre-amended law),
 and (d) the true reason of the remedy.

48 Also see Circular 1/2024 explaining the amendments carried out by Finance Act, 2023, p. 78.

49 See BCAJ 58(2026) 261, 262.

50 Section 56(2)(x) of ITA 1961.

51 Sunil Pran Sikand v ACIT [2024] 466 ITR 770 (Bom), 
the case pertained to AY 1997-98 and appeal was admitted by the Court on 13th June 2006 
against the ITAT order dated 20th September 2002. The appellant herein was the son of the deceased assessee.

52 Ibid. para 9.

53 See Lord Halsbury LC, in Quinn v Leathem [1901] AC 495, 
wherein he inter alia observed that a case is only an authority for what it actually decides and 
that it cannot be quoted for a proposition that may seem to follow logically from it, 
quoted and endorsed by Justice Katju in Sarva Shramik Sanghatana (KV) Mumbai v State of Maharashtra [2008] 1 SCC 494 (SC) (para 15);
 Ambica Quarry Works v State of Gujarat & Others [1987] 1 SCC 213 (para 18); See also CIT v Sun Engineering Works P Ltd [1992] 198 ITR 297 (SC) 
and CIT v Thana Electricity Supply Ltd [1994] 206 ITR 727 (Bombay).

54 See BCAJ 58(2026) 258-261.

NATURE OF INCOME – UNDER WHAT HEAD WOULD THE CONTINGENT CONSIDERATION BE TAXED

Contingent consideration is an obligation on the acquirer to transfer additional assets or equity interests to the former owners of an acquiree if specified future events occur or conditions are met. Common conditions or triggers for such payments include:

• Financial Performance: Achieving specified performance targets, such as exceeding a certain level of revenue, earnings, or EBITDA within a set period. [akin to the facts of Hemal Raju (supra)];
• Operational Milestones: Reaching a specific milestone on a research and development project or obtaining regulatory approvals for a product;
• Share Price Targets: Reaching a specified share price for the acquirer’s stock. [akin to the facts of Inglis (supra)]; or
• Continuing Employment: Payments linked to the continued employment of selling shareholders who become key employee’s post-acquisition.

While the first three categories generally retain the character of capital receipts⁵⁵, the fourth category—payments linked to continued employment—exposes the transaction to characterization risks. In practice, particularly involving individual promoters, share purchase agreements often stipulate cumulative conditions: the satisfaction of financial metrics (e.g., achieving ‘X’ EBITDA or a specific share price) coupled with a requirement for continued employment for a defined tenure (Y’ years). In such hybrid scenarios, a critical question arises: should the contingent consideration be regarded as capital receipts (may be taxable as capital gains) or as compensation for services rendered (salary)?⁵⁶

In the absence of a specific test under the IT Act, the principles laid down in Ind AS 103 (Business Combinations) could be referred to for distinguishing between “purchase consideration” and “remuneration for post-combination services”.⁵⁷ The distinction turns on the substance of the arrangement. The primary litmus test is the linkage to service: if the contingent payment is automatically forfeited upon termination of employment, it is likely to be treated as remuneration. Conversely, if the payment is unaffected by the cessation of employment, it supports the characterization as additional purchase consideration. Other determinative factors include the reasonableness of the employee’s standalone salary, the proportionality of payments relative to shareholding, and the specific formula used for valuation.⁵⁸

These propositions are equally applicable under the IT Act. The factors delineated in Ind AS 103 are fundamentally commercial in nature and grounded in the doctrine of substance over form. Accordingly, they would serve as a critical guide in ascertaining the true character of the payment and determining the specific head of income to which it is inextricably connected.

In this regard, reference may be made to the decision of the Madras High Court in Anurag Jain⁵⁹ and the Authority for Advance Rulings (AAR) ruling in Moody’s Analytics.⁶⁰ The judgment in Anurag Jain should not be treated as laying down a blanket principle applicable to all situations where a promoter or individual shareholder receives contingent consideration while also being required to continue in employment with the company for a specified period. The mere existence of a continued employment condition should not, by itself, operate as an embargo against characterizing contingent payments as consideration for the transfer of assets. Instead, a holistic evaluation of the surrounding facts and commercial arrangements is warranted. One may refer to Ind AS 103 for the relevant factors, as discussed above.

Notably, such a comprehensive analysis appears to be absent in both the AAR ruling and the decision of the Madras High Court. Considerable emphasis was placed on the forfeiture or restitution of contingent consideration upon termination for cause. However, even where “cause” encompassed failure to achieve specified EBITDA thresholds, the contingent consideration was not, in fact, returnable in such circumstances. This nuance does not appear to have received adequate judicial attention.

55 Taxability as capital gains depending on the discussion undertaken above.

56 It may also be regarded as business income, in the absence of an employer-employee relationship.

57 This distinction is critical for accounting purposes: 
remuneration is recognized as a compensation expense in the post-combination period,
 whereas consideration is measured at its fair value on the acquisition date and forms part of the initial calculation of goodwill.

58 In this regard one may refer to Appendix B of Ind AS 103. Para B54 and Para B55 provide detailed guidance in this regard. 
Broadly, factors such as forfeiture on termination, alignment with employment period, below-market salary, 
disproportionate payouts, or profit-sharing style formulas point toward remuneration, while valuation-linked formulas and 
fair market compensation more strongly support treatment as additional consideration.

59 Anurag Jain v. AAR [2009] 308 ITR 302 (Madras), arising from an AAR order (277 ITR 1).

60 Moody’s Analytics Inc., USA, In re [2012] 348 ITR 205 (AAR).

A SHORT PRACTITIONER’S PERSPECTIVE

To preserve capital gains treatment, earn-out provisions should be drafted as an integral part of the negotiated share consideration, with a consistent commercial narrative across the SPA, employment documents, valuation materials, board papers, and correspondence. Post-closing compensation for sellers who remain involved in the business should be separately documented and benchmarked at arm’s length, and the earn-out should ideally be linked to objective business or valuation metrics rather than continued employment or service-based conditions; drafting should also avoid language suggesting bonus, incentive, or reward, and instead clearly state that the earn-out is part of the share purchase price and not remuneration for services, the following protective clause may be incorporated into the SPA:

DRAFT CLAUSE FOR SPA

“The Parties mutually acknowledge and agree that the Contingent Consideration (as defined herein) payable to the Sellers under Clause [Insert Clause Number] constitutes an integral component of the Purchase Price for the transfer of the Sale Shares and represents the deferred capital value of the Company negotiated between the Parties.

It is expressly clarified that the Contingent Consideration is strictly linked to the achievement of the Financial Milestones and does not, in any manner, constitute remuneration, compensation, bonus, or reward for any past, present, or future employment, consultancy, or other services rendered or to be rendered by the Sellers (or their affiliates) to the Acquirer, the Company, or any of their respective affiliates.

The Parties further acknowledge that any post-closing services provided by the Sellers to the Company shall be governed exclusively by a separate [Employment Agreement / Consultancy Agreement] dated [Insert Date], under which the Sellers shall be independently compensated at an arm’s-length fair market value, which is entirely distinct from and independent of the Sellers’ entitlement to receive the Contingent Consideration under this Agreement.”

APPLICABILITY OF SECTION 92(2)(M)

Section 92(2)(m)(iii)(B) of the IT Act provides that where a person receives any specified property (such as shares) for a consideration that is less than its FMV, the difference between such FMV and the consideration paid is taxable as income from other sources in the hands of the recipient (buyer).

In the context of contingent consideration, a question arises: what constitutes the “consideration” paid by the buyer? Is it merely the upfront cash, or does it include the obligation to pay future contingent amounts?

The term “consideration” is not defined under the IT Act and must be understood in its contextual sense. Section 2(d) of the Indian Contract Act, 1872⁶¹ defines consideration to include past, executed, and executory consideration. For the purposes of Section 92(2)(m), consideration would ordinarily include the initial purchase consideration and deferred consideration (being executory consideration) at their full value.

However, a promise to pay contingent consideration is conditional and cannot be equated with executory consideration simpliciter. Given the uncertainty, the FMV of the obligation to pay (or the corresponding right to receive, in the hands of the seller) should be included in determining the value of consideration.

In essence, the full value of consideration accruing to the transferor may be regarded as the consideration due from the transferee. This aggregate value (Upfront + Deferred + FMV of Contingent Obligation) should be benchmarked against the FMV of the shares received to determine if any deemed income arises under Section 92(2)(m).

61 Section 2(d) reads: “When, at the desire of the promisor,
 the promisee or any other person has done or abstained from doing or does or abstains from doing, 
or promises to do or the abstain from doing something, such an act or abstinence or promise is called a consideration for the promise”.

OBLIGATION TO WITHHOLD TAXES

Section 393(2), Table: Sl. No.17⁶² casts an obligation on any person responsible for paying to a non-resident any sum chargeable to tax under the IT Act to withhold tax at the rates in force at the time of credit of such income to the account of the payee or at the time of payment thereof, whichever is earlier.

For initial and deferred consideration, the withholding obligation is clear. However, for contingent consideration, the issue is whether withholding is required prior to accrual. Even where contingent consideration is recognized in the books of account (e.g., as a provision under Ind AS), the mere credit of such amount may not be sufficient to trigger withholding obligations if the income has not legally accrued to the payee.

A tenable view is that income has not accrued until the contingency materializes. This position is reinforced by the language of Section 393(2), Table: Sl. No.17, which applies only to sums “chargeable to tax.” If the income has not accrued, it is not yet chargeable.

This is also the practice followed generally and finds mention in the decision of the Mumbai ITAT in Huntsman Investments (Netherlands) B.V.⁶³ In this case, the buyer withheld taxes on the contingent consideration only upon its crystallization, distinct from the closing date consideration.

However, if the rationale of Marren v. Inglis (supra) is adopted—treating the contingent right as a separate asset transferred at closing—it may be prudent, from a risk-mitigation perspective, to withhold tax on the FMV of that right at the time of the initial transfer. Given the ambiguity, the prevailing practice remains to withhold tax on contingent consideration only upon crystallization.

62 Section 195 of ITA 1961.

63 Huntsman Investments (Netherlands) B.V. v DCIT [2024] 166 taxmann.com 63 (Mum Trib). 
While not a direct ruling on the timing of tax withholding, a factual finding was recorded in Para 7, 
wherein it was noted that the buyer had withheld taxes on the contingent consideration only upon its crystallization, 
distinct from the consideration paid at closing. In this case, Huntsman had sold the shares of Huntsman Advanced Materials Solution Private Limited 
to the Pidilite Industries Ltd. for an aggregate consideration of USD 285 million bifurcated into two components:
 ‘closing date consideration’ of USD 256.9 million and the ‘contingent consideration’ of USD 28.1 million.

CONCLUSION

The taxation of contingent consideration remains one of the more unresolved areas of capital gains law under the IT Act. Judicial authority clearly supports the proposition that such consideration does not accrue in the year of transfer so long as the seller has no enforceable right to receive it. The real controversy lies in what follows thereafter.

The principles in Marren v. Inglis provide a conceptually elegant framework by treating the contingent right as a separate capital asset and taxing the value of that right at inception, with further gains computed upon realization. Yet the Indian position is complicated by fundamental questions as to whether the right is itself a capital asset, how such a right is to be valued, and whether Section 90(3), is broad enough to deem the cost of acquisition of such rights to be nil. The issue is therefore far from free from doubt.

“The taxation of contingent consideration remains one of the more unresolved areas of capital gains law under the IT Act. “

A substantial counter-argument remains available that, depending on the nature of the right and the application of B.C. Srinivasa Setty, some receipts may still fall outside the charge to capital gains tax in the absence of a clear statutory fiction. Added to this are practical characterization risks where earn-outs are linked with continued employment and may, in substance, represent remuneration rather than purchase consideration.

Until legislative clarity is provided, the issue is likely to remain contested between literal and purposive readings of the statute. From a policy standpoint, a specific framework—similar in spirit to Section 67(12)—for contingent consideration, escrow releases, and claw backs would greatly reduce uncertainty and litigation. As Chief Justice of India S.H. Kapadia⁶⁴ observed, “Certainty is integral to the rule of law. Certainty and stability are fundamental to any fiscal system, and tax policy clarity is crucial for taxpayers (including foreign investors) to make rational economic decisions in the most efficient manner”.

Additionally, readers may consider the taxability of contingent consideration in cases involving non-residents who have invested in shares of Indian companies and are residents of countries with which India has a Double Taxation Avoidance Agreement (DTAA). In such cases, while India retains the right to tax gains arising from the transfer of shares in an Indian company, the right to tax gains from the transfer of other assets may lie with the country of residence.⁶⁵ For instance, in a joint development agreement, where a landowner (a company) parts with a portion of land to a developer in exchange for a right to a share in the project, the consideration for the transfer of land is the right to receive a share in the project. If the landowner transfers this right before receiving the completion certificate, what is being transferred is the right itself, not the land or building. Therefore, in such cases, Section 78⁶⁶ of the IT Act, which applies only to the transfer of land or building, should not apply.⁶⁷ A similar distinction should be drawn between the share and the right to receive contingent consideration when applying the DTAA.

64 In Vodafone International Holdings B.V. v Union of India [2012] 341 ITR 1 (SC), para 91. Similarly, refer to the observations of Justice Radhakrishnan in para 3 of his concurring judgment.

65 Illustratively refer to India-Singapore DTAA [Article 13(4B) and 13(5)] and India-Mauritius DTAA [Article 13(3A), Article 13(4)].

66 Section 50C of ITA 1961.

67 The decision of the Bombay High Court in Vidarbha Veneer Industries Ltd, (in liquidation) v ITO [2026] 484 ITR 132 (Bom) 
extending the scope of Section 50C to all immovable properties (not just land and building) 
may warrant reconsideration based on the literal language of the deeming provision. For a detailed critique on the judgment, 
one may refer to 484 ITR (Journal) 1-12.

BCAJ Admin

The Revised Code of Ethics, 2026, effective April 1, 2026, modernizes the ethical framework for Indian Chartered Accountants while preserving core professional integrity. The 13th Edition introduces a restructured three-volume format. Volume I updates domestic provisions, expanding permitted advisory services to include AI, forensics, and sustainability, while relaxing digital communication, website, and advertising guidelines. Volume II converges with the IESBA 2024 Code, strengthening independence rules around non-assurance services, expanding the definition of Public Interest Entities, and updating NOCLAR applicability. Finally, Volume III introduces entirely new ethical standards dedicated to sustainability assurance.

Ethics: A Timeless Foundation Rooted in Indian Tradition

The idea of ethics has deep roots in India’s philosophical and cultural traditions. The principle of Satyameva Jayate — “Truth Alone Triumphs” — reflects a timeless value that has guided personal conduct, public life and social institutions for centuries. Embedded in the national ethos, this principle continues to hold great relevance in modern professional life.

For Chartered Accountants, this ideal translates into a commitment to truth, transparency, fairness and professional responsibility. Ethical conduct is not limited to compliance with prescribed rules; it requires continuous alignment of professional behaviour with fundamental values. These values become especially important in situations where regulations may not provide explicit answers, or where competing interests require careful professional judgment.

Enhanced Significance of Ethics in the Accountancy Profession

The accountancy profession occupies a position of public trust. Chartered Accountants interact with a wide range of stakeholders — clients seeking professional advice, investors making financial decisions, regulators overseeing compliance, financial institutions evaluating credibility, and the public whose confidence supports the economic system.

In such a setting, ethics is not merely a regulatory obligation. It is the defining strength of the profession. The credibility, dignity and long-term sustainability of the Chartered Accountancy profession depend on the trust that society places in its members. That trust can be preserved only when professional competence is supported by integrity, independence and ethical conduct.

Genesis and Evolution of the Ethical Standards Board

Recognising the need for structured ethical guidance, the Institute of Chartered Accountants of India constituted the Ethical Standards Committee in 1976. This marked an important step in institutionalising ethical standard-setting for the profession.

Over the years, the Committee evolved in response to the changing professional environment. It was renamed as the Committee on Ethical Standards and Unjustified Removal of Auditors (CESURA), reflecting an expanded role, including its function as a fact-finding body. Subsequently, it was reconstituted as the Committee on Ethical Standards (CES) in 2005. In December 2008, it assumed its present name — the Ethical Standards Board (ESB) — aligning its role more closely with developments in ethical standard-setting at the national and international levels.

Today, the Ethical Standards Board is responsible for developing and issuing ethical standards, guiding members on matters of professional conduct, examining ethical issues referred by various stakeholders, and promoting awareness and compliance. Its role has steadily expanded from standard-setting to active engagement with the profession on ethical issues arising in practice.
The current year is particularly significant as it marks nearly five decades of the Board’s sustained contribution to strengthening ethical standards within the profession. This milestone reflects ICAI’s continuing commitment to integrity, independence and professionalism.

Evolution of the Code of Ethics

The Code of Ethics is a foundational publication that sets out the ethical framework for the Chartered Accountancy profession in India. Its origins go back to 1963, when ICAI issued the first edition titled the “Code of Conduct”. The initial framework incorporated statutory provisions and judicial interpretations, thereby providing a formal structure for regulating professional behaviour.

With the growth of the profession and changes in the regulatory landscape, the Code underwent significant transformation. In 2001, its nomenclature was changed from “Code of Conduct” to “Code of Ethics”, reflecting a broader and more principle-based approach. The focus expanded beyond prescribed conduct to include values, independence requirements and the exercise of professional judgment.

The evolution of the Code demonstrates the profession’s responsiveness to emerging challenges. Each revision has sought to maintain a balance between regulatory discipline and practical relevance, ensuring that the Code remains robust, contemporary and adaptable.

The Revised Code of Ethics, 2026: A Significant Milestone

The revised Code of Ethics, 13th Edition, comprising Volumes I, II and III, is applicable with effect from April 1, 2026, except for Serial No. (xxxi) relating to “Assessment and evaluation of Social Impact, CSR Impact, Business Responsibility and Sustainability Reporting, and the like” under Management Consultancy and Other Services issued under Section 2(2)(iv) of the Chartered Accountants Act, 1949. This particular provision in Volume I is effective from December 11, 2025.

The revision reflects a comprehensive effort to align the Code with contemporary developments, international standards and the evolving needs of the profession. It also recognises the expanding role of Chartered Accountants in areas such as sustainability, technology, forensic services, governance and public interest reporting.

A Revised Structure

The 13th Edition brings a significant structural change. In the earlier 12th Edition, Volume I was converged with the IESBA Code of Ethics, 2018 edition; Volume II contained domestic provisions governing Chartered Accountants; and Volume III served as a Case Laws Referencer.

The revised Code reorganises this structure. Volume I now contains domestic provisions governing Chartered Accountants, including amendments arising from the Chartered Accountants Act, Council decisions and contemporary developments. It also includes the Council General Guidelines. Volume II is converged with the IESBA Code of Ethics, 2024 edition, with suitable modifications for Indian requirements. Volume III is a new addition and deals with Ethics Standards for Sustainability Assurance, including independence standards.

The Case Laws Referencer, which was earlier part of the Code, has now been issued as a separate publication.

A Shloka that Sets the Tone

The revised Code begins with the shloka:

धर्मो रक्षति रक्षितः

Meaning: Dharma protected, protects. Therefore, let us not violate Dharma.

This opening is not merely symbolic. It reflects the philosophy underlying the Code. If professionals protect ethical principles, those principles in turn protect the profession. For a profession built on public trust, this message is both timeless and practical.

VOLUME I: DOMESTIC PROVISIONS

Bringing the Chartered Accountants Act to the Forefront

Volume I has been comprehensively updated to reflect amendments arising from the Chartered Accountants Act, contemporary developments and decisions of the Council. It provides members with a consolidated view of domestic ethical requirements applicable to Chartered Accountants.

Expansion of Professional Services

The revised Code broadens the scope of Management Consultancy and Other Services under Section 2(2)(iv) of the Chartered Accountants Act, 1949. Earlier, 28 services were recognised under this provision. The revised Code increases the list to 32 by including the following services:

• Forensic Accounting and Investigation;
• Research Analyst recognised by a regulator;
• Assessment and evaluation of Social Impact, CSR Impact, Business Responsibility and Sustainability Reporting, and the like; and
• Artificial Intelligence Consultancy in areas of services that can be rendered by a Chartered Accountant in practice.

Further, “Management and operational audits” has been expanded to include Information System Audit. These changes recognise the increasing demand for Chartered Accountants in specialised advisory and assurance areas, including forensic investigations, sustainability reporting, information systems and emerging technologies.

The revised Code also permits Chartered Accountants in practice to enter into partnerships with other recognised professionals under an Insolvency Professional Entity or Registered Valuers Entity, subject to compliance with the provisions of the Code.

Communication with the Previous Auditor

The recognised mode of communication with the previous auditor has been updated from “Registered Acknowledgement Due” to “Registered/Speed Post with Acknowledgement Due”. This change reflects current postal practices and provides practical clarity to members.

Compliance with Appointment Provisions

Clause (9) of Part I of the First Schedule to the Chartered Accountants Act, 1949 has been updated to incorporate amendments arising from the Chartered Accountants, Cost and Works Accountants and Company Secretaries (Amendment) Act, 2022.

The revised provision now requires compliance not only with Sections 139 to 141 of the Companies Act, 2013, but also with any other applicable law governing the appointment of auditors. For instance, appointment of auditors in banking and insurance companies must comply with the relevant sectoral laws.

New Clause Relating to Auditors

A new Clause (5) has been inserted in Part II of the Second Schedule. It provides that a member, whether in practice or not, shall be deemed guilty of professional misconduct if he acts as an auditor of a company in contravention of the provisions of the Companies Act, 2013.

The objective is to uphold the sanctity of the audit process and reinforce the statutory responsibilities attached to the role of an auditor.

Modernising Professional Communication and Visibility

One of the important features of the revised Code is its recognition of modern modes of professional communication. The earlier Code permitted educational videos but restricted the mention of firm names and contact details. The revised provisions now allow members to upload educational audio, video and podcast content, with the firm’s name and contact details, provided the content remains educational in nature.

Restrictions relating to professional visibility have also been relaxed. Members writing articles or letters to the press on subjects connected with the profession may mention the name of the firm in which they are a partner or proprietor. Chartered Accountants in practice may conduct virtual programmes and webcasts, and invitations for such programmes may be sent not only to clients and staff of other Chartered Accountants, but also to others.

Another important change concerns network firms. Firms forming part of a network may now mention the name of the network on professional stationery, and the network may mention the names of the firms forming part of it. Networks registered with ICAI are also permitted to have websites, subject to the applicable website guidelines.

Write-up and Contemporary Forms of Communication

The revised Code significantly updates the Council Guidelines for Advertisement, 2008. The definition of “write-up” has been expanded to include “contemporary form” and “directories”, thereby recognising modern presentation formats and electronic directories as legitimate means of professional communication.
Several restrictions on the content of write-ups have been relaxed:

• the earlier limit on font size has been removed;
• the mandatory requirement to mention Membership Number or Firm Registration Number has been dispensed with;
• members have greater flexibility in including additional professional information;
• for non-exclusive services, the names of clients and the nature of assignments may be mentioned, subject to the client’s permission; and
• for services exclusively reserved for Chartered Accountants, only the names of clients may be mentioned, again subject to the client’s permission.

At the same time, the underlying principle remains unchanged. A write-up must comply with the prescribed guidelines. It should not be false, misleading, exaggerated or undignified. Its purpose must be to provide information, not to secure professional work through solicitation or unfair advantage.

Website Guidelines: Pull and Push Technology

The website guidelines have also been modernised. Chartered Accountants, firms and registered networks may use both “pull” and “push” technology for non-exclusive services, while exclusive services must continue to follow the “pull” model.

Websites may display peer review status, Audit Quality Maturity Model level, and affiliation with a registered network. The revised provisions also permit passport-style photographs of persons associated with the firm, photographs of professional events organised by the firm, and photographs of professional events where lectures are delivered by partners or proprietors.

These changes recognise the importance of digital presence in professional practice, while retaining safeguards against solicitation and misleading advertisement.

Listing with Application-Based Service Provider Aggregators

A practical and relevant change relates to listing with online application-based service provider aggregators. Earlier, there was a prohibition where members or firms were listed along with categories such as businessmen, technicians, maintenance workers, event organisers and similar service providers.

The revised position permits members and firms to list themselves with online application-based service provider aggregators for non-exclusive services. This reflects present market realities and the growing use of digital platforms. There is no restriction on listing for non-exclusive services.

Members may also list themselves on platforms of the Government or regulators for providing professional services, such as the GeM portal. Members are also encouraged to use “CA Connect”, the listing portal on the platform of the Institute.

Guidelines on Ethical Issues, 2026

Another important change is the shift in terminology from “Council General Guidelines, 2008” to “Guidelines on Ethical Issues, 2026”. The revised guidelines address several practical matters affecting members in practice.

Non-payment of Undisputed Audit Fees

The revised Code introduces a new chapter on non-payment of undisputed audit fees in the case of continuing audits. A member in practice shall not sign the audit report of a Public Interest Entity if the undisputed audit fees for the previous year have not been paid.

In the case of non-PIE entities, the restriction applies where undisputed audit fees for two consecutive previous years have not been paid. An exemption is provided where insolvency resolution proceedings have been initiated and a Resolution Professional has been appointed.

Indebtedness and Audit Assignment Limits

The limit of indebtedness for accepting appointment as auditor has been increased from ₹1,00,000 to ₹5,00,000. The revised provision also clarifies that, for this purpose, the term “auditor” does not include an internal auditor, concurrent auditor or an auditor giving a report to management.

The limit on the number of company audit assignments has been increased from 30 to 40 audits of companies, excluding One Person Companies and Dormant Companies.
Further, the Guidelines for Practice in Corporate Form have been amended to include services such as forensic accounting, administrative services, research analysis, social impact assessment and evaluation, CSR impact assessment, Business Responsibility and Sustainability Reporting, and artificial intelligence services that may be rendered through a company.

Audit Fees through Digital Media

In line with the Government of India’s policy to promote the digital economy, the Council has recommended that members or firms should accept audit fees only through digital modes or banking channels.

Volume II: Convergence with the IESBA Code, 2024

Volume II of the revised Code is converged with the IESBA Code of Ethics, 2024 edition, with necessary modifications to suit Indian provisions.

The earlier terminology such as “Professional Accountant”, “Professional Accountant in Public Practice” and “Professional Accountant in Service” has been replaced with “Chartered Accountant”, “Chartered Accountant in Practice” and “Chartered Accountant in Service”. This change brings the language of the Code closer to the Chartered Accountants Act and the professional identity of Indian members.

Honesty as Part of Integrity

The fundamental principle of integrity has always required a Chartered Accountant to be straightforward and honest in professional and business relationships. The revised Code further strengthens this principle by including a specific paragraph on honesty.

Responding to Non-Compliance with Laws and Regulations

The revised Volume II contains provisions relating to Responding to Non-Compliance with Laws and Regulations, commonly known as NOCLAR. The earlier applicability criterion of ₹250 crore has been removed. The provisions now apply to all listed companies and their material subsidiaries as defined in Regulation 16C of SEBI LODR. The provision relating to NOCLAR in the case of an imminent breach has also been restored.

These changes reinforce the public interest responsibility of Chartered Accountants and their role in responding appropriately to non-compliance with laws and regulations.

Non-Assurance Services to Audit Clients

A significant area of revision relates to Non-Assurance Services to Audit Clients, particularly under Section 600. This area is important because providing advisory or consultancy services to an audit client may create threats to independence, especially a self-review threat.

The revised provisions adopt a more consistent structure across subsections. They also introduce new prohibitions, particularly for Public Interest Entity audit clients, where certain non-assurance services may create self-review threats. Examples include valuation services and certain tax advisory services where the effectiveness of the advice depends on a particular accounting treatment.

The revised provisions clarify that advice and recommendations to audit clients may create a self-review threat in certain circumstances. Advisory services are not automatically prohibited; however, the firm must evaluate whether providing such services would affect independence.

Revised Definition of Public Interest Entity

The revised Code incorporates an additional parameter in the definition of Public Interest Entity by including “an entity one of whose main functions is to take deposits from the public”.

The earlier provision has also been modified to include entities having borrowings of ₹500 crore or more, to be assessed at both the beginning and end of the year.

The revised definition of Public Interest Entity is as follows:

A Public Interest Entity means:

(a) a listed entity; or

(b) an entity one of whose main functions is to take deposits from the public; or

(c) an entity:

(i) defined by regulation or legislation as a public interest entity; or

(ii) having borrowings of ₹500 crore or more, to be assessed at both the beginning and end of the year.

This revised definition extends enhanced safeguards to entities that have significant public interest implications.

Volume III: Ethics Standards for Sustainability Assurance

Volume III deals with Ethics Standards for Sustainability Assurance, including independence standards. These standards are converged with the International Ethics Standards for Sustainability Assurance, including International Independence Standards, issued by IESBA.

The standards prescribe requirements for sustainability assurance providers while performing sustainability assurance engagements. They also include provisions relating to independence in such engagements.

Where laws or regulations preclude a sustainability assurance provider from complying with certain provisions of this part, such laws and regulations shall prevail, and the practitioner shall comply with all other applicable provisions. Further, where industry or sector-specific provisions prescribe more stringent or additional requirements, such provisions shall apply to the concerned industry or sector.

The inclusion of sustainability assurance standards is an important development. It recognises the growing relevance of sustainability reporting and assurance, and prepares the profession to meet emerging expectations from businesses, regulators, investors and society.

Balancing Growth with Ethical Integrity

The revised Code strikes a careful balance between enabling professional growth and preserving ethical integrity. It recognises new opportunities in areas such as artificial intelligence, forensic accounting, sustainability, digital platforms and specialised advisory services. At the same time, it reinforces independence, objectivity, transparency and professional dignity.

The changes discussed above are indicative in nature. Members are advised to refer to the complete Code of Ethics available at ethics.icai.org for detailed provisions and applicability.

Role of the Ethical Standards Board Beyond Standard-Setting While formulation of ethical standards remains a central function, the role of the Ethical Standards Board extends well beyond standard-setting. The Board actively supports members in understanding and applying ethical principles in day-to-day professional work.

It also plays an important role in promoting awareness and disseminating knowledge. Through publications, programmes, guidance material and technology-based initiatives, the Board works to strengthen ethical competence within the profession. Its efforts are directed towards ensuring that ethical standards do not remain confined to the text of the Code, but are reflected in actual professional conduct.

CONCLUSION: SUSTAINING THE PROFESSION THROUGH ETHICAL COMMITMENT

The Chartered Accountancy profession derives its strength from the trust it commands. The Ethical Standards Board has played a vital role in nurturing and strengthening this trust. Through its work in standard-setting, guidance, awareness and capacity-building, it has helped ensure that ethical principles remain central to professional practice.
However, the responsibility of upholding ethics does not rest with the Board alone. It belongs equally to every member of the profession. Ethical conduct requires conscious and continuous effort, particularly when professional judgment is tested by pressure, ambiguity or competing interests.

The revised Code of Ethics, 2026 should not be seen merely as a compliance document. It is a guide for professional conduct in a changing world. It explains what is permitted, what is restricted and, more importantly, what is expected from a Chartered Accountant.

For members in practice, it provides clarity on communication, websites, non-assurance services, independence and emerging professional opportunities. For members in service, it reinforces honesty, integrity, responsibility in responding to non-compliance, and the need to act beyond mere employment instructions. For the profession as a whole, it strengthens alignment with global standards and creates a structured path for sustainability assurance.

The message of the revised Code is clear: the profession may modernise, but it must not lose its ethical foundation. Visibility may increase, but dignity must remain. Technology may assist, but professional judgment must remain human. Opportunities may expand, but independence must never be compromised.

BCAJ Admin

Under SA 510, incoming auditors must independently verify opening balances during initial engagements to ensure they lack misstatements affecting the current period. In India, this is especially challenging because professional conduct rules prohibit predecessor auditors from sharing their working papers. Consequently, incoming auditors must essentially reconstruct the prior year’s closing position from scratch using only client records and signed financial statements. Because this workload is rarely priced correctly, practitioners must explicitly plan and budget for opening balance procedures at the initial engagement stage. If sufficient evidence is unavailable or misstatements remain unresolved, the auditor must modify their current year report accordingly.

SA 510: WHAT IT COVERS

SA 510, “Initial Audit Engagements—Opening Balances,” sets out the auditor’s responsibilities in relation to opening balances when taking up an audit for the first time. It applies where the previous year’s financial statements were either not audited or were audited by a predecessor auditor. Accordingly, since a newly incorporated entity preparing its first financial statements has no prior period, this standard does not apply to it. Opening balances extend beyond opening figures and also include matters requiring disclosure at the beginning of the period, such as contingencies and commitments. Where comparative financial information is presented, SA 710 assumes relevance, while SA 300 provides guidance on planning activities at the commencement of an initial audit engagement.

THE RISK OF GETTING IT WRONG

The importance of SA 510 lies in a simple but fundamental proposition: if opening balances are misstated, the current period’s financial statements may also be misstated. The incoming auditor cannot simply carry forward prior balances without independent verification. The reliability of the current year’s audit opinion rests, in part, on the soundness of the starting point.

WHAT THE STANDARD REQUIRES

The auditor’s objective under SA 510 may be summarised in three points:

1. Obtain sufficient appropriate audit evidence as to whether opening balances contain misstatements that materially affect the current period;
2. Determine whether accounting policies reflected in opening balances have been consistently applied, or whether changes have been properly accounted for, presented, and disclosed; and

3. Where the prior year was audited by another firm, assess whether any modification in the predecessor auditor’s report remains relevant to the current period.

Where the previous year’s financial statements were audited, the auditor may obtain sufficient appropriate audit evidence by reviewing the audited financial statements, including schedules and other supporting documents. Ordinarily, the current auditor can place reliance on the predecessor’s closing balances, except where current-period procedures indicate the possibility of misstatements in opening balances. This conditionality matters: reliance is permitted as a starting position, but it is not unconditional.

VERIFICATION PROCEDURES

The procedures required under SA 510 vary depending on the nature of the balance being verified. It is advisable to complete opening balance procedures before initiating current-period audit work. Once current-year procedures are underway, revisiting opening balances adds complexity, and, in practice, these procedures may not receive the attention they warrant.

For current assets and liabilities:

• The collection or payment of opening accounts receivable and accounts payable during the current period provides natural evidence of the opening position.
• Balance confirmations from banks, vendors, and customers on a sample basis corroborate the opening figures independently.

For inventories:

Current period closing procedures provide limited evidence about what was on hand at the start of the year. Additional procedures are therefore required:

• Observe a current physical inventory count and reconcile it to the opening inventory quantities.
• Perform audit procedures on the valuation of opening inventory items.
• Perform audit procedures on gross profit, inventory turnover, and cut-off.

For non-current assets and liabilities (property, plant and equipment, investments, and long-term debt):

• Third-party balance confirmations and reconciliation.
• Review of the fixed asset register (FAR) and physical verification documents. Where these are incomplete or unavailable, invoices should be verified on a sample basis for material items.
• Verification of demat statements and, where investments are not held in demat form, physical verification.

Beyond balance-specific procedures, the auditor must also review the prior year’s audited financial statements and the predecessor auditor’s report, verify the carry-forward of balances, and assess whether any prior qualification or modification continues to affect the current period. Where opening balance misstatements are identified and remain unresolved, they must be communicated to management and those charged with governance in accordance with SA 450.

THE STANDARD IN PRINCIPLE, THE PRACTICE IN INDIA

It is worth acknowledging that audit practice has made genuine progress in recent years. Firms increasingly use improved documentation, digital working papers, data analytics, and more structured engagement acceptance procedures. And yet, first-year audits involving opening balances remain an area where gaps persist.

A first-year audit in India is, in effect, two audits. When an auditor takes over an engagement, SA 510 requires independent verification of opening balances. While ISA 510 permits review of the predecessor auditor’s working papers in certain cases, SA 510 modifies this approach for India. Since Clause 1 of Part I of the Second Schedule to the Chartered Accountants Act, 1949 treats disclosure of information acquired during a professional engagement to any person other than the client as professional misconduct, a predecessor auditor cannot provide access to working papers to another auditor. Accordingly, SA 510 has replaced the requirement to review predecessor working papers with perusal of the audited financial statements and other relevant documents relating to the prior period financial statements.

The practical consequence is that verifying opening balances requires the incoming auditor to essentially re-perform a closing-balance audit of the prior year from scratch, using only the signed financial statements and whatever records the client makes available. And then the current year’s audit follows on top of that. The workload this implies is rarely reflected in how first-year engagements are scoped or priced.

Opening balance procedures have no natural billing home. In most engagements, the effort required to verify opening balances is absorbed into the current year’s audit fee rather than scoped as a distinct first-year requirement. This is a market reality, but it creates a compliance risk. A critical area that directly affects the reliability of the current period’s financial statements may receive insufficient attention, not because practitioners are unaware of SA 510, but because the engagement economics do not make room for it.

Two further conditions compound these challenges. Client records at the commencement of a new engagement are often incomplete, making independent reconstruction of opening balances more difficult. And there is frequently an expectation from management that the incoming auditor will accept prior balances as given, without the independent verification required by SA 510.

The way around these constraints is the same: plan earlier and plan explicitly.

• Identify SA 510 as a distinct risk item at the engagement acceptance stage, not after current-period work has begun.
• Budget separately for first-year opening balance procedures. This makes the scope visible to the client and ensures the work is actually performed.
• Use a focused checklist for high-risk areas: inventory, fixed assets, provisions, and related-party balances tend to carry the most opening balance risk.
• Communicate early with management and those charged with governance, particularly where records are incomplete or the prior audit file is unavailable.
• Strengthen documentation, review discipline, and planning under SA 300.

REPORTING OUTCOMES

Depending on the findings from opening balance procedures, SA 510 may require the auditor to reflect those conclusions in the audit report. The possible outcomes include:

• where the auditor is unable to obtain sufficient appropriate audit evidence regarding opening balances, the resulting limitation must be reflected in the audit report and may lead to a qualified opinion or a disclaimer of opinion, depending on the circumstances;
• where misstatements in opening balances could materially affect the current period’s financial statements and remain unresolved after additional procedures, they must be communicated in accordance with SA 450, and the opinion may need to be qualified or adverse;
• where accounting policies reflected in opening balances have not been consistently applied, or changes have not been properly accounted for, presented, or disclosed, the auditor may need to issue a qualified or adverse opinion; and where the predecessor auditor’s opinion was modified, and that matter remains relevant and material to the current period, the current auditor must modify the opinion accordingly. Where the matter has since been resolved or is no longer relevant, that conclusion should be documented appropriately.

PRACTICAL EXAMPLE

Case Illustration – Opening Inventory Misstatement

ABC Ltd. appointed a new auditor for FY 2024-25. During opening balance procedures, the auditor noted that inventory of ₹1 crore carried forward from the previous year included obsolete items that should have been written down. The overstatement affected both opening inventory and current-year profit. Management declined to record an adjustment. Although the issue originated in the prior year, it had a material impact on the current year’s financial statements. Accordingly, the auditor evaluated the need for a modified opinion under SA 510.

Key takeaway: Opening balance errors are not merely historical issues; they can directly affect the current year’s audit opinion.

Case Illustration – Inability to Verify Opening Inventory

A newly appointed auditor was engaged to audit a trading company. Opening inventory amounted to ₹15 crore. The auditor had not observed the prior year’s physical stock count and the client was unable to provide adequate stock records, movement registers or valuation workings relating to the opening inventory. As the auditor could not obtain sufficient appropriate audit evidence regarding a material opening balance, a limitation of scope arose under SA 510, requiring consideration of a qualified opinion or disclaimer, depending on materiality and pervasiveness.

Key takeaway: When evidence relating to opening balances is unavailable, the issue may affect the auditor’s opinion even when current-year records are otherwise satisfactory.

Case Illustration – Missing Fixed Asset Records

An incoming auditor found that fixed assets of ₹25 crore had been carried forward from prior years, but the entity maintained no comprehensive fixed asset register. For several material assets, management could not provide acquisition documents or evidence of ownership. Since the auditor could not independently verify significant opening balances, additional procedures were required and the impact on the audit opinion had to be evaluated under SA 510.

CONCLUSION

SA 510 warrants greater practical attention because opening balances form the foundation of the current year’s audit opinion. The constraints specific to India, particularly the restriction on access to predecessor working papers under the Clause 1 of Part I of the Second Schedule to the Chartered Accountants Act, 1949, mean that compliance requires more deliberate planning than the standard alone might suggest. A first-year audit here is not a routine handover; it is an independent reconstruction of the prior year’s closing position, followed by the current year’s audit. Recognising that reality, and planning for it explicitly, is what sound first-year audit practice looks like.

BCAJ Admin

The Income-tax Act 2025 simplifies the tax structure for Registered Non-Profit Organisations (RNPOs) but inadvertently introduces three critical drafting anomalies. First, corpus donations excluded from “regular income” might fall into the taxable “residual income” basket, potentially losing their historical tax exemption. Second, income applied towards non-registered purposes risks double taxation, as it is disallowed as a deduction from regular income while simultaneously being taxed as specified income. Finally, the omission of a clause enforcing “additional income-tax” on accreted income when normal tax is zero could render the levy unenforceable. Legislative clarifications are urgently needed.

The provisions relating to charitable institutions (now rechristened as Registered Non-Profit Organisations -RNPOs), have undergone significant structural revamp in the Income-tax Act, 2025 (“2025 Act”). Consolidation of scattered provisions of the Income-tax Act, 1961 in one single chapter XVII-B, arrangement of sections in a logical sequence and expression of law in a simpler language-these changes are undoubtedly welcome and make the law easier to navigate.

At the same time, the extensive restructuring appears to have introduced certain serious structural anomalies and drafting gaps which may have unintended tax consequences for a large number of RNPOs. Some provisions seem capable of altering long-settled tax positions, while others raise computational or interpretational issues that were absent in the 1961 Act. If left unaddressed, these issues may become fertile grounds for avoidable litigation, defeating the very purpose of simplification.

This article examines three such anomalies that merit careful consideration and timely clarification.

ISSUE 1 : WHETHER THE DRAFTING OF 2025 ACT HAS CHANGED THE TREATMENT OF CORPUS DONATIONS?

Treatment of Corpus Donations in the 1961 Act

In the 1961 Act, corpus donations were initially excluded from the definition of income itself by virtue of exclusion contained in clause (iia) of Sec. 2(24). Direct Tax Law (Amendment) Act, 1989 deleted that exclusion from Sec. 2(24)(iia) and instead brought in Sec. 11(1)(d) w.e.f. 01.04.89 providing as follows:

11. (1) Subject to the provisions of sections 60 to 63, the following income shall not be included in the total income of the previous year of the person in receipt of the income—
……….

(d) income in the form of voluntary contributions made with a specific direction that they shall form part of the corpus of the trust or institution, subject to the condition that such voluntary contributions are invested or deposited in one or more of the forms or modes specified in sub-section (5) maintained specifically for such corpus.

Thus, the 1961 Act is very clear in its treatment of corpus donations for registered charitable or religious institutions – a corpus donation, subject to the fulfilment of conditions regarding its investment etc., is excluded from the “total Income” itself, meaning thereby for all practical purposes, it never enters the computation of income at all.

Relevant Provisions of the 2025 Act

In the 2025 Act, the total income of RNPOs is being categorised into 3 buckets with each bucket having a separate taxability under sec. 334(1):

• Specified Income- taxable @30%
• Regular Income- taxable at the applicable rates
• Residual Income- taxable at the applicable rates

Section 334 makes it clear that the Income-tax payable by an RNPO on its “total income” for any tax year shall be the aggregate of the amounts calculated above.

The definition of “income” contained in Sec. 2(49) of the 2025 Act is similar to the definition contained in Sec. 2(24) of the 1961 Act. As per clause (c) of Sec. 2(49), “Income” of an RNPO includes voluntary contributions received by it.

By virtue of Sec. 335(d), Regular Income of an RNPO includes all voluntary contributions received by it and then Sec. 338(b) provides that the corpus donations received by an RNPO are not to be included in the “regular income”.

Residual Income has been defined in Sec. 355(j) as follows:

“residual income” means the total income without giving effect to the provisions of this Part, as reduced by regular income and specified income.

Residual Income is a new category created by the 2025 Act and as the name suggests, is a residuary figure. It catches whatever remains of the total income when Regular Income and Specified Income have been reduced from it.

The Emerging Anomaly

Against this backdrop, the issue arising is whether, in the era of 2025 Act, corpus donations in the hands of RNPOs continue to enjoy the same exemption as accorded to them by Sec. 11(1)(d) of the 1961 Act, or the structural recalibration of the Act has inadvertently brought about a change in this position?

As mentioned above, the wordings in the 1961 Act are that corpus donation shall not be included in the “total income”. Replacing this, the 2025 Act provides that a corpus donation shall not be included in the “regular income”.

The question arises whether the non-inclusion of a corpus donation in the “regular income” under the 2025 Act is the same as non-inclusion of corpus donation in the “total income” under the 1961 Act? To put it differently, once a corpus donation is excluded from the “Regular Income” under Section 338(b) of the 2025 Act, where does it go? Does it fall into the bucket of “exempt income”, or still remains within the sphere of “total income”?

The issue assumes added significance due to the concept of “Residual Income” introduced in the 2025 Act – Total Income Less Regular Income and Specified Income = Residual Income. And it is here that the drafting anomaly becomes evident. Once a corpus donation- by virtue of being voluntary contribution – falls within the ambit of “total income” of an RNPO, and is then not allowed to enter the “Regular Income” by Sec. 338 (b), it does not move out from the clutches of “total income”, the “Residual Income” is standing there to catch it.

To put it somewhat poetically, in the era of the 2025 Act, a corpus donation appears to be destined for a short and unhappy journey- in the total income as a voluntary contribution, out of Regular Income, and straight into the lap of Residual Income — a basket that, unlike the corpus donation of the 1961 Act, enjoys no exemption from tax. And thus, it appears that the time-tested exemption available to corpus donation has got lost in the drafting of the 2025 Act.

The capital-receipt argument

There is of course a catena of judicial decisions holding that corpus donation being a capital receipt is not includible in the total income at all. But till now, the legal battle regarding taxability or otherwise of corpus donation was limited only to unregistered charitable institutions (One may refer to Dec. 2021 issue of BCA Journal for a detailed discussion on the Taxability of Corpus Donation Received By An Unregistered Trust). Registered institutions were entitled to claim a clear exemption for corpus donation by virtue of provision of Sec. 11(1)(d) of the 1961 Act. Now in the 2025 Act that unambiguous tax position seems to have got shrouded in uncertainty even for the registered NPOs.

Unless clarified, the present drafting of the 2025 Act has the potential to unsettle the long-settled tax exemption of corpus donations enjoyed by the registered charitable institutions in the 1961 Act.

ISSUE 2 : INCOME APPLIED FOR PURPOSES OTHER THAN THE PURPOSE FOR WHICH RNPO IS REGISTERED- WHETHER TAXABLE TWICE ?

Taxable Regular Income

As mentioned above, in the 2025 Act total income of an RNPO is being divided into 3 categories- Specified Income, Regular Income and Residual Income.

Regular Income is the core of this troika covering –

• income from charitable/religious activities,
• income from any property, deposit or investment held for charitable/religious purposes
• Voluntary contributions
• Gains of permissible commercial activities

This regular income is to be converted into “Taxable Regular Income” (TRI) u/s. 336 by reducing “application of income” and accumulation thereof from the 85% of Regular Income. The resulting Taxable Regular Income, if any, is then taxable at the applicable rate.

Application of Income

Section 341 sets the parameters regarding “application of income” which is to be reduced from the “Regular Income”.

Sub-section (1) of section 341 provides that “any sum applied by it for charitable or religious purpose in India for which it is registered”, shall be allowed as application of income to a registered non-profit organisation.

The words “for the purpose for which it is registered” are significant. They connote that if any amount is applied by an RNPO for a charitable or religious purpose other than the purpose for which it is registered, such amount shall not be treated as application of income. Consequently, such amount shall not be allowed as a deduction from the Regular Income while computing the Taxable Regular Income u/s. 336.

Let’s take an example. The only income of an RNPO is bank interest of Rs. 20 lacs.

The RNPO is registered for educational purposes. During the year, it spends:

• Rs. 8 lacs on distribution of books to school children and
• Rs. 9 lacs on some non-educational purposes.

The expenditure of Rs. 8 lacs is in furtherance of the educational objects of the RNPO and therefore qualifies as application of income u/s. 341. However, the expenditure of Rs. 9 lacs on non-educational purposes is not for the purposes for which the RNPO is registered. Accordingly, this amount shall not pass the test of Sec. 341 and shall not be treated as application of income.

As a result, the Taxable Regular Income of the RNPO shall be computed as under:

Under section 334, this amount of Rs. 9 Lacs shall be taxable at the applicable rate.

Whether Such Amount Shall be Taxable as “Specified Income” also?

Let us now refer to section 337 dealing with Specified Income.

Section 337 lays down 13 different situations where an amount shall be treated as “Specified Income” of the RNPO. By virtue of Sec. 334, all specified incomes are taxable @ 30%.

Serial No. 10 of the table in Sec. 337 provides that any income applied to purposes other than charitable or religious purposes for which the RNPO is registered shall be treated as “Specified Income” and shall be taxable as such in the tax year in which such application takes place.

Thus, on the one hand, Sec. 341(1) does not allow the application of income for purposes other than for which the RNPO is registered to be reduced from the Regular Income and, on the other hand, Sec. 337 treats the same amount as Specified Income.

Applying this to our above example, the amount of Rs.9 Lacs applied towards non-educational purposes, being applied for purposes other than the objects for which the RNPO is registered, would get covered by TSN 10 of Sec. 337 and accordingly shall be taxable as Specified Income also. The overall implication would be that Regular Income is getting taxed without the benefit of such application and the application itself is also getting taxed separately.

1961 Act Vs. 2025 Act

In the 1961 Act, the corresponding provision for taxability of Specified Income is section 115BBI. There is no provision in Sec. 115BBI similar to Table Sr. No. 10 of Sec. 337 i.e. application of income to purposes other than charitable or religious purposes for which the RNPO is registered is not a “Specified Income” in the 1961 Act.

Moreover, section 115BBI gives a two tier tax calculation mechanism by providing that the income-tax payable shall be the aggregate of, —

(i) the amount of income-tax calculated at the rate of thirty per cent on the aggregate of such specified income; and

(ii) the amount of income-tax with which the assessee would have been chargeable had the total income of the assessee been reduced by the aggregate of specified income referred to in clause (i).

In the 2025 Act, there is no provision corresponding to the above clause (ii) providing for reduction of “specified income” from the regular income or providing that whatever has been included in the Specified Income shall not be included in the Regular Income. Consequently, as demonstrated by the example discussed above, there appears to be a clear case of the same amount being subjected to tax twice—first at the income level as Regular Income, and then again at the application level as Specified Income.

It can certainly be argued that the specific overrides the general and, thus, when the same amount is covered by two categories of income, it should be classified under the more specific head (Specified Income) rather than under the general head (Regular Income). However, acceptance of this proposition would ultimately depend upon judicial approval through the course of litigation—precisely the kind of uncertainty that the 2025 Act seeks to minimise.

Clarifications Needed in the Act

It may be appreciated that both these issues assume greater significance in the backdrop of CPC’s software driven ITR processing, which operates mechanically on the basis of the wordings in the Act and leaves hardly any room for application of the principles of statutory interpretation to mitigate drafting gaps.

For the computational scheme of Regular Income, Specified Income and Residual Income to function seamlessly, the 2025 Act appears to require two clarifications:

a. Whatever is included in the Specified Income, shall be excluded from the Regular Income.
b. Whatever is excluded from Regular Income, shall not be included in the Residual Income.

In the absence of these clarifications, the three categories of income may not have mutual exclusivity and may instead overlap with one another- resulting in the same amount being subjected to tax under more than one category or, conversely, an amount intended to be excluded from taxation inadvertently finding its way into the Residual Income.

ISSUE 3 : TAXABILITY OF ACCRETED INCOME- IS SOMETHING MISSING?

Sec. 352 of the 2025 Act provides for levy of tax on accreted income. The charging provision in sub section 1 reads as follows:

“Every specified person shall, in addition to the income-tax chargeable in respect of his total income, be liable to pay additional income-tax on accreted income at the maximum marginal rate…..”

Sec. 352 vs. Sec. 115TD

Sec. 352 of 2025 Act is the reincarnation of Sec. 115TD of the 1961 Act.

At first glance, both provisions look the same (except for the presentation difference in Sec. 352 by way of addition of a table, formula based calculation etc.). However, a closer reading reveals some significant distinctions.

One would observe that while Sec. 115TD starts with a non-obstante clause- “notwithstanding anything contained in the Act”, its replacement-“irrespective of”-does not find a place in Sec. 352 of 2025 Act.

This omission may, however, be explained by the presence of the comprehensive overriding provision contained in section 334(2) of the 2025 Act which provides that the provisions of the whole chapter XVII-B shall apply irrespective of anything to the contrary contained in any other provision of this Act other than sections 96 to 98.

It is actually another difference which merits consideration.

Both under section 115TD of the 1961 Act and section 352 of the 2025 Act, tax on accreted income is levied as “additional income-tax” and is stated to be payable “in addition to the income-tax chargeable in respect of total income”.

Sec. 115TD(4) of the 1961 Act contains another specific provision regarding the levy of tax :-

4) Notwithstanding that no income-tax is payable by a specified person on its total income computed in accordance with the provisions of this Act, the tax on the accreted income under sub-section (1) shall be payable by such specified person.

In the 2025 Act, the provision corresponding to Sec. 115TD(4) is missing. And this leads to an important question –

Since the tax under section 352 is payable “in addition to the income-tax chargeable in respect of total income”, would it still be payable in a case where there is no total income and no income-tax chargeable in respect of total income in the tax year in which accreted income arises u/s 352?

To put it differently, does the levy of additional income-tax on accreted income u/s. 352 require something to which it can be added/fastened to, or would it still be payable even if there is nothing for it to be “in addition to”?

Additional Income Tax in the 1961 Act

In the 1961 Act, there are at least three similar instances of additional income-tax being levied:

1. Section 115-O (Dividend Distribution Tax)

2. Section 115-QA (Tax on buy-back of shares)

3. Section 115TD (Tax on accreted income)

In each of these cases:

• The levy has been described as additional income-tax.
• It is payable “in addition to” the normal income-tax, and
• There is a specific provision laying down that additional tax would be payable notwithstanding that there is no tax payable on total income. [Ref.: Sec. 115-O(2), 115QA(2) and 115TD(4)]

So, the 1961 Act is clear in its intent – though the additional income-tax is payable “in addition to” the normal tax, by the force of Sec. 115-O(2)/115QA(2)/115TD(4), it will still be payable even if “normal tax” is not there.

Possible Argument under Sec. 352

Section 352 continues to provide that tax on accreted income is payable “in addition to” the tax on total income. However, unlike its predecessor, it is not protected by the declaration of intent that the levy would continue to apply even in the absence of any normal tax liability. This creates room for the argument that the words “in addition to the income-tax chargeable in respect of total income” presuppose the existence of an income-tax liability on total income. If no such liability exists, there is nothing to which the additional income-tax can be added, and accordingly the charging mechanism fails.

It can certainly be counter-argued that even if “income-tax chargeable on total income” is absent, the additional tax u/s 352 would still be there- being added to Zero. However, acceptance of this interpretation raises a conceptual difficulty- if the expression “in addition to” by itself is sufficient to achieve that result, then the specific provisions enacted by Parliament in sections 115-O(2), 115-QA(2), and 115TD(4) of the 1961 Act would become largely redundant.

Additional Income-tax : Judicial Interpretation

The concept of “additional income-tax” has previously come up for judicial interpretation in the context of erstwhile section 143(1A) of the 1961 act, (prior to its amendment by the Finance Act, 1993).

At the relevant time, section 143(1A)(a)(i) provided that where adjustments were made while processing the return under section 143(1), the Assessing Officer shall “further increase the amount of tax payable under sub-section (1) by an additional income-tax…”.

Interpreting this provision, the Delhi High Court in Modi Cement Ltd. v. Union of India (1992) 193 ITR 91 held that where even after the adjustments, returned income was a loss and no tax was payable, the levy of additional income-tax could not be sustained. The courts reasoned that where no tax is payable, “question of there being any further increase to this does not arise” (Also Allahabad High Court in Indo-Gulf Fertilizers And Chemicals vs Union Of India 195 ITR 485).

Although these decisions arose in the context of section 143(1A), the principle underlying them is certainly of relevance. Where the statute contemplates an additional income-tax as an increase over, or in addition to, the normal income-tax, the existence of a normal tax liability may constitute the very foundation for the additional levy.

Whether the omission of the equivalent of section 115TD(4) in section 352 is inconsequential or gives birth to a sustainable legal proposition, the answer will emerge only through future judicial interpretations. Until then, the issue is likely to remain an interesting subject of debate—unless, of course, the legislature settles it first.

CONCLUSION

The Income-tax Act, 2025 is undoubtedly a significant step towards simplifying the law governing charitable institutions. However, simplification should not come at the expense of certainty. It is hoped that the issues discussed above will receive timely attention, either through legislative amendment or suitable clarification, so that the objective of simplification is achieved without giving rise to avoidable litigation.

BCAJ Admin

Under the OECD Model Convention, the residence State generally relieves double taxation. However, exceptions shift this obligation to the State hosting a permanent establishment (PE). First, if the residence State is also the source of income attributable to the PE, the PE State must credit the residence State’s source tax. Second, in “triangular cases” where a PE earns income from a third State, the PE State must relieve the third-State tax by extending domestic unilateral relief to the PE via non-discrimination principles, or through specific treaty clauses. Practitioners must carefully account for these exceptions in their cross-border financial models.

I. THE GENERAL RULE

1. The architecture of double taxation relief under the OECD Model Convention rests on a simple division- the State of source taxes first, and the State of residence relieves. Articles 23A (exemption method) and 23B (credit method) apply only to the State of residence (State R). They oblige that State either to exempt income which the Convention permits the other Contracting State to tax, or to credit the tax paid in the other State against its own levy. Paragraph 8 of the Commentary on the said Articles makes this explicit by stating that the Articles “apply only to the State of residence and do not prescribe how the other Contracting State has to proceed.”

2. This general rule, however, is not without exceptions. Paragraphs 9 to 10 of the Commentary on Articles 23A and 23B, read with paragraphs 67 to 70 of the Commentary on Article 24, identify situations in which the obligation to extend relief travels away from the residence State and settles, wholly or partly, on the State in which a permanent establishment (PE) is situated. Two fact patterns dominate this discussion: first, where the residence State is itself the State of source; and second, the classic “triangular case” where income flows from a third State to a PE.

II. FIRST EXCEPTION — RESIDENCE STATE AS SOURCE STATE (PARAGRAPH 9)

3. Paragraph 9 of the Commentary on Articles 23A and 23B deals with the situation where a resident of State R derives income from State R itself through a PE in the other Contracting State (State E). Under Article 7(1) read with Article 21(2), State E may tax such income (other than income from immovable property situated in State R) if it is attributable to the PE. Remarkably, State R must still give relief under Article 23A or 23B for the income attributable to the PE, notwithstanding that the income originally arises in State R.

4. The Commentary then carves the true exception. It provides that where the Contracting States agree to preserve for State R a limited right to tax dividends or interest within the ceilings of Articles 10(2) and 11(2) as would have been taxed by a Source State, the two States “should also agree upon a credit to be given by State E for the tax levied by State R, along the lines of paragraph 2 of Article 23A or of paragraph 1 of Article 23B.” In other words, it is the PE State and not the residence State that extends the credit for the source tax of the residence State.

5. Paragraph 9.1 adds a wrinkle for exemption-method treaties. Where State R applies Article 23A (dealing with exemption method), the combination of Articles 7 and 23A prevents State R from taxing the dividends or interest even as the State of source, although had the same income been paid to a resident of the other State, State R could have taxed it at the rates in Articles 10(2) and 11(2). The Commentary then provides that States finding this unacceptable may insert a clause preserving State R’s source taxation, with State E giving a corresponding credit, though no credit is due if State E, under its domestic law, does not tax the dividends or interest attributed to the PE.

6. The working appended to this article (Sheet “Paragraph 9”) illustrates the rule with an Indian flavour. In the said example, India is the residence State and also the source State of interest of Rs.100. The enterprise has a PE in Sri Lanka to which the interest is attributable. Sri Lanka taxes the PE profits of Rs. 600 (revenue Rs.1,000 less expenses Rs.400) at 20 per cent, i.e. Rs.120. We may assume that India retains a limited source right of 10 per cent on the gross interest, i.e. Rs.10 under the India-Sri Lanka DTAA. [The assumptions have been made solely for illustrative purposes and are not based on the respective domestic laws of the States and the inter-se treaty position between them]

7. Sri Lanka, as PE State, grants the credit contemplated by paragraph 9 of Commentary on Articles 23A and 23B at the lower of the Indian tax on the interest (Rs.10) and the Sri Lankan tax attributable to that interest (Rs.100 × 60% profit ratio × 20% = Rs.12), i.e. Rs.10, leaving a net Sri Lankan tax of Rs.110 (i.e. 120- 10). India, as residence State, then taxes the interest (Rs.10) and the balance PE profits of Rs.540 (i.e. Rs.900 * 60% profit ratio) at 30 per cent (Rs.162), giving credit for the proportionate Sri Lankan tax of Rs.99 (Rs.110 × 900/1,000), restricted to the Indian tax thereon. The net Indian tax is Rs.73 (10+162-99) and the aggregate burden across both States is Rs.183 (110+73). Double taxation stands relieved, but only because each State performed a crediting function: Sri Lanka for India’s source tax, and India for Sri Lanka’s PE tax.

III. SECOND EXCEPTION — THE TRIANGULAR CASE (PARAGRAPH 10)

8. Paragraph 10 of OECD Commentary on Articles 23A and 23B addresses the triangular configuration- a resident of State R derives income from a third State (State S) through a PE situated in State E. State E may tax the income attributable to the PE (Articles 7(1) and 21(2)), and State R must give relief under Article 23A or 23B for the income attributable to the PE. So far, the general rule holds. The difficulty lies elsewhere in as much as the Convention between R and E contains no provision obliging State E to relieve the tax levied by the third State (State S) where the income arises. The PE thus risks bearing third-State withholding tax with no treaty avenue for credit in the State that actually taxes it on a net basis.

9. The Commentary supplies the answer through the non-discrimination Article i.e. under Article 24(3). By applying such non-discrimination provision the Commentary requires that any relief provided under the domestic laws of State E (double taxation conventions excluded) for its own residents must equally be granted to a PE in State E of an enterprise of State R. Paragraph 10 expressly cross-refers to paragraphs 67 to 72 of the Commentary on Article 24.

IV. THE ARTICLE 24 DIMENSION — PARAGRAPHS 67 TO 70

10. Paragraph 67 of the Commentary on Article 24 states the principle: when foreign income is included in the profits attributable to a PE, it is right to grant the PE credit for the foreign tax borne by such income when such credit is granted to resident enterprises under domestic law. This is the equal-treatment obligation in action. On the basis of the said principle of equal treatment a unilateral relief provision under the domestic law of State E [which may be similar to section 91 of the Income-tax Act, 1961] cannot be confined to its’ residents.

11. Paragraph 68 confronts the harder case. What if State E’s domestic law grants no unilateral credit and relief flows only from tax conventions? The PE is not a “person” and not a “resident”, and is therefore not itself entitled to the benefits of State E’s conventions with third States (State S). Paragraph 69 frames the resulting question for dividends and interest received by the PE from a third State: whether, and to what extent, the PE State should credit the third-State tax that cannot be recovered.

12. Paragraph 70 records the consensus that double taxation does arise and some method of relief should be found. It observes that most member countries can grant credit on the basis of domestic law or of Article 24(3) itself. However it also provides that, States that cannot grant credit under their domestic law owing to absence of such a credit mechanism thereunder, or that wish to clarify the position, may supplement Article 24(3) with wording that permits the PE State (State E) to credit the third-State tax (State S) “by applying the rate of tax provided in the convention between the State of which the enterprise is a resident and the third State”, subject to a ceiling: the credit “shall not exceed the amount that an enterprise that is a resident of the first-mentioned State can claim under that State’s convention with the third State.” If the unrecoverable tax under the treaty or convention between State R and the third State (i.e. State S) is lower than that under the treaty or convention between State E and third State (State S), only the lower tax is credited. The PE, in effect, receives the less favourable of the two treaties, which amounts to a floor of protection and not a charter for treaty shopping.

V. THE TRIANGULAR CASE IN NUMBERS

13. The second and third sheets of the workings model the triangle with India as residence State (30 per cent), a PE in Sri Lanka (20 per cent) and interest of Rs.100 arising in Bangladesh suffering withholding at 25 per cent (Rs.25). PE profits are Rs.600 on revenue of Rs.1,000. [Again these assumptions are for illustrative purposes and do not represent the actual position under the respective domestic laws and the inter-se treaty position between the States.]

14. Route one — domestic-law relief (Sheet “Paragraph 10 of Commentary on Articles 23A and 23B read with Paragraph 67 on Article 24”). Sri Lanka is assumed to have a unilateral relief provision similar to section 91 of the Income Tax Act, 1961. Its tax of Rs.120 is reduced by credit at the lower of the Bangladesh rate (25%) and its own effective rate (12%), applied to the doubly taxed interest of Rs.100 resulting in a credit of Rs.12, leaving net Sri Lankan tax of Rs.108 (120-12). By applying Article 24(3), this domestic relief must be extended by Sri Lanka to the Indian enterprise’s PE. India then levies Rs.180 on the income inclusive of interest, allowing credit of Rs.18 for the Bangladesh tax (lower of Rs.25 and the Indian tax attributable to such interest of Rs.18) and Rs.108 for the Sri Lankan tax. The total foreign tax credit thus extended by India would be Rs.126 (Rs.108 + Rs.18), resulting in net Indian tax Rs.54 (180-126). Aggregate outflow across the three States would be Rs.187 (25+108+126).

15. Route two — the paragraph 70 treaty clause (Sheet “Paragraph 10 of Commentary on Articles 23A and 23B read with Paragraph 70 of Commentary on Article 24”). Here Sri Lanka is assumed to have no unilateral relief under its’ domestic law, but the India–Sri Lanka treaty contains the clause suggested by paragraph 70 of the Commentary on Article 24. Sri Lanka computes the credit under the India–Bangladesh treaty (Rs.18, being the lower of Rs.25 being Bangladesh Tax on interest and the Indian tax attributable to the interest) and caps it at what its own resident could claim under the Sri Lanka–Bangladesh treaty (Rs.12, being the lower of Rs.25 and the Sri Lankan tax attributable to the interest income). The credit is the minimum of the two i.e. Rs.12, and the net Sri Lankan tax is again Rs.108 (120-12). The Indian computation is unchanged, and the aggregate outflow is again Rs.187.

16. Two features of the illustrations deserve emphasis. First, in both routes the PE State’s credit is rate-capped at its own effective tax attributable to the doubly taxed income (12 per cent), so a residue of Bangladesh tax (Rs.13) remains unrelieved at the PE level. This difference however gets absorbed downstream while computing the tax credit given by India as State of residence as India being the State of residence extends credit for the taxes paid in Sri Lanka. However, with respect to taxes paid in Bangladesh, India does not extend full credit of Rs.25 (being the tax paid in Bangladesh on interest), but limits it to the Indian tax attributable to such interest being Rs.18. The difference of un-credited Bangladesh Tax of Rs.7 (i.e. 25-18) has resulted in the aggregate burden of Rs.187 exceeding the tax of Rs.180 (i.e. Rs.1000 * 60% profit percentage * 30% being tax rate in India) that a pure residence taxation would have produced. Relief in triangular cases is real but imperfect. Secondly, the paragraph 70 clause and a section 91-type domestic provision converge on the same result in this fact pattern, which is precisely its design i.e. to place PEs on par with, but not better than, local residents.

VI. CONCLUSION

17. The proposition that the residence State alone bears the burden of relieving double taxation is accurate only as a first approximation. Paragraph 9 of the Commentary on Articles 23A and 23B shows that where residence and source converge in one State and the income is attributable to a PE in the other, the PE State must credit the residence State’s source tax. Paragraph 10 of Commentary on Articles 23A and 23B, read with paragraphs 67 to 70 of the Commentary on Article 24, shows that in triangular cases the PE State must extend to the PE whatever unilateral relief its domestic law gives its own residents, or may by treaty bind itself to a credit capped at the less favourable of the two relevant conventions.

18. For Indian practice the lessons are concrete. Indian enterprises with foreign PEs earning Indian-source interest or dividends should examine whether the PE State has granted the paragraph 9 credit before computing relief under section 90 read with relevant article of the applicable treaty. Conversely, where a foreign enterprise operates a PE in India that receives third-country income, Article 24(3)-type non-discrimination clauses oblige India to extend section 91-type relief to that PE on par with residents. In triangular structures, the residual, unrelieved sliver of source-State tax is a costing reality that deserves a line in every cross-border financial model. The general rule tells us who usually pays for relief, the exceptions remind us that in treaty law, as in life, the burden does not always fall where one first expects.

WORKINGS AS PER PARAGRAPH 9 OF 2017 OECD COMMENTARY ON ARTICLES 23A AND 23B

Nature of case: There is a convergence of residence and source in the same State and income is effectively connected with a PE in the other State.

Assumptions made:

1. India is the resident State. India is also the source State inasmuch as interest is arising in India.

2. Enterprise has a PE in Sri Lanka and interest is attributable to such PE and is taxed as business profits in Sri Lanka at say 20%.

3. India has limited taxing rights under the Indo–Sri Lanka Treaty to tax the interest at a lower rate of say 10% on gross basis.

WORKINGS AS PER PARAGRAPH 10 OF 2017 OECD COMMENTARY ON ARTICLES 23A AND 23B READ WITH PARAGRAPH 67 OF 2017 OECD COMMENTARY ON ARTICLE 24

Nature of case: Income derived by a resident of Residence State (R), from a source in Source State (S) but is considered as income of a PE situated in a Third State (€).

Assumptions made:

1. India is the resident State. India taxes profits as a resident State at full rate (assuming 30%).

2. Enterprise has a PE in Sri Lanka and interest is attributable to such PE and is taxed as business profits in Sri Lanka at 20%.

3. The interest is derived from a third State say Bangladesh (source State). Tax rate in Bangladesh presumed at 25%.

4. It is presumed that Sri Lanka has a provision similar to section 91 of the IT Act, 1961 in its domestic law.

WORKINGS AS PER PARAGRAPH 10 OF 2017 OECD COMMENTARY ON ARTICLES 23A AND 23B READ WITH PARAGRAPH 70 OF 2017 OECD COMMENTARY ON ARTICLE 24

Nature of case: Income derived by a resident of Residence State (R), from a source in Source State (S) but is considered as income of a PE situated in a Third State (€).

Assumptions made:

1. India is the resident State. India taxes profits as a resident State at full rate (assuming 30%).

2. Enterprise has a PE in Sri Lanka and interest is attributable to such PE and is taxed as business profits in Sri Lanka at 20%.

3. The interest is derived from a third State say Bangladesh (source State). Tax rate in Bangladesh presumed at 25%.

4. It is presumed that Sri Lanka does not have a provision similar to section 91 of the IT Act, 1961 in its domestic law. However, it is presumed that the DTAA between India and Sri Lanka has a clause similar to that provided in paragraph 70 of the OECD Commentary on Article 24 which enables Sri Lanka to extend the credit available under the DTAA between India and a third State, subject to such credit not exceeding what is available as per the DTAA between Sri Lanka and such third State.

5. It is presumed that the tax rates at which credit is available in respective treaties is based on the rates mentioned above in respect of each jurisdiction.

This article is based on the 2017 OECD Model Tax Convention and Commentary: paragraphs 8, 9, 9.1 and 10 of the Commentary on Articles 23A and 23B, and paragraphs 67 to 70 of the Commentary on Article 24, with illustrative computations assuming Indian tax at 30%, Sri Lankan tax at 20%, Bangladesh withholding at 25% and an Indian limited source rate of 10% on interest. Figures are illustrative only and do not represent the actual domestic law positions and the inter-se treaty positions between the Contracting States referred to.

BCAJ Admin