Category: Closements

6.2    Brief facts of six categories of assessees [referred to para 2.1 of Part I of this write-up] before the Supreme Court in cases of Ahmedabad Urban Development Authority and connected matters [AUDA’s case] and the contentions raised by each one of them before the Court as well as the arguments of the Revenue are summarized in paras 3.1 to 3.3 of Part I of this write-up.

6.3    After considering the arguments of both the sides, the legislative history of the relevant provisions and amendments therein from time-to-time, the effect of Finance Minister’s speeches at the relevant time and relevant Circulars of the CBDT as well as the prior relevant judicial precedents dealing with respective provisions at the relevant time referred to in earlier Parts I & II of this write-up, the Court dealt with the effect of 2008 Amendment (including subsequent amendments in the said Proviso). The Court also explained the effect and implications of the provisions of section 11(4) & (4A) in the light of 2008 Amendment and concluded on the interpretation of Sec 2(15) which defines “Charitable Purpose” post 2008 Amendment in the context of GPU category object with which the Court was mainly concerned. These are summarized in paras 5.1 to 5.5.3 of Part II of this write-up.

ACIT(E) VS. AHMEDABAD URBAN DEVELOPMENT AUTHORITY (449 ITR 1 -SC)

7.2    In respect of the first category of assessees being statutory corporations, authorities or bodies, etc such as AUDA, the Court firstly held that statutory entities eligible for exemption under the erstwhile section 10(20A) prior to its deletion w.e.f. 1st April, 2003 can make a claim under section 11 r.w.s 2(15) of the Act as a GPU category charity. In this context, the Court also referred to its earlier decisions in the cases of Gujarat Industrial Development Corporation-GIDC [(1997) 227 ITR 414 (SC)] rendered in the context of section 10(20A) and Shri Ramtanu Co-op Hsg Society [(1970) 3 SCC 323 (SC) – five judge bench] and noted that in these cases the Court had taken a view that such industrial development corporations are involved in “development” and are not essentially engaged in trading and that is binding.

7.2.1    Similarly, the Court also noted its judgment in Gujarat Maritime Board [(2007) 295 ITR 561(SC) ] where the Board was earlier getting exemption under section 10(20) as Local Authority and the fact that section 10(20) was subsequently amended retrospectively to define Local Authority whereby the Gujarat Maritime Board ceased to be eligible to claim exemption under section 10(20). However, in that case also, the Court held that sections 10(20) and 11 of the Act operate in totally different spheres. Even if the Board is not considered as a Local Authority [due to this amendment], it is not precluded from obtaining registration under section 12A of the Act and claiming exemption under section 11. This was in the light of definition of the words’ Charitable Purpose’ as defined in section 2(15) which includes GPU category.

7.2.2    The Court then observed that rates, tariffs, fees, etc. as specified in the enactments and charged by statutory corporations for undertaking essential activities will not be characterised as ‘commercial receipts’. The reasons for the same were given by the Court as under [page 112]:

“….. The rationale for such exclusion would be that if such rates, fees, tariffs, etc., determined by statutes and collected for essential services, are included in the overall income as receipts as part of trade, commerce or business, the quantitative limit of 20% imposed by second proviso to Section 2(15) would be attracted thereby negating the essential general public utility object and thus driving up the costs to be borne by the ultimate user or consumer which is the general public…By way of illustration, if a corporation supplies essential food grains at cost, or a marginal mark-up, another supplies essential medicines, and a third, water, the characterization of these, as activities in the nature of business, would be self-defeating, because the overall receipts in some given cases may exceed the quantitative limit resulting in taxation and the consequent higher consideration charged from the user or consumer.”

7.2.3    In view of the above, the Court took the view that Statutory Corporations, Board, Authorities, etc.[by whatever name called] in the Housing Development, Town Planning, Industrial Development sectors are involved in advancement of object of general public utility and considered as Charities in the GPU category. Such entities may be involved in promoting public object and also in the course of pursuing their object may get involved or engaged in commercial activities. As such, it needs to be determined whether such entities are to be treated as GPU category Charities for claiming exemption. The Court also laid down certain tests [pages 118 to 120] to determine if the statutory corporations or bodies are GPU category Charities. These tests are broadly summarised herein – (i) whether state or central law or memorandum of association, etc. advances any GPU object, (ii) whether the entity is set up for furthering development or charitable object or for carrying on trade, business or commerce or service in relation thereto [i.e. Commercial Activity/Activities], (iii) rendering services or providing goods at cost or nominal mark-up, will ipso facto not be activities in the nature of Commercial Activities. However, if the amounts are significantly higher, they will be treated as receipts from Commercial Activities (iv) collection of fees, rates, etc. fixed by the statute under which the body is set up will not per se be characterised as ‘fee, cess or other consideration’ for engaging in activities in the nature of trade, commerce, etc. (v) whether statute governing the entity permits surplus or profits that can be earned and whether state has control over the corporation (vi) as long as statutory body furthers a GPU object, carrying on other activities in the nature of Commercial Activities that generate profits and the receipts from which are within the permissible limits as stated in the said Proviso to section 2(15), it will continue to be GPU category Charity.

7.3    Coming to the second category of assessees being statutory regulatory bodies/ authorities for which the sample case was of the Institute of Chartered Accountants of India (ICAI), the Court noted the relevant provisions of the Chartered Accountants Act, 1949 and held that ICAI is a Charity advancing GPU objects. In this context, the Court held as under [page 122]:

“…… As things stand, the Institute is the only body which prescribes the contents of professional education and entirely regulates the profession of Chartered Accountancy. There is no other body authorised to perform any other duties which it performs. It, therefore, clearly falls in the description of a charity advancing general public utility. Having regard to the previous discussion on the nature of charities and what constitutes activities in the ‘nature of trade, business or commerce’, the functions of the Institute ipso facto does not fall within the description of such ‘prohibited activities’. The fees charged by the Institute and the manner of its utilisation are entirely controlled by law. Furthermore, the material on record shows that the amounts received by it are not towards providing any commercial service or business but are essential for the providing of service to the society and the general public.”

7.3.1    The Court also noted that there are several other regulatory bodies that discharge functions otherwise within the domain of the State (including the one regulating professions of Cost and Work Accountants, Company Secretary, etc.). In this context, the Court further held as under [page 123]:
“…Therefore, it is held that bodies which regulate professions and are created by or under statutes which are enjoined to prescribe compulsory courses to be undergone before the individuals concerned is entitled to claim entry into the profession or vocation, and also continuously monitor the conduct of its members do not ipso facto carry on activities in the nature of trade, commerce or business, or services in relation thereto.”

7.3.1.1    The Court, however, added that if the consideration charged by regulatory entities such as annual fees, exam fees, etc. is ‘vastly or significantly higher’ than the costs incurred by the regulatory entity, the case would attract the said Proviso to section 2(15) of the Act. In this context, following observations of the Court are worth noting [page 123]:

“At the same time, this court would sound a note of caution. It is important, at times, while considering the nature of activities (which may be part of a statutory mandate) that regulatory bodies may perform, whether the kind of consideration charged is vastly or significantly higher than the costs it incurs. For instance, there can be in given situations, regulatory fees which may have to be paid annually, or the body may require candidates, or professionals to purchase and fill forms, for entry into the profession, or towards examinations. If the level of such fees or collection towards forms, brochures, or exams are significantly higher than the cost, such income would attract the mischief of proviso to Section 2(15), and would have to be within the limits prescribed by sub-clause (ii) of the proviso to Section 2(15).”

7.3.2    While deciding the matter of the Andhra Pradesh State Seeds Certification Authority and the Rajasthan State Seeds and Organic Production certification Agency [set-up under Seeds Act, 1966] also falling within the second category of assessees, the Court held that these entities tasked with the work of certification of seeds are performing regulatory function and do not engage in activities by way of trade, commerce or business, for some form of consideration.

7.4    With respect to the third category – trade promotion bodies, councils, associations or organisations, the Court at the outset stated that the predominant object test laid down in Surat Art’s case [ for this also refer to para 5.3.3 of Part II of this write-up] was in the context of section 2(15) applicable prior to the 2008 Amendment. In view of the 2008 Amendment, the Court held that the position had undergone a change and opined as follows [page 124]:

“In the opinion of this court, the change in definition in Section 2(15) and the negative phraseology – excluding from consideration, trusts or institutions which provide services in relation to trade, commerce or business, for fee or other consideration – has made a difference. Organizing meetings, disseminating information through publications, holding awareness camps and events, would be broadly covered by trade promotion. However, when a trade promotion body provides individualized or specialized services – such as conducting paid workshops, training courses, skill development courses certified by it, and hires venues which are then let out to industrial, trading or business organizations, to promote and advertise their respective businesses, the claim for GPU status needs to be scrutinised more closely. Such activities are in the nature of services “in relation to” trade, commerce or business. These activities, and the facility of consultation, or skill development courses, are meant to improve business activities, and make them more efficient. The receipts from such activities clearly are ‘fee or other consideration’ for providing service “in relation to” trade, commerce or business.”

7.4.1 After laying down the aforesaid ratio, coming to the facts of the assessee under this category – Apparel Export Promotion Council [AEPC], the Court held that its activities such as booking bulk space and renting it to individual Indian exporters, charging fees for skill development and diploma courses, market surveys and market intelligence aimed at catering to specified exporters involved an element of Commercial Activities. The Court then concluded as under [page 125]:

“In the circumstances, it cannot be said that AEPC’s functioning does not involve any element of trade, commerce or business, or service in relation thereto. Though in some instances, the recipient may be an individual business house or exporter, there is no doubt that these activities, performed by a trade body continue to be trade promotion. Therefore, they are in the “actual course of carrying on” the GPU activity. In such a case, for each year, the question would be whether the quantum from these receipts, and other such receipts are within the limit prescribed by the sub-clause (ii) to proviso to Section 2(15). If they are within the limits, AEPC would be – for that year, entitled to claim benefit as a GPU charity.”

7.5    The Court then proceeded to consider the cases of fourth category of assessees being non-statutory bodies. In respect of one such assessee – ERNET, the Court noted that it was a not-for profit society set up under the aegis of the Union Government with the objects of advancing computer communication in India, develop, design, set up and operate nationwide state of the art computer communication infrastructure, etc. After noting the activities of the assessee and also the fact that it’s project, funded through Government, support educational network and development of internet infrastructure in numerous other segments of the society, the Court felt that functions of ERNET are vital to the development of online educational and research platforms and held that its activities cannot be said to be in the nature of Commercial Activities. For this, the Court also noted that ERNET received fees to reimburse its costs and that the material on record did not suggest that its receipts were of such nature so as to be treated as fees or consideration towards business, trade or commerce.

7.5.1    In case of another assessee in this category – NIXI which was set-up under the aegis of Ministry of Information and Technology for production and growth of internet services in India, to regulate the internet traffic, act as an internet exchange, and undertake “.in” domain name registration. The Court also noted that NIXI is a not-for profit, and is barred from undertaking commercial and business activity and it charges annual membership fees of Rs. 1,000 and registration of second and third domain at Rs 500 and Rs. 250. Having regard to the findings on record and material available, an importance of country’s needs to have domestic internet exchange and other relevant facts, the Court rejected the Revenue’s contention that NIXI was involved in Commercial Activities.

7.5.2    GS1 India was another assessee in this category. GS1 codes were developed and created by GS1 international, Belgium which was not for profit under the Belgium Tax Laws. The coding system has been used worldwide and is even mandatory for some services/goods or adopted for significant advantages on account of its worldwide recognisation and acceptance. GS1 India is affiliated and was conferred exclusive rights relating to GS1 coding in India. The GS1 code provides a unique identification to a product with wide range of benefits such as facilitating tracking, tracing of the product, product recalls, detection of illegal trade, etc. The Revenue believed that GS1 India is a monopolistic organisation with an exclusive license in relation to bar coding technology which is admittedly used for fees or other consideration and it provides services mostly to business, trade, etc. On the other hand GS1 also claims that it performs important public function which enables not merely manufacturers but others involved in supplies of various articles by packaging, etc to regulate and ensure their identity.

7.5.2.1    Considering overall facts of GS1 India, the Court held that though GS1 undertakes activities in the nature of GPU, the services provided by it are in relation to trade, commerce or business. In this context, the Court opined as under [page 130]:

“In the opinion of this Court, GS1’s functions no doubt is of general public utility. However, equally the services it performs are to aid businesses manufactures, tradesmen and commercial establishments. Bar coding packaged articles and goods assists their consigners to identify them; helps manufactures, and marketing organizations (especially in the context of contemporary times, online platforms which serve as market places). The objective of GS1 is therefore, to provide service in relation to business, trade or commerce – for a fee or other consideration. It is also true, that the coding system it possesses and the facilities it provides, is capable of and perhaps is being used, by other sectors, in the welfare or public interest fields. However, in the absence of any figures, showing the contribution of GS1’s revenues from those segments, and whether it charges lower amounts, from such organizations, no inference can be drawn in that regard. The materials on record show that the coding services are used for commercial or business purposes. Having regard to these circumstances, the Court is of the opinion that the impugned judgment and order calls for interference.”

7.5.2.2    The Court also concluded that though GS1 India is involved in advancement of GPU, its services are for the benefit of trade and business, from which it receives significantly high receipts. Therefore, its claim for exemption was rejected in view of the amended provisions of section 2(15). However, with respect to claims to be made by GS1 in future, the Court observed that the same would have to be independently assessed if GS1 is able to show that it charges its customers on cost-basis or at a nominal markup.

7.6    In respect of state cricket associations falling within the fifth category, the Court firstly held that the claim of the associations will not fall within the ‘education’ limb in section 2(15) but will have to be examined under the last limb – GPU category. In this regard reference was made to the decision in Loka Shikshana Trust’s case [referred to in para 1.3.1 of Part I of this write-up] where it was held that ‘education’ would entail formal scholastic education. The Court then noted that the state associations apart from receiving amounts towards sale of entry tickets, also receive advertisement money, sponsorship fees, etc. from BCCI. The Court also noted the fact [in case of Gujarat as well as Saurashtra Cricket Associations] that the records reveal the large amount of receipts from such activities as against which the amount of expenditure is much lower leaving good amount of excess in the hands of such associations in the relevant year. The Court also observed that the activities of the cricket associations are run on business lines. It further noted that the expenses borne by the cricket associations did not disclose any significant proportion being expended towards sustained or organized coaching camps or academics. The Court also noted that broadcasting and digital media rights have yielded huge revenues to BCCI and the state associations are entitled to a share in the revenue of BCCI. The Court also noted the method adopted [auctioning such rights] by BCCI to obtain better terms, and gain bargaining leverage. The Court felt that these rights are apparently commercial.

7.6.1    Based on the above factual position, the Court directed the AO to decide the matter afresh and held as under [page 143]:

“In the light of these, the court is of the opinion that the Income-tax Appellate Tribunal – as well as the High Court fell into error in accepting at face value the submission that the amounts made over by BCCI to the cricket associations were in the nature of infrastructure subsidy. In each case, and for every year, the tax authorities are under an obligation to carefully examine and see the pattern of receipts and expenditure. Whilst doing so, the nature of rights conveyed by the BCCI to the successful bidders, in other words, the content of broadcast rights as well as the arrangement with respect to state associations (either in the form of master documents, resolutions or individual agreements with state associations) have to be examined. It goes without saying that there need not be an exact correlation or a proportionate division between the receipt and the actual expenditure. This is in line with the principle that what is an adequate consideration for something which is agreed upon by parties is a matter best left to them. These observations are not however, to be treated as final; the parties’ contentions in this regard are to be considered on their merit.”

7.7    In case of Tribune Trust, one of the assessees falling within the sixth category of private trust, the Court referred to the past litigation history of the assessee under the 1922 Act leading to the decision of Privy Council referred to in para 1.2.1 of Part I of this write-up and finding that the trust was established as Charity- GPU category and also noted the fact that the exemption was continuously allowed in this category under 1961 Act also including under section 10(23C)(iv) from assessment year 1984-85 onwards.

7.7.1    The Court then considered the facts of the case under appeal for the A.Y. 2009-10 in which the exemption was denied by the Revenue based on 2008 Amendment to section 2(15). The Punjab and Haryana High Court upheld the action of the Revenue by concluding that the income is derived by the Trust from the activities [publishing and sale of newspaper, etc.] which were based on profit motive. In doing so it had also noted that 85 per cent of the revenue of the Trust was from advertisements and interest.

7.7.1.1    Finally, the Court stated that though publication of advertisements is intrinsically linked with newspaper activity and is an activity in the course of actual carrying on of the activity towards advancement of the trust’s object, publishing advertisements is an activity in the nature of trade, commerce or business for a fee or consideration. The Court held that though the objects of the assessee trust fell within the GPU category, it would not be entitled to exemption under section 2(15) of the Act as the advertisement income received by the trust constituted business or commercial receipts and the same exceeded the limits laid down in the said Proviso to section 2(15).

7.7.2    The Court then considered the case of Shri Balaji Samaj Vikas Samiti, another assessee falling in the category of private trust wherein the assessee society was formed with the object of establishing and running a health club, arogya kendra; its object also included organization of emergency relief center, etc. Other objects included promotion of moral values, eradication of child labour, dowry, etc. The assessee had entered into arrangement with State agency to supply mid-day meals to students of primary schools in different villages through contracts entered into with some entity. Material for preparation of the mid-day meal was supplied by the Government and it was claimed that it only obtained nominal charges for mid-day meals. Registration application was rejected by the Revenue on the basis that it was involved in Commercial Activity. The Tribunal agreed with the assessee that the supply of mid-day meal did not constitute Commercial Activity and that it promoted object of GPU and directed grant of registration under section 12AA of the Act and this was affirmed by the Allahabad High Court. The Revenue had contended that assessee’s only activity for the relevant year was supply of mid-day meals which is not within its objects. The Supreme Court felt that there is no clarity with respect to whether the activity of supplying mid-day meal falls within the objects of the assessee and in the absence of this it is not possible for the Court to assess the activity in which the assessee was engaged to determine whether it falls in GPU category.

7.7.2.1    On the above facts the Court stated as under [page 147]:

“The first consideration would be whether the activity concerned was or is in any manner covered by the objects clause. Secondly, the revenue authorities should also consider the express terms of the contract or contracts entered into by the assessee with the State or its agencies. If on the basis of such contracts, the accounts disclose that the amounts paid are nominal mark-up over and above the cost incurred towards supplying the services, the activity may fall within the description of one advancing the general public utility. If on the other hand, there is a significant mark-up over the actual cost of service, the next step would be ascertain whether the quantitative limit in the proviso to section 2(15) is adhered to. It is only in the event of the trust actually carrying on an activity in the course of achieving one of its objects, and earning income which should not exceed the quantitative limit prescribed at the relevant time, that it can be said to be driven by charitable purpose.”

7.7.2.2    Despite the above, the Court ultimately decided not to interfere with the judgment of the High Court and held as under [page 147]:

“This court, in the normal circumstances, having regard to the above discussion, would have remitted the matter for consideration. However, it is apparent from the records that the tax effect is less than Rs.10 lakhs. It is apparent that the receipt from the activities in the present case did not exceed the quantitative limit of Rs.10 lakhs prescribed at the relevant time. In the circumstances, the impugned order of the High Court does not call for interference.”

8    After dealing with general interpretation of section 2(15) and cases of all the categories of assessees, the Court proceeded to give Summation of Conclusions which is worth noting.

8.1    In the context of general test to be applied under section 2(15), the Court broadly stated that the assessee pursuing object of GPU category should not engage in Commercial Activity as envisaged in the said Proviso to section 2(15). If it does so, then (i) such Commercial Activity should be connected [“actual carrying out…..” inserted w.e.f. 1st April, 2016 to the achievement of its GPU object; and (ii) receipts from such Commercial Activities should not exceed the quantitative limit provided from time to time[ currently, 20 per cent of the total receipts of the entity for the relevant previous year- w.e.f. 1st April, 2015]. Generally, charging of any amount for GPU activity, which is on cost-basis or nominally above the cost cannot be considered to be Commercial Activities as envisaged in the said Proviso. If such charges are markedly or significantly above the cost incurred by the assessee then the same would fall within the mischief of “cess, fees or any other consideration” towards the Commercial Activity. This position is clarified through illustrations [referred to in Para 5.5.2 of Part II of this write-up] by the Court which would also be relevant in this context. The Court has also summarised its conclusion on section 11(4A) of the Act and for all the six categories of assessees as well as on application of interpretation. Summation of Conclusions given by the Court deserves careful reading. However, due to space constraint and to avoid making this write-up further lengthy (which otherwise has already become lengthy extending to division in three parts, mainly on account of lengthy judgment dealing with six categories of assessees) the same is not reproduced here. The detailed Summation of Conclusions are available at pages 147 to 151 of the reported judgment which, as earlier mentioned , are worth reading to consider various implications arising out of the above judgment. In this context, useful reference may also be made to ‘Summation of Interpretation of section 2(15)’ appearing at pages 101 and 102 of the reported judgment.

CONCLUSION

9.1.1    In the context of Specific Objects category even if the said Proviso is not applicable, if Trust earns business profits it would be necessary to comply with the requirements of section 11(4A) to claim exemption under section 11. As such, the business should be incidental to the attainment of objective of the Trust [such as education, medical relief, etc]. The advantage in this category in respect of business profit could be that the limit of 20 per cent specified in the said Proviso would not be applicable. However, at the same time, it is advisable that the activity of education itself should not be carried on purely on commercial lines consistently yielding significant profit. In this context, the observations in the recent judgment of Madras High Court in the case of Mac Public Charitable Trust [(2023) 450 ITR 368] are worth noting. In this case, while dealing with the case of violation of the provisions of the Tamil Nadu Educational Institution [Protection of Collection of Capitation Fees Act, 1992 and cancellation of Registration under Income–tax Act, the High Court has elaborately discussed the concept of education with reference to various judgments and stated [page 462] that education can never be a commercial activity or a trade or a business and those in the field of education will have to constantly and consistently abide by this guiding principle. For this, the recent judgment of the Supreme Court [April, 2023] in the case of Baba Bandasingh Bahadur Education Trust [Civil Appeal No 10155 of 2013- for A.Y. 2006-07] delivered in the context of section 10(23C) (vi) should also be looked at.

9.1.2    In Specific Object category of education, the meaning of the term ‘education’ is equally relevant. The Supreme Court in LokaShikshana Trust’s case [(1975) 101 ITR 234] has given a narrower meaning of the term ‘education’ appearing in section 2(15) to say that it is process of training and developing the knowledge, skill, mind and character of students by formal schooling. As such, it means imparting formal scholastic learning in a systematic manner and the Supreme Court in its recent judgment in New Noble Education Society Trust’s case [448 ITR 592- considered in this column of BCAJ- January & February, 2023] has also followed this narrower meaning[refer para 5.5.1 of Part II of write-up on that case- BCAJ February,2023]. This meaning is also considered by the Court in AUDA’s case [at page 139- para 225] and that should be borne in mind. This should be equally applicable to the term education appearing in the definition of charitable purpose under section 2(15). For this useful reference may also be made to recent decision of Ahmedabad bench of Tribunal in the case of Gujarat Council of Science Society [ITA No 2405/AHD/2017, ITA No 260/AHD/2018 and ITA No 306/AHD/2019] vide order dtd 20/3/2023 for A.Ys 2013-14 to 2015-16. In this case, the Tribunal also took a view that prospective applicability of the judgment in New Noble’s case is only confined to cases involving the interpretation of the term “solely” and did not find any inconsistency with the same for the meaning /definition /scope of the term “education” as used in section 2(15). It may also be noted that the Bombay High Court in Laura Entwistle and Ors’s case- The Trustees of American School Bombay Education Trust [ TS- 102-HC-2023(Bom)] and the Orissa High Court in Sikhya ‘O’ Anu Sandhan’s case [TS- 04-HC-2023(Ori)] have taken a view that the judgment of the Supreme Court in New Noble’s case should operate prospectively and cannot be applied to earlier period. Of course, the issue of distinction drawn by the Ahmedabad Tribunal was not before the High Courts in these cases.

9.1.3    It is also possible that the Trust pursuing only the object of specific category, say education, may also carry out some incidental activities perceiving the same to be part of education or incidental to the imparting education. In such cases, on facts, a possibility of Revenue treating such other activity as GPU category and invoking the said Proviso can’t be ruled out. If ultimately the Revenue succeeds on this, the risk of losing total exemption under section 11 for that year remains by virtue of the provisions of section 13(8). Therefore, such Trusts will have to be cautious in this respect. Furthermore, if GPU category object is not part of its objects, some further issues may also need consideration [also refer to para 7.7.2.1 above].

9.2    In view of the ratio laid down by the Court in AUDA’s case, the meaning of `charitable purpose’ as applicable post 2008 Amendment in section 2(15) is now settled. In this regard, as stated in para 5.3.3 Part II of this write-up, the predominant object test laid down by the Supreme Court in Surat Art’s case no longer holds good post the 2008 Amendment. Likewise, `ploughing back’ of business income to `feed’ the charity is also not relevant. In this context, the expressions cess, fees, etc. [consideration] should be given purposive interpretation and accordingly, the same should be understood differently for various categories of assessees such as statutory bodies, regulatory authorities, non-statutory bodies, etc. [referred to in para 5.3.2 of Part II of this write-up]. Therefore, the Trust having GPU object will not satisfy the definition of ‘charitable purpose’ in section 2(15) in cases where such Trust carries on any activity in the nature of trade, commerce or business or any activity of rendering any service in relation thereto for consideration [i.e. Commercial Activity] even though its ‘predominant object’ is charitable in nature and even if business income from such activity is utilised to feed the charity. What is now relevant is the fact of undertaking Commercial Activity during the relevant year. However, in such an event, the Trust should ensure that it complies with the twin requirements[ w.e.f. 1st April, 2016 onwards] of relaxations provided [for earlier period also refer para 1.6 of Part I of this write-up] in the said Proviso so as to satisfy the definition of ‘charitable purpose’, namely, (i) the Commercial Activity should be undertaken in the course of actual carrying out of the GPU object [Qualitative Condition]; and (ii) the aggregate receipts from such activity do not exceed 20 per cent of the total receipts of the Trust of that previous year [Quantitative Condition]. In such cases, the Trust also needs to comply with the provisions of section 11(4A).

9.2.1    For the purpose of determining whether the Trust is carrying on any Commercial Activity, the Court has placed significant emphasis on the amount of consideration charged and has stated that generally if, the consideration charged is significantly more than the cost incurred by such Trust, that would fall in the category of consideration towards Commercial Activity and where the consideration charged is at cost or nominal mark-up on the cost incurred by the Trust it should not be regarded as towards Commercial Activity. This is the under lying broad principle for this purpose and this should be borne in mind in every case. At the same time, the fact of determination of mark-up charged is either nominal or significant is left open without any further guidance and this being highly subjective, may lead to litigation. Likewise, the Court has also not dealt with [perhaps rightly so] the meaning of ‘cost’ for this purpose and therefore, in our view, the same should be determined on the basis of generally accepted principles of commercial accounting.

9.2.2    For the above purpose, various explanatory illustrations given by the Court in the above case [referred to in para 5.5.2 of part II of this write-up] are relevant.

9.2.3    For all practical purposes, as a general rule, it is advisable to also maintain separate books of account in respect of each incidental activity carried on by the Trust pursuing any category of object [i.e. Specific, GPU or both] to meet with, wherever needed, the requirement of section 11(4A) so as to avoid possibility of any litigation on non-compliance of requirement of maintaining separate books of account contained in section 11(4A), whenever the same becomes applicable.

9.3    In view of the narrow interpretation of the term `incidental [used in provisions of section 11(4A)] made by the Court [referred to in para 5.4.3 Part II of this write-up] to claim exemption for profits of the incidental business, it would be necessary that the business activity should be conducted in the course of achieving GPU object to be regarded as incidental business activity and of course, the requirement of maintaining a separate books of account for the same also should be met to claim exemption under section 11. Interestingly, for this purpose, the Court has relied on 2008 Amendment with subsequent amendments and also stated that introduction of clause (i) in the said Proviso by amendment of 2016 is clarificatory. In this context, it is worth noting that the Supreme Court in Thanthi Trust’s case [referred to in para 1.4.2 of Part I of this write-up] while dealing with section 11(4A) has taken a view [post-1992 amendment] that business whose income is utilised by the Trust for achieving its charitable objects is surely a business which is incidental to the attainment of its objectives. The Court in AUDA’s case has distinguished this case on the ground [referred to in para 5.4.2 of Part II of this write-up] that in that case, the Court was dealing with a case of Specific Object category [education] and not GPU category object and the ratio of that case cannot be extended to cases where the Trust carries on business which is not held under trust and whose income is utilised to feed the charitable object. It is difficult to appreciate this distinction and both the judgments being of equal bench [three judges], some litigation questioning this view cannot be ruled out.

9.3.1    In the context of distinction between the provisions of section 11(4) and 11(4A), from the observations of the Court [referred to in para 5.4.1 of part II of this write-up], one may be inclined to take a view that if the business is held under trust, then the case of the assessee will fall only under section 11(4) and section 11(4A) would apply only to cases where business is not held under trust. The Court also noted that there is also difference between business held under trust and the business carried on by or on behalf of the trust. Normally, the business undertaking will be considered as held under the trust where it is settled by the donor or trust creator in the trustees. Referring to the test applied in J.K. Trust’s case [referred to in para 5.4.1 of part II of this write-up], the Court also noted that for a business to be considered as property held under trust, it should have been either acquired with the help of funds originally settled or the original fund settled upon the trust must have proximate connection with the later acquisition of the business. We may also mention that similar view is also expressed in the judgment [authored by justice R. V. Easwar] of Delhi High Court [by a bench headed by justice S. Ravindra Bhat- who has now authored the judgment in AUDA’s case] in the case of Mehta Charitable Prajnalay Trust [(2013) 357 ITR 560,572] in which Thanthi Trust’s case judgment has also been considered. It may be noted that observations of the Court [referred to in para 5.4.1] appear to be summarising the position noticed by the Court after referring to earlier judgments and may not necessarily seem to be expressing its view on such legal position. In this context, the judgment of the Supreme Court in Thanthi Trust’s case [referred to para 1.4.2 of Part I of this write-up] is worth noting wherein also business was held under trust and the Court has applied the provisions of section 11(4A).

9.4    Article 289(1) of the Constitution of India exempts property and income of a State from Union taxation. However, Article 289(2) of the Constitution permits the Union to levy taxes inter alia in respect of a trade or business of any kind carried on by, or on behalf of a State Government or any income accruing or arising in connection therewith. In view of this, judgment in AUDA’s case has held that every income of state entity is not per se exempt from tax. State controlled entities will have to evaluate whether the functions performed by them are actuated by profit motive or whether the same are in the nature of essential service provided in larger public interest. In this regard, the Court has laid down certain tests [referred to in para 7.2.3 above]. As clarified by the Court [refer para 5.3.3 of Part II of this write-up], statutory fees or amounts collected by state entities as provided in the enactments under which they have been set up will not be treated as business or commercial in nature. The same view emerges in respect of fees/cess etc. collected in terms of enacted law [by state or center] on amount collected in furtherance of activities such as education, regulation of profession etc. by regulatory authority/body.

9.5    The Revenue had filed a miscellaneous application before the Supreme Court seeking clarifications in the aforesaid decision of AUDA so as to enable it to redo the assessments in accordance with the Court’s judgment for the past and examine the eligibility on a yearly basis for the future. The Court in its order dated 3rd November, 2022 ([2022] 449 ITR 389 (SC)) disposed of the application and held that the appeals decided against the Revenue were to be treated as final. With respect to the applicability of the judgment to other years, the Court stated that the concerned authorities would apply the law declared in its judgment having regard to the facts of each such assessment year.

9.6     In view of the above judgment of the Court in AUDA’s case, the popular understanding that beneficial circular issued by the CBDT under section 119 are binding on the Revenue authorities in all cases has again come-up for questioning. In this case, the Court has opined [as stated in para 5.3 of Part II of this write-up] that such circulars are binding on the Revenue authorities if they advance a proposition within the framework of the statutory provision. However, if they are contrary to the plain words of a statute, they are not binding. Furthermore, the Court has also stated that such circulars are also not binding on the courts and the courts will have to decide the issue based on its interpretation of a relevant statute. As such, the debate will again start as to the binding effect of such circulars which are considered by the assessing officers as contrary to the plain words of the statue. It is unfortunate that on this issue, the debate keeps on resurfacing at some intervals and something needs to be positively done in this regard to finally settle the position on this issue to provide certainty.

9.7    Clause (46A) is inserted in section 10 by the Finance Act, 2023 to exempt any income arising to a body or authority or Board or Trust or Commission, not being a company, which has been established or constituted by or under a Central or State Act with one or more of purposes specified therein and is notified by the Central Government in the Official Gazette. The following purposes are specified in the said clause (i) dealing with and satisfying the need for housing accommodation; (ii) planning, development or improvement of cities, towns and villages; (iii) regulating, or regulating and developing, any activity for the benefit of the general public; or (iv) regulating any matter, for the benefit of the general public, arising out of the object for which the entity has been created. Therefore, statutory authorities /bodies, etc. can get themselves notified under this provision to avoid the potential litigation for claiming exemption under section 11 and in such cases, the above judgment in AUDA’s case will not be relevant.

9.8    Unlike the judgment of the Supreme Court in New Noble Education Society’s case [(2022) 448 ITR 598 – considered in this column in BCAJ January and February, 2023], the Court has not stated that the judgment in AUDA’s case will apply prospectively. Therefore, as per the settled position, this decision will act retrospectively and accordingly, will apply to all past cases also post 2008 Amendment. As such, post the above judgment in AUDA’s case, various benches of the Tribunal and Courts have started considering this judgment for deciding matters coming before them. Some of such cases are briefly noted herein.

9.8.1    The Supreme Court in Servants of People Society’s case [(2022) 145 taxmann.com 234 /(2023) 290 Taxman 127] vide order dated 21st October, 2022 summarily disposed of the SLP filed by the Revenue challenging the decision of the Delhi High Court [(2022) 145 taxmann.com 145] in terms of its decision in AUDA’s case by observing that the matter is fully covered by that judgment. In this case, it is worth noting that the assessee-society ran schools, medical centers and also a printing press and published a newspaper. The profits so generated were used for charitable purposes and, apparently, the activities of the assessee were not for profit motive. The Delhi High Court [seems to be for A.Ys 2010-11, 2012-13 to 2014-15] had held that the assessee was not involved in any trade, commerce or business and, therefore, the mischief of said Proviso to section 2(15) of the Act was not attracted. Interestingly, while dealing with the appeal of the Revenue in the case of the same assessee for a different assessment year [seems to be for A.Y. 2011-12 as mentioned in the High Court judgment reported in [(2022) 447 ITR 99], the Supreme Court in order dated 31st January, 2023 [(2023) 452 ITR 1-SC] noted that the Society was running schools, medical center, old age home etc. as well as printing press for publishing newspaper and further noted that the assessee society claimed exemption in respect of income from newspapers which included advertisement revenue of Rs. 9,52,57,869 and surplus of Rs.2,16,50,901. After noting these facts, the Court held that the law regarding interpretation of section 2(15) of the Act had undergone a change due to the decision in AUDA’s case for which the Court referred to its conclusion in AUDA’s case in relation to Tribune Trust’s case [referred to in para 7.7 above] and noted that in that case it was held that while advertisement is intrinsically linked with the newspaper activity which satisfies the requirement of carrying out such activity in the course of actually carrying on the activity towards advancement of object [referred to in clause (i) of the said Proviso– Qualitative Condition]but the condition of quantitative limit imposed in clause (ii) of the said Proviso has also be fulfilled. Accordingly, the Court remitted the matter to the AO for fresh consideration of the nature of receipts in the hands of the assessee and to re-examine as to whether the amounts received by the assessee qualify for exemption under section 11.

9.8.2    The Gujarat High Court in the case of GIDC [(2023) 442ITR 27] has followed the above judgment in AUDA’s case and confirm the view of the Tribunal granting the exemption to the assessee for A.Y. 2015-16. For this, the High Court has relied on the view taken by the Supreme Court in AUDA’s case[ being the first category of assessee therein] as well as on the general interpretation of the definition of ‘charitable purpose’ under section 2(15) post 2008 Amendment.

9.8.3    The Mumbai bench of Tribunal in case of The Gem & Jewellery Export Promotion Council [ITA Nos. 752/MUM/2017, 989/MUM/2019 and 2250/MUM/2019- Assessment Years 2012-13 to 2014-15] had an occasion to consider the assessee’s claim for exemption under section 11 which was denied by the AO by treating the activity of conducting exhibitions on a large scale [international as well as domestic] as Commercial Activities under the said Proviso and that was also upheld by the CIT(A).After elaborate discussion and considering the judgment of the Court in AUDA’s case[ including in relation to AEPC’s case referred to in paras 7.4 & 7.4.1 above], the Tribunal noted that the assessee had incurred a net loss from this activity of exhibitions conducted within and outside India in each year as revealed by the records. Factually, the assessee has charged consideration for conducting exhibitions/trade fairs slightly below the cost. As such, there being no mark-up on consideration charged from the exporters, in the broad principles laid down by the Court in AUDA’s case, this activity is beyond the preview of Commercial Activity as envisaged in the said Proviso and the assessee is entitled to claim exemption under GPU category objects.

9.8.3    In some cases, the Tribunal has decided the issue against the assessee following the law laid down in the above judgment in AUDA’s case such as : (i) Fernandez Foundation’s case[(2023) 199 ITD 37 – Hyd] wherein the assessee’s application for registration under section 12AA was rejected, inter alia, on the ground that the assessee was involved in activities which were in the nature of trade and provided medical facilities at market rates and, in fact, the amount charged by the assessee was far more than the amount charged by other diagnostics centers/hospitals for similar tests/ diagnostic/ treatment. The Tribunal upheld the order of CIT(E) and stated that assessee neither provided services at reasonable rate nor utilised its surplus for helping medical aid/facilities to the poor/needy persons at free of cost. Treatments were provided only to limited patients at a concessional rate which was a meagre portion of its total revenue earned. ITAT also referred to the decision of the Supreme Court in AUDA’s case and the observations made therein examining the issue of profit generated by charities engaged in GPU objects and observed that the CIT(E) was correct in holding that the assessee was charging on the basis of commercial rates from the patients and had failed to demonstrate that the charges/fee charged by it were on a reasonable markup on the cost; (ii) In Maharaja Shivchatrapati Pratishsthan’s case [(2023) 199 ITD 607], the Pune Bench of Tribunal rejected the claim of exemption under section 11 for A.Y. 2013-14 following AUDA’s case and stated that crux of the interpretation of the said Proviso to section 2(15) is to first examine the receipts of the assessee from pursuing GPU category object are on cost-to-cost basis or having a nominal profit on one hand or having a significant mark-up on cost on the other hand and the latter cases are a business activity but the former is non-business activity. Noting the fact on record that in this case the revenue from performing drama for various institutes/companies was Rs 1.96 crores and the cost for such performance was only Rs. 1.16 crores, the Tribunal took the view that profit elements in drama performance is more than 40 per cent of the gross receipts and that patently falls in the category ‘significant mark-up cases’ and hence business activity. Considering the significant margin on performing drama uniformly, the Tribunal took the view that this activity is in nature of business activity and ceases to fall within the domain of ‘chartable purpose’ as the business receipts exceeds 20 per cent of total receipts. The Tribunal also took the view that the contention of the assessee that the review petition has been filed in AUDA’s case is not relevant as that does not alter in any manner binding force of the judgment in terms of Article 141 of the Constitution of India.

9.9    As mentioned in para 7.1 above, the Court had divided the appeals before it into six categories of assessees and the Court has dealt and decided each category of assessee’s case [ as referred to in para 7.2 to 7.7.2.2 above] and also given summation of conclusions [as mentioned in para 8 above].In this concluding part of the write-up, we have only briefly dealt with the major general principles emerging from the judgment in AUDA’s case as mainly applicable to GPU categories of cases and not separately dealt with the Court’s conclusion of each category of assessees for the same reasons as stated in para 8.1 above. In all these cases, the decision of the Court is applicable for the assessment years in appeals and other year cases will have to be decided on yearly basis considering the facts in relevant year based on the law laid down by the Court in the above case.

9.10    If the exemption under section 11 is lost by the Trust in a given year on account of applicability of the said Proviso, then its taxable income now will have to be computed in accordance with the provision of section 13(10) read with section 13(11) introduced by the Finance Act, 2022 [w.e.f. 1st April, 2023] which, to an extent, brings certainly on this and give some comfort for determining tax liability. Furthermore, in our view, merely because the exemption is lost in a given year in such cases, the Registration granted to the Trust does not become liable to be cancelled.

9.11    At the time of 2008 Amendment, the possibility of an adverse view in many cases was perceived by many tax professionals as well as by some senior counsel and some trusts while claiming exemption under section 11, also started paying advance tax out of abundant caution. As such, the possibility of adverse judgment from the Supreme Court based on the clear language of the said Proviso was not ruled out. However, in this context, the judgment in the AUDA’s case seems to have gone far beyond the perception formed at that time. As such, the judgment, on an overall basis, is likely to create unending uncertainty and in large number of cases, possibly, give rise to long-drawn litigations. It was expected when this judgment was pronounced that the Government will make appropriate amendment in the said Proviso to make the law fair and reasonably workable but unfortunately, in the Finance Act, 2023 this has not been done except insertion of section 10(46A) [referred to in para 9.7 above] for the benefit of statutory authorities, etc. In the recent past, more so with the recent amendments in past few years, the feeling has started developing amongst those who are sparing time and resources for bonafide philanthropic purposes that the Charitable Trusts are, perhaps, treated in the most uncharitable manner in this respect and this is not a good sign for the nation. May be, in some cases, the Revenue may have noticed abuse of the exemption provisions. But the larger question is: is it fair to punish the entire community of charity by making such provision?

9.1 As mentioned in para 1.2 of Part I of this write-up (BCAJ May, 2022), the said Explanation to section 37(1) provides for disallowance of certain expenses. These are popularly known as illegal/prohibited expenses. As further mentioned in para 1.3 of Part I of this write-up, the MCI Regulations prohibit medical practitioners from aiding, abetting or committing any unethical acts specified in Clause 6 which, inter-alia, include receiving any gift, gratuity, commission etc. for referring, recommending or procuring of any patient for any treatment. The scope of this prohibition was expanded on 14th December, 2009 by inserting Clause 6.8 which, in substance, provided further restrictions prohibiting medical practitioners from accepting from any Pharmaceutical or Allied Health Care Industry (hereinafter referred to as Pharma Companies) any emoluments in the form of travel facility for vacation or for attending conferences/seminars, certain hospitality etc. (popularly known as freebies) referred to in para 1.4 of Part I of this write-up. The CBDT issued a Circular dated 1st August, 2012, clarifying that expenses incurred by Pharma Companies for distribution of freebies to medical practitioners violate the provisions of MCI Regulations and should be disallowed under the said Explanation to Section 37(1). The validity of this Circular was upheld by the Himachal Pradesh High Court (Confederation of Indian Pharma Industry’s case), as mentioned in para 4 of Part I of this write-up. As discussed in Part I of this write-up, Punjab & Haryana High Court (KAP Scan’s case) and Madras High Court (Apex Laboratory’s case) had upheld the disallowance of such expenses. The Mumbai bench of the Tribunal (PHL Pharma’s case – discussed in para 6 of Part I of this write-up) had taken a view that the MCI Regulations are not applicable to Pharma Companies, and based on that decided the issue in the favour of the assessee after considering the judgments of Punjab & Haryana High Court as well as Himachal Pradesh High Court. For this, the Tribunal also relied on the decision of Delhi High Court (Max Hospital’s case referred to in para 5 of Part I of this write-up) in which the MCI had filed an affidavit that it has no jurisdiction to pass any order against the Hospital and its jurisdiction is only confined to medical practitioners. Subsequently, the correctness of this decision of the Tribunal was doubted by one bench of Mumbai Tribunal (Macleod’s case), and it had recommended the constitution of a larger bench to decide the issue, as mentioned in para 7 of Part I of this write-up.

9.2 As discussed in para 8 of Part-I of this write-up, the Madras High Court in Apex Laboratories (P) Ltd. vs. DCIT LTU (Tax Case Appeal no. 723 of 2018) upheld the order of the Income-tax Appellate Tribunal (Tribunal) which had disallowed the assessee’s claim for deduction for A.Y. 2010-11 with regard to expenditure incurred for giving gifts/ freebies to doctors holding that such expenditure resulted in violation of the MCI Regulations and was hit by the said Explanation to section 37(1) of the Income-tax Act 1961 (‘the Act’).

APEX LABORATORIES (P) LTD. VS. DCIT LTU (2022) 442 ITR 1 (SC)

10.1 The correctness of the above referred Madras High Court judgment came up for decision before the Supreme Court at the instance of the assessee.

10.2 Before the Supreme Court, the assessee submitted that the MCI Regulations were enforceable only against the medical practitioners and prohibited doctors from accepting freebies. However, the MCI Regulations did not bind the pharmaceutical companies, nor did it expressly prohibit the pharmaceutical companies from giving freebies to doctors. The assessee, in this regard, placed reliance on the decision of the Delhi High Court in Max Hospital’s case and Rajasthan High Court in Dr. Anil Gupta vs. Addl. CIT [IT Appeal No. 485 of 2008] and submitted that as these decisions were accepted and were not further challenged in appeal, it was not open to re-consider the present issue in the assessee’s case.

10.2.1 The assessee also placed reliance on the Supreme Court decision in the case of Dr. T.A. Quereshi vs. CIT [(2006) 287 ITR 547] and on the Madhya Pradesh High Court decision in CIT vs. Khemchand Motilal Jain Tobacco Products (P) Ltd. [(2012) 340 ITR 99] to urge that the Revenue could not deny a tax benefit because of the ‘nature’ of expenditure. It was further submitted that the Memorandum explaining the provisions of the Finance (No. 2) Bill, 1998 and CBDT Circular No. 772 dated 23rd December, 1998 stated that the said Explanation to section 37(1) was introduced to disallow taxpayers from claiming “protection money, extortion, hafta, bribes, etc.” as business expenditure which showed that the intention of the Parliament was to bring only the ‘illegal’ activities which were treated as an ‘offence’ under the relevant statutes within the ambit of the said Explanation. It was submitted that as the Income-tax Act was not a social reform statute, it ought to be strictly interpreted more so when the act of giving gifts by a pharmaceutical company was not treated as ‘illegal’ by any statute.

10.2.2 The assessee also submitted that the CBDT circular No. 5/2012 dated 1st August, 2012 clarifying that any expense incurred by Pharma Companies for distribution of freebies to medical practitioners in violation of the provisions of MCI Regulations shall not be allowed as deduction u/s 37(1) of the Act; enlarged the scope of the MCI Regulations which was beyond its scope. In any case, it was urged that the CBDT circular could apply only ‘prospectively’ from the date of its publication on 1st August, 2012 and not ‘retrospectively’ from the date of publication of the MCI Regulations on 14th December, 2009.

10.3 On the other hand, the Revenue argued that the act of giving gifts by Pharma Companies to doctors was ‘prohibited by law’ being specifically covered by the MCI Regulations even though the same may not be classified as an ‘offence’ under any statute. Accordingly, the same would fall within the scope of the said Explanation to section 37(1). Revenue further submitted that the intention of the Legislature was to disincentivize the practice of giving gifts and freebies in exchange of doctors’ prescribing expensive branded medication as against generic ones, thereby burdening patients with unnecessary cost. Such an act of accepting gifts in lieu of prescribing a pharmaceutical companies’ medicine clearly amounted to professional misconduct on the doctors’ part and also had a direct bearing on public policy.

10.3.1 The Revenue further contended that in the present case, the medical practitioners were provided expensive gifts such as hospitality, conference fees, gold coins, LCD TVs, fridges, laptops etc. to promote its product which clearly constituted professional misconduct. It was also contended that scope of MCI Regulations was not limited to a finite list of instances of professional misconduct but was broad enough to cover those instances not specifically enumerated as well.

10.3.2 The Revenue also placed reliance on the Punjab & Haryana High Court’s decision in the case of Kap Scan & Diagnostic Centre (P) Ltd. [(2012) 344 ITR 476] and the decision of the Himachal Pradesh High Court in Confederation of Indian Pharmaceutical Industry [(2013) 353 ITR 388].

10.4 After considering the rival contentions, the Supreme Court proceeded to decide the issue. The Court first referred to the provisions contained in the said Explanation to section 37(1) dealing with disallowance of illegal/prohibited expenses and stated that it restricts the allowance of deduction in respect of any expenditure for ‘any purpose which is an offence or which is prohibited by law’. The Court also dealt with the meaning of the words ‘offence’ as well as ‘prohibited by law’ and stated as under [Pg. 16]:

“…It is therefore clear that Explanation 1 contains within its ambit all such activities which are illegal/prohibited by law and/or punishable”

10.4.1    The Court also referred to the provisions contained in MCI Regulations Clause 6.8 as well as the fact that the MCI Regulations also provide the corresponding punishment for violation thereof by medical practitioners and noted that acceptance of freebies given by Pharma Companies was clearly an offence on the part of the medical practitioner which was punishable in accordance with the provisions of the MCI Regulations.

10.4.2 While referring to the view taken by the Tribunal in P.H.L. Pharma’s case that the MCI Regulations were inapplicable to Pharma Companies and the assessee’s contention that the scope of the said Explanation was restricted only to ‘protection money, extortion, hafta, bribes etc.’, the Court opined as under [Pg.19]:

“This Court is of the opinion that such a narrow interpretation of Expln. 1 to s.37(1) defeats the purpose for which it was inserted, i.e., to disallow an assessee from claiming a tax benefit for its participation in an illegal activity. Though the Memorandum to the Finance Bill, 1998 elucidated the ambit of Expln. 1 to include “protection money, extortion, Hafta, bribes, etc.”, yet, ipso facto, by no means is the embargo envisaged restricted to those examples. It is but logical that when acceptance of freebies is punishable by the MCI (the range of penalties and sanction extending to ban imposed on the medical practitioner), pharmaceutical companies cannot be granted the tax benefit for providing such freebies, and thereby (actively and with full knowledge) enabling the commission of the act which attracts such opprobrium.”

10.4.3 In the context of contention of the non-applicability of MCI Regulations to Pharma Companies and deductibility of such expenses (i.e. freebies etc.) in their assessments, the Court also referred to the judgment of the constitution bench in the case of P.V. Narasimha Rao [(1998) 4 SCC 626] delivered in the context of the Prevention of Corruption Act (P.C.Act), where the contention was rejected that P.C. Act only punished (prior to the 2018 amendment) the bribe-taker who was a public servant, and not the bribe-giver. In this regard, the Court held as under [Pg.21]:

“Even if Apex’s contention were to be accepted – that it did not indulge in any illegal activity by committing an offence, as there was no corresponding penal provision in the 2002 Regulations applicable to it – there is no doubt that its actions fell within the purview of “prohibited by law” in Explanation 1 to Section37(1).

Furthermore, if the statutory limitations imposed by the 2002 Regulations are kept in mind, Explanation (1) to Section 37(1) of the IT Act and the insertion of Section 20A of the Medical Council Act, 1956 (which serves as parent provision for the regulations), what is discernible is that the statutory regime requiring that a thing be done in a certain manner, also implies (even in the absence of any express terms), that the other forms of doing it are impermissible.”

10.4.4 Considering the expected approach of the Courts in the matters involving issues relating to immoral or illegal acts, the Court observed as under [Pgs. 22/23]:

“It is also a settled principle of law that no Court will lend its aid to a party that roots its cause of action in an immoral or illegal act (ex dolomalo non oritur action) meaning that none should be allowed to profit from any wrongdoing coupled with the fact that statutory regimes should be coherent and not self-defeating. Doctors and pharmacists being complementary and supplementary to each other in the medical profession, a comprehensive view must be adopted to regulate their conduct in view of the contemporary statutory regimes and regulations. Therefore, denial of the tax benefit cannot be construed as penalizing the assessee pharmaceutical company. Only its participation in what is plainly an action prohibited by law, precludes the assessee from claiming it as a deductible expenditure.”

10.4.5     Considering the relationship between medical practitioners and their patients and, in that context, explaining the effects of distributing such freebies to the medical practitioners on society in general, the Court observed as under [Pg. 23]:

“This Court also notices that medical practitioners have a quasi-fiduciary relationship with their patients. A doctor’s prescription is considered the final word on the medication to be availed by the patient, even if the cost of such medication is unaffordable or barely within the economic reach of the patient – such is the level of trust reposed in doctors. Therefore, it is a matter of great public importance and concern, when it is demonstrated that a doctor’s prescription can be manipulated, and driven by the motive to avail the freebies offered to them by pharmaceutical companies, ranging from gifts such as gold coins, fridges and LCD TVs to funding international trips for vacations or to attend medical conferences. These freebies are technically not ‘free’ – the cost of supplying such freebies is usually factored into the drug, driving prices up, thus creating a perpetual publicly injurious cycle…….”

10.4.6 In the above context, the Court also noted that the threat of prescribing medication that is significantly marked-up, over effective generic counterparts in lieu of such a quid pro quo exchange was also taken cognizance of by the Parliamentary Standing Committee on Health and Family Welfare as well as other studies in this regard. In this regard, the Court further stated that the High Court decisions in the case of Kap Scan & Diagnostic Centre (P) Ltd. and Confederation of Indian Pharmaceutical Industry (supra) had correctly referred to the importance of public policy while deciding the issue before it.

10.4.7 The Court also held that agreement between the pharmaceutical companies and the medical practitioners in gifting freebies for boosting sales of prescription drugs was violative of section 23 of the Contract Act, 1872, which provides that the consideration or object of an agreement shall be unlawful if the Court regards it as immoral or opposed to public policy, in which event, the agreement shall be treated as void.

10.4.8 With respect to the date of applicability of the CBDT Circular No. 5/2012, the Court stated that as the Circular was clarificatory in nature, the same would take effect from the date of implementation of the MCI Regulations i.e. 14th December, 2009.

10.4.9 The Court distinguished the decisions relied upon by the assessee. With respect to Dr. T.A. Quereshi’s decision, the Court stated that the same dealt with a case of business ‘loss’ and not business ‘expenditure’. Khemchand Motilal Jain Tobacco Products (P) Ltd.’s decision was distinguished as the assessee in that case was not a willful participant in the commission of an offence or activity prohibited by law whereas Pharma Companies misused a legislative gap to actively perpetuate the commission of an offence.

10.4.10  The Supreme Court also rejected the assessee’s plea that the taxing statutes had to be construed strictly and observed as under [Pg. 28]:

“Thus, pharmaceutical companies’ gifting freebies to doctors, etc. is clearly “prohibited by law”, and not allowed to be claimed as a deduction under s. 37(1). Doing so would wholly undermine public policy. The well-established principle of interpretation of taxing statutes that they need to be interpreted strictly cannot sustain when it results in an absurdity contrary to the intentions of the Parliament…..”

10.4.11     While dismissing the appeal of the assessee, and deciding the issue in favour of the Revenue, the Court finally concluded as under [Pgs. 30 & 31]:

“ In the present case too, the incentives (or “freebies”) given by Apex, to the doctors, had a direct result of exposing the recipients to the odium of sanctions, leading to a ban on their practice of medicine. Those sanctions are mandated by law, as they are embodied in the code of conduct and ethics, which are normative, and have a legally binding effect. The conceded participation of the assessee – i.e., the provider or donor- was plainly prohibited, as far as their receipt by the medical practitioners was concerned. That medical practitioners were forbidden from accepting such gifts, or “freebies” was no less a prohibition on the part of their giver, or donor, i.e., Apex.”

CONCLUSION

11.1 In view of the above judgment of the Supreme Court, the issue now stands fairly settled that any expenditure incurred by a Pharma Company for giving gifts/ freebies to medical practitioners in violation of MCI Regulations falls within the ambit of the said Explanation, and will not be allowed as deduction u/s 37 of the Act. Further, such claim of expenditure will be disallowed from the date of publication of the MCI Regulations i.e. 14th December, 2009 and that the CBDT Circular dated 1st August, 2012 is merely clarificatory and would also take effect from 14th December, 2009. In view of this, the view taken by the Tribunal in many cases that this Circular will apply prospectively and approved by the Bombay High Court in Goldline Pharmaceutical’s case [(2022)441 ITR 543] would no longer hold good. In light of the Supreme Court decision, the reference to Special bench by the Tribunal in the case of Macleods Pharmaceutical’s case (supra) will be rendered infructuous.

11.2 The above judgment in Apex Laboratories’ case was followed by the Calcutta High Court in the case of Peerless Hospitex Hospital and Research Center Ltd. vs. Pr. CIT [(2022) 137 taxmann.com 359 (Calcutta)]. In this case, the assessee was engaged in the business of running a multi-speciality hospital. It had claimed deduction in respect of fee paid to doctors for referring patients to the assessee’s hospital which was allowed during the course of original assessment proceedings. The Assessing Officer issued a notice u/s 148 of the Act, after 4 years [A.Ys. 2011-12 & 2012-13] seeking to disallow the said expenditure on the basis that the expense was prohibited by law and was therefore disallowable as per Explanation 1 to section 37(1). Following the above judgment of the Supreme Court and after giving detailed reasonings, the High Court held that such expenses are not deductible. The High Court also noted that no such provisions restricting Pharma Companies is made in the law and expressed a wish that the Central and State governments take note of this legislative gap and make appropriate law to penalize them also for participating in such activities. Finally, the High Court, on the facts of the case of the assessee, also took the view that re-opening on the same material is a mere change of opinion and quashed the notices issued u/s 148 as conditions for issuance of such notices were not met in this case.

11.3 While upholding the disallowance of expenditure on such freebies, the Supreme Court also referred to the legal position that technically, MCI Regulations are not applicable to the Pharma Companies making them punishable for resultant violation on the part of medical practitioners. According to the Court, the expenditure is hit by provisions of the said Explanation 1 to section 37(1). It appears that the only consequence (apart from the corporate governance issue, if any, more so as such acts of the assessee are also held as being opposed to public policy) for the Pharma Companies for such acts will be to suffer disallowance in their tax assessments. As such, the tax cost will be the extra cost for the Pharma Companies for the past as well as for the future in such cases. The Supreme Court rightly noted [refer para 10.4.5 above] that such freebies are really not free, and the cost thereof is usually factored in the cost of drugs price. In future, in the absence of any specific provision for punishment, some Pharma Companies may follow this practice for this tax-cost also, further driving prices up. If this happens, the poor patients may have to bear this additional cost also and that would be a sad day. Perhaps, the Calcutta High Court may have expected the Government to take note of this legislative gap keeping such unintended consequences in mind.

11.4 Since the Court has upheld the disallowance in the hands of Pharma Companies for its participations in such activities leading to violations of MCI Regulations by the medical practitioners, the effect of this judgment will not necessarily be limited to Pharma Companies and may extend to other sectors/situations also wherever such practices/participation is found.

11.5 While dealing with the provisions of the taxing statute, the normal rule is to apply the principle of ‘strict interpretation’. The Supreme Court in this case has rejected the contention of the assessee for applying such a rule in this case and stated that this principle cannot sustain when it results in an absurdity contrary to the intention of the Parliament [refer para 10.4.10 above].

11.6 In the cases of Pharma Companies distributing freebies to medical practitioners [as well as in other similar cases], the law is now made clear by the Supreme Court and therefore, in such cases, the same is covered within the ambit of Explanation 1 [Pre – 2022 amendment], and accordingly, it should apply even to earlier years. In view of this, the Tax Auditors of Pharma Companies etc. will have to be extremely cautious while reporting on particulars contained in clause 21(a) of Form No. 3CD for A.Y. 2022-23 also, more so with the 2022 amendment.

11.7 The question of disallowance of expenditure arises in cases where it is found that such expenditure is in violation of some provisions of law etc. treating the same as illegal/ prohibited expense as envisaged in the said Explanation 1 to section 37(1) [read with the effect of amendment by Finance Act, 2022, at least from the A.Y. 2022-23]. If the expenditure is not found to be in such violation in the hands of the recipient, the issue of disallowance in the hands of the Pharma Companies should not arise. The Supreme Court has rejected the view of non-applicability of the said Explanation 1 to section 37(1) taken by the Tribunal in PHL Pharma’s case [refer para 10.4.2 above] on the ground that such narrow interpretation based on the non-applicability of MCI Regulations to Pharma Companies, is not correct. However, interestingly, the Tribunal in that case, has further given finding of facts [refer para 6.4 of Part I of this write-up] with regard to the nature of various expenses incurred by the assessee in that case. The issue would arise that whether such findings could be considered as the Tribunal taking the view that, on facts, such expenses do not result in any violation of MCI Regulations in the hands of the recipients. The Revenue may look at this finding to show that the Tribunal only clarified that these are primarily business expenses eligible for deduction u/s 37(1), and observation that they are purely business expenditure and is not impaired by the said Explanation 1 to section 37(1) is generic, considering the context of such observations.

11.7.1 It also seems to us that every expenditure incurred by the Pharma Companies for certain distribution/providing facilities to medical practitioners should not necessarily be regarded as violating MCI Regulations resulting into disallowance thereof as illegal/prohibited expenses. As such, when normal medical conferences/seminars are organized by Pharma Companies, more so if organized domestically, purely for educational/knowledge spreading purposes amongst the medical practitioners, the expenditure for the same, ipso facto, should not necessarily be considered as illegal / prohibited expenses resulting into disallowance. In this respect, the reference [in para 10.4.5 above] of ‘funding of international trips for vacation or to attend medical conferences’ by the Supreme Court will have to be read in context and should not be construed in the manner that expenditure for all medical conferences now falls into this prohibited category, more so when they are domestically held. It also seems that the distribution of free samples by the Pharma Companies to the medical practitioners in the normal course of business to prove the efficacy of the product should also not be viewed as falling into this prohibited category. Of course, all these are subject to a caveat that freebies granted under the guise of seminar/ conferences etc., to medical practitioners can always be questioned for this purpose. Ultimately, the assessee has to satisfy the authority that the expenditure is not in violation of the MCI Regulations as held by the Himachal Pradesh High Court [refer para 4.4 of Part I of this write-up] in Confederation of Indian Pharma Industry’s case. This judgment is approved by the Supreme Court in the above case.

11.8 Finance Act, 2022 has inserted Explanation 3 in section 37 of the Act with effect from 1st April, 2022 to clarify that the expression “expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law” used in Explanation 1 to section 37 shall include and be deemed to have always included inter-alia any expenditure incurred by an assessee to provide any benefit or perquisite in any form to a person whether or not carrying on business or exercising profession where acceptance of such benefit or perquisite by such person is in violation of any law or rule or regulation or guideline which governs the conduct of such person. The new Explanation 3 also specifically expands the scope of the existing provision contained in Explanation 1 to include violation of foreign laws. Considering the language of the amendment of the Finance Act, 2022, the debate is on as to whether this extended scope of illegal/ prohibited expense will apply retrospectively or only from the A.Y. 2022-23. The majority view prevailing in the profession seems to be that the same should apply prospectively, though the Revenue may contend otherwise. As such, the litigation for the past years on the applicability of this expanded scope also cannot be ruled out.

11.9 While the issue of taxability of such freebies for recipients was not before the Supreme Court in the above case, the CBDT in its said Circular dated 1st August, 2012, in para 4, has also clarified that the value of freebies enjoyed by the medical practitioners is also taxable as business income or income from other sources, as the case may be, depending on facts of each case and Assessing Officers have been asked to examine the same in cases of such medical practitioners etc, and take an appropriate action. It may also be noted that for this purpose, it is not relevant whether the receipts of such benefits violates the MCI Regulations or not. In view of this, more so with the provisions of section 28(iv), the Tax Auditors will also have to be extremely cautious while reporting on particulars contained in clause 16 of Form No. 3CD. This will make the task of Tax Auditors more difficult as practically, hardly it may be feasible for the Tax Auditors to find about the receipt of such benefit/ perquisite by the assessee unless the assessee himself declares the same.

11.10 It is also worth noting that the Finance Act, 2022 also inserted new section 194R [w.e.f. 1st July, 2022] which provides for deduction of tax at source (TDS) in respect of any benefit or perquisite provided to a resident and therefore, that also will have to be considered by the assessee and Tax Auditors from the next year i.e., A.Y. 2023-24. Of course, this may help the Tax Auditors of recipients of such benefits to find out the instances of receipts of any such benefit or perquisite.

11.11 The larger and the most relevant issue which may still need consideration: is it fair to leave the determination of the violations of all such laws/regulations etc. to the Assessing Officer by interpreting these laws/regulations etc.? Is he really equipped to carry out this difficult task?

One thing seems certain that we are again heading for long drawn litigations on these provisions, more so in post-2022 amendment era. We do not know for whose benefit? Perhaps, one more bonanza for the profession?

1.1 Sizeable debt funds are being raised by the corporates through the issue of debentures. To make the issue of debentures attractive, such debentures are issued with different terms. Sometimes debentures are issued at a discount with nominal or lower rate of interest. At times, the debentures are issued at par for a fixed period with specified interest rate, but the option is also given to the debenture holders for upfront payment of present value of interest on debentures in the very first year for the entire period of debentures. In such cases, the accounting treatment of such interest is guided by the accounting principles, and generally the expenditure on interest is spread over the life of the debentures on an appropriate basis.

1.2 The expenditure of revenue nature incurred on issue of such debentures generally qualifies for deduction u/s. 37(1) of the Income-tax Act, 1961 (the Act). Section 36(1)(iii) of the Act grants deduction of interest on capital borrowed for business purpose. Accordingly, interest on such debentures should generally qualify for deduction u/s. 36(1)(iii) of the Act, subject to certain exceptions with which we are not concerned in this write-up.

1.3 In the past,for the assessees following mercantile system of accounting, the issue was under debate with regard to the year of deductibility of interest under the Act, in cases where the upfront payment of present value of interest on debenture is made in the very first year for the entire period of debentures and for accounting purpose, such interest is amortised over the redemption period of debentures in the books of account.

1.4 Earlier, the issue with regard to deductibility of discount on issue of debentures under the Act came up for consideration before the courts. Finally, the Apex Court in the case of Madras Industrial Investment Corporation Ltd [225 ITR 802 – Madras Industrial Investment’s case] settled the controversy with regard to deductibility of such discount and the year of its deductibility. In this case, the Apex Court, on the facts of that case, held that the discount on issue of debentures constitutes revenue expenditure. The Court further held that, although a liability of such expenditure has been incurred in the year of issue of debenture, this is a continuing liability which stretches over the period for which the debentures were issued and therefore, the liability spreads over such period. Accordingly, the deduction of such expenditure will also be spread over on a proportionate basis during the tenure of the debentures. The Court also noted that this view is in conformity with the accounting practice in which such discount is amortised over the redemption period of debentures. It may be noted that in this case, initially, the assessee itself had claimed deduction on proportionate basis and subsequently, changed it’s position in this respect. We had analysed this judgment in this column in the July, 1998 issue of the journal.

1.5 Recently, the issue with regard to the year of deductibility of upfront payment of interest in the first year of the tenure of debentures referred to in para 1.3 above came up for consideration before the Apex Court in the case of Taparia Tools Ltd. and the Court has decided this issue. Considering the importance and usefulness of this judgment, it is thought fit to consider the same in this column.

Taparia Tools Ltd. vs. JCIT – 260 ITR 102 [Bom.]

2.1 The issue referred to in para 1.3 above came up before the Bombay High Court in the above case. In this case, the brief facts were: the assessee was following mercantile system of accounting and it had issued non-convertible debentures of the face value of Rs. 100 each aggregating Rs. 600 lakh on a private placement basis. Under the terms of issue,effectively, as noted by the Court,the debenture holders were entitled to receive interest periodically on half yearly basis @ 18% p.a. for five years. Alternatively, the debenture holders had the option to receive one year upfront payment of Rs. 55 per debenture immediately on allotment. The debentures were redeemable at a premium of Rs. 10 per debenture in one installment any time after the end of fifth year from the date of allotment but, not later than the seventh year from that date.

2.1.1 The company made allotment of debentures to six parties on two different dates. On 29th March, 1996, the allotment was made to one party for which the company had received Rs. 495 lakh and on 19th June, 1996, the company had made an allotment to five parties for which the company had received Rs. 100 lakh from one party and Rs. 1.25 lakh each from the other four parties. Out of six parties, two lenders exercised the option to receive upfront payment. Accordingly, upfront payment of Rs. 2,72,25,000 became payable to one party (who was allotted debentures of the face value of Rs. 495 lakh) on 29th March, 1996 and Rs. 55 lakh became payable to another party (who was allotted debentures of the face value of Rs. 100 lakh)on 19th June, 1996. The other four debenture holders holding debentures of the aggregate face value of Rs. 5 lakh opted for payment of interest periodically as per the terms of issue of debentures. In the books of account, the assessee had shown the upfront payment of interest of both the years as ‘deferred revenue expenditure’ to be written off over a period of five years. Similarly, the premium of Rs. 60 lakh payable on redemption of debentures was also proportionately debited to each year’s profit and loss account and credited as reserve on the liability side of the balance sheet. Even for tax purpose, the claim by deduction of this premium payable on redemption was spread over the life of the debentures.

2.1.2 For the purpose of furnishing return of income for the assessment year 1996-97, the assessee claimed entire upfront payment of interest of Rs. 2,72,25,000 as deduction and similarly, in the Return of income from the assessment year 1997- 98, the full deduction of Rs. 55 lakh paid upfront was claimed as deduction. For both the years, the deduction was disallowed by the Assessing Officer (AO) on the ground that liability for the full amount regarding discounted interest paid upfront has not been incurred in the respective accounting years and the approximate income which the assessee would have earned by utilisation of Rs. 595 lakh (Rs. 495 lakh and Rs. 100 lakh) borrowed was not offered for taxation. Relying on the judgment of the Apex Court in Madras Industrial Investment’s case, the AO spread over the deduction of interest expenditure over a period of five years and worked out the amount of deduction of interest by applying appropriate discount rate for the assessment year 1996-97 [Rs. 74,250 – for three days (annual amount being Rs. 89,10,000) as against the claim of Rs. 2,72,25,000]. For the assessment year 1997-98 also, similar approach was adopted. It seems that in subsequent years, deduction was allowed on this basis. On first appeal, for the Assessment Year 1996-97, the Commissioner of Income-tax (Appeals) [CIT (A)] took the view that the entire scheme was made to avoid tax and the upfront payment was repayment of capital out of the total borrowing and accordingly, the actual borrowing for the assessment year 1996-97 was only Rs. 2,22,75,000 (and not Rs. 495 lakh). For this, the CIT(A) also relied on the judgment of the Apex Court in the case of McDowell & Company Ltd. [154 ITR 148 – McDowell’s case]. Based on this, the CIT(A) allowed deduction on this reduced amount of borrowing for three days. The Tribunal set aside the order of CIT(A) and restored the order of the AO.

2.2    It seems that similar views were taken for the assessment years 1997-98 and subsequent years. It also seems that appeals for three assessment years (1996-97 to 1998-99) were filed by the assessee  as  well  as  the  revenue  before  the Bombay high Court. details of the other years are not available. Appeals of the Revenue were filed on the ground that the upfront payment represented repayment of borrowed capital and therefore, the assessee was entitled to deduction u/s. 36(1)(iii) only on the net amount of rs. 2,22,75,000.

2.3    On the above facts, the matters came-up before the Bombay high Court, and the high Court, it seems, dealt with the appeals by first taking the appeal for the assessment year 1996-97 as the base. It seems that in the assessee’s appeals, large number of questions were raised  before  the Court. however, the high Court framed the following substantial question of law for its decision [Page 107]:

“Whether, on the facts and circumstances of the case and in law, the tribunal was right in holding that, even though the liability of payment of interest stood liquidated in the first year itself, such liability had to be allowed on a spread over basis over the life of the debentures?”

2.4    On behalf of the assessee, it was, inter alia, contended that the upfront payment of Rs. 55 per debenture on 29th march, 1996 was on account of interest and the CIT(a) wrongly treated the payment   of   Rs.   55   per   debenture   on   capital account.  the terms of issue of debentures in this respect are very clear. for accounting purpose, the assessee has debited 1/5th of Rs. 55 for five years in profit and loss account but, for the purpose of determining deductibility of the amount under the act one has to go by the year in which the liability arises under the terms of issue of debentures, and for that purpose, the treatment in the books of account is irrelevant.  The assessee is following mercantile system of accounting and under the terms of issue, the liability arose in the first year itself and therefore, deductibility thereof  cannot be spread over the five years as erroneously done by the ao. It was further contended that it was not open to the revenue to tamper with the terms of issue and therefore, the ao was wrong in spreading the deduction over the five years. Such spreadover in five years amounts to altering the terms and conditions of the issue of debentures which was not permissible. It was also pointed out that, had the assessee not claimed the deduction in the very first year, the Revenue could have denied deduction in the second and subsequent years  on the ground that no liability accrued in those years and no amount was also paid during those years.   The  method  of  determining  the  quantum for allowing the deduction on a spreadover basis adopted by the revenue was also questioned.

2.4.1    It was further contended that the judgment of the apex Court in the case of madras industrial investment’s case did not apply to the facts of the case  of  the  assessee.  this  was  distinguished  on various grounds which, inter alia, include: in that case, the Court was concerned with the concept of premium payable at the time of redemption and in this case, although the assesse is liable to pay 10% premium at the time of redemption, that has been claimed on the basis of tests laid down in that case and,therefore, in this case, we are not concerned with the deductibility of such premium. Present case is concerned with the deductibility of upfront payment of interest which became payable in the very first year ending on 31st march, 1996. it was further pointed out that in madras industrial investment’s case, the premium amount was payable after five years and therefore, the apex Court has allowed amortisation whereas in this case, the liability to pay interest arose in the very first year and that is also discharged in the first year itself. Furthermore, in that case the liability was a continuing liability which is not the case in this case. From the judgment of the apex Court in that case, it would appear that the option was with the assessee to claim deduction in the very first year when it discharged the accrued liability or to spread it over for five years. As such, according to the learned counsel appearing on behalf of the assessee, the judgment of the Apex Court in the madras industrial investment’s case had no application to the facts of the present case. A reliance was also placed on the judgment of the Bombay high Court in the case of Buckau Wolf new india engineering Works Ltd. [157 ITR 751] in which case, the amount was payable in installments and yet, the high Court took the view that the deduction for the entire amount should be given in the first year because the liability was accrued in the first year.

2.4.2    It was also pointed out that @ 55 per debenture, the assessee was required to pay Rs. 4,45,50,000 interest in five years but by paying upfront amount of Rs. 2,72,25,000 it has been able to save a payment of interest to the extent of Rs. 1,73,25,000.  While spreading over the deduction,even the revenue is ultimately allowing deduction of Rs. 4,45,50,000 as against the claim of deduction of Rs.2,72,25,000 made by the assessee. It was also contended that the Revenue has wrongly invoked the judgment of the apex Court in mcdowell’s case.

2.4.3    The  learned  counsel  for  the  assessee  further contended that under the terms of issue, the lenders were free to opt for interest on half yearly basis @ 18% per annum for five years (i.e. in aggregate  Rs.  90  per  debenture)  or  to  receive upfront  payment  of  Rs.  55  per  debenture  in  the year of allotment itself.  Therefore, the lenders had a right to receive discounted amount of interest in the first year under the second option. In other words, by making upfront payment of Rs. 55 per debenture, the assessee has brought the present value  of  rs.  90  to  Rs.  55  which  is  nothing  but discounted value of the interest otherwise payable in five years. Under the first option, the assessee would  have  paid  Rs.  89,10,000  every  year  for  a period of five years on this amount of borrowing. however, by making upfront payment of discounted value of interest amounting to Rs. 2,72,25,000,the assessee  got  rid  of  the  annual  liability  of  Rs. 89,10,000 for five years. It was also contended that the  revenue  has  accepted  that  upfront  payment of Rs. 55 per debenture was revenue expenditure and by spreading over the amount of deduction, the  revenue  allows  deduction  of  rs.  89,10,000 per year for a period of five years aggregating the  amount  to  Rs.  4,45,50,000  as  against  the assessee’s claim of deduction of Rs. 2,72,25,000 in the first year. Therefore, there is no loss to the revenue. As such, the only question which the ao was required to decide was whether the liability to pay interest was incurred in the first year itself or not, and if so, the assessee was entitled to obtain full deduction in the first year.

2.4.4    It  was  also  pointed  out  that  the  tribunal  has proceeded on the footing that the entire measure was adopted because the assessee had surplus income whereas the concerned lender had brought forward losses. In this respect, it was contended that the court should not take into account extraneous factors while deciding the claim of the assessee.

2.4.5    Referring to the judgment of the Apex Court in the case of tuticorin alkali Chemicals and fertilizers Ltd. [227 itr 172 – tuticorin’s case], it was further contended that the deduction of expenditure under the act does not depend on what the assessee debits in its accounts but, it depends on the provisions of the law.  Therefore, in this case, the fact that the assessee has not debited the full amount to profit and loss account in the first year itself cannot be the ground for its disallowance in that  year. The  tax  cannot  be  levied  on  the  basis of entries made  by  an  assessee  in  its  books  of account.

2.4.6    It was also contended that the tribunal has erred in introducing matching concept to the effect that the expenditure must relate to the income in the assessment year and the benefit was spread over for a period of five years and therefore, the expenditure must also be spread over. According to the learned counsel, since the  liability  in  this case is incurred in the first year itself, the assesseee was entitled to full deduction in that year and, therefore, the question of co-relating the expenditure to income/ benefit for five years does not arise.  For this, the reliance was placed on the judgment of the Apex Court in the case of Mysore Spinning and mfg. Co. Ltd. [61 itr 572].

2.5    On  behalf  of  the  revenue,  it  was,  inter  alia, contended that the option given to the lenders refers to upfront one-time payment and it does not speak of interest. the upfront payment of Rs. 55 per debenture, as against the amount of Rs. 90, was made to get the benefit of differential amount of Rs. 45 for a period of five years and therefore, the ao was right in spreading the expenses over that period. If the argument of the assessee for deduction of the full amount in the first year is accepted, then the computation of income will stand distorted, because the assesse got the benefit of Rs. 45 for five years. Upfront payment of  Rs.  55  was  on  account  of  advance  payment of interest in the first year for five years. As such, the principle laid down by the apex Court in the madras industrial investment’s case was squarely applicable to the facts of the case of the assessee. It was also contended that under both the options, the interest was payable every six months and therefore, the amortisation principle was applicable to  both  the  options.  Therefore,  even  Rs.  55  per debenture was payable by way of interest for five years which was paid by the assessee in the first year and therefore, the ao was right in applying the principle of amortisation in this case.

2.5.1    Supporting the appeals filed by  the  Revenue,  the learned counsel appearing on behalf of the revenue,  further  contended  that,  as  against  the amount  of  Rs.  4,95,00,000  borrowed  on  29th march, 1996, on the same day, an amount of Rs. 2,72,25,000 was repaid in the name of upfront payment of interest and therefore, the actual borrowed capital left with the assesse was only Rs. 2,22,75,000 which was used for the purpose of business. Since part of the borrowed capital was refunded to the subscribers on the same date, the actual borrowed capital remaining was the net amount and the tribunal has failed to appreciate this factual positon. as such, the assessee was entitled to claim deduction u/s. 36(1)(iii) for interest only on Rs. 2,22,75,000.

2.5.2.1 It was also contended that the entire scheme of issue of non-convertible debenture was devised to defeat the collection of tax revenue. In the present case, the assessee has not paid the discounted value of interest, but has repaid part of the face value of the debenture itself under the garb of upfront payment of interest at present value. therefore, the tribunal has erred in giving spread over and granting deduction of Rs. 4,45,50,000 @ 18% per annum for five years on the gross amount (i.e. Rs.4,95,00,000) of debentures.

2.6    After considering the contentions raised on behalf of both the sides, the Court proceeded to decide the question referred to in para 2.3.  For this purpose, at the outset, the Court noted the following relevant terms of the issue of debentures [Page115]:

“3(a) Each debenture shall carry interest at the rate of 2%. Per annum above the prime lending rate and the interest shall be payable half-yearly.
(b)    Each debenture shall carry interest at the rate of  Rs.  55  per  debenture,  payable  up-front  within thirty days of the exercise of option or from the date of allotment, whichever is earlier”.

These  terms  were  not  accepted  by  the  lenders.
The final terms of the issue were as follows:

“2.  Terms of the issue:
(a)    Up-front fee – the debenture shall carry up- front fee at the rate of Rs. 55 per debenture payable up-front immediately on allotment.
(b)    Redemption  period  –  the  debenture  shall be redeemed at a premium of 10 per cent, i.e.,  Rs.10  per  debenture,  in  one  instalment any time after the end of the fifth year from the date of allotment, but not later than the seventh year from the date of allotment.”

2.6.1    The Court then briefly referred to the facts of the present case and stated that the question which arises for determination in this case is whether Rs.  55  per  debenture  (total  –  Rs.  2,72,25,000) deductible in the first year of allotment or that expenditure was to be apportioned over the period of five years, which is the life of the debenture. The Court also noted that the assesse is following the mercantile system of accounting on the basis of which the assessee has made a claim for the full amount in the first year itself whereas the Revenue has treated this as deferred revenue expenditure (DRE)  and  apportioned  the  expenditure  for  five years. The Court then stated that for the purpose of deciding this issue, two concepts are required to be borne in mind, viz., matching and discount rate.

2.6.2    The   Court   then   proceeded   to   consider   the ‘matching concept’ referred to in above para.  for this purpose, the Court noted that the mercantile system of accounting is based on accrual. under this system, book profits are liable to be taxed. The profits earned and credited in the books of account constitute the basis of computation of income.  the  system  postulates  the  taxation  of monies that are due and payable by the parties to whom they are debited. explaining the effect  of the ‘matching concept’ in the mercantile system of accounting, the Court observed as under [Page no. 116]:
“…….therefore,  under  the  mercantile  system  of accounting, in order to determine the net income of an accounting year, the revenue and other incomes are matched with the cost of resources consumed (expenses). under the mercantile system of accounting, this matching is required to be done on accrual basis. under this matching concept, revenue and income earned during an accounting period, irrespective of actual cash in- flow, is required to be compared with expenses incurred during the same period, irrespective of actual out-flow of cash. In this case, the assesse is following the mercantile system of accounting. this matching concept is very relevant to compute taxable income particularly in cases involving dre. it has been recognised by numerous judgments…    ”

2.6.2.1    The Court then referred to the judgment of the apex Court in the case of Calcutta Co. Ltd. [37 ITR 1] and stated that, in that case, the Court had held that the expression ‘profits or gains’ used in section 10(1) of the income-tax act, 1922 [similar to section 28(i) of the act] should be understood in its commercial sense and there can be no computation of such profits and gains until the expenditure, which is necessary for the purpose of  earning  receipts  is  deducted  therefrom.  the Court then noted that in that case the apex Court had applied the ‘matching concept’ and allowed the deduction of an expenditure required to be incurred in subsequent period on an estimated basis which related to the income that was already accounted on the ground that otherwise it was not possible to compute profits and gains. The Court then stated that this concept is also applied by the apex Court in the case of madras industrial investment’s case and for that purpose the Court noted the following observations from the head notes of that case [Page 117]:

“Ordinarily, revenue expenditure which is incurred wholly and exclusively for thepurpose of business must be allowed in its entirety in the year in which, it is incurred. it cannot be spread over a number of years even if the assessee has written it off in his books, over a period of years. However, the facts may justify an assessee who has incurred expenditure in a particular year to spread and claim it over a period of ensuing years. in fact, allowing the entire expenditure in one year might give a very distorted picture of the profits of a particular year. Issuing debentures is an instance where, although the assesse has incurred the liability to pay the discount in the year of issue of debentures, the payment is to secure a benefit over  a  number  of  years.  There  is  a  continuing benefit to the business of the company over the entire  period.  the  liability  should,  therefore,  be spread over the period of the debentures”.

2.6.2.2    The Court then stated that the ‘matching concept’ is also covered by section 36(1)(iii) read with section 43(2), which defines the word ‘paid’ to include incurred according to the method of accounting. Both these sections are part of the provisions relating to computation of business income. Interest on monies borrowed for business purposes is an expenditure in the business, which is deductible under section 36(1)(iii).   the Court then pointed out that for claiming deduction u/s. 36(1)(iii), the necessary conditions are: the capital must have been borrowed; it must have been borrowed for business purpose and the interest must have been paid i.e., actually paid or incurred in accordance with the method of accounting followed by the assessee.

2.6.2.3    Referring to the facts of the case of the assessee, the Court noted that the assessee got the benefit of the borrowed money for a period of five years and if the ‘matching concept’ is not applied, the profits get distorted. In this context the Court then observed as under [Page 118]:

“……for  the  year  ending  march  31,  1996,  the assessee has submitted that it has incurred an expenditure  amounting  to  rs.  2,72,25,000  as and by way of interest deductible under section 36(1)(iii) of the income-tax act. however, in the annual accounts, the said amount is not debited to the profit and loss account. It is interesting     to note from the profit and loss account for the year ending March 31, 1996, that profit after tax  was  rs.1,86,34,016.  now  if  the  expenditure incurred was Rs. 2,72,25,000 as submitted by the assessee then the assessee could never have earned the said profit of Rs. 1,86,34,016. This is how the profit got distorted. In the annual report, the assessee has conceded that Rs. 2,72,25,000 was deferred revenue expenditure to be written off over five years. In his order, the Assessing Officer has recorded a finding of fact which categorically brings out the ‘matching concept’. he has stated that for the accounting year March 31, 1996, profit after  tax  increased  to  Rs.  1,86,34,016  from  rs. 50 lakhs in the last year ending march 31, 1995. Therefore, the Assessing Officer was right in apportioning the expenditure at 18 per cent. per annum on Rs. 495 lakhs amounting to Rs.74,259 for three days because only then the estimated expenditure   could   match   with   income   of   Rs. 1,86,34,016…    ”

2.6.2.4    Considering the above referred accounting treatment and the accounting profit for the year ending 31st march, 1996, the Court stated that the  assessee  has  shown  Rs.  2,72,25,000  as deferred  revenue  expenditure  and   according to the Court, this expenditure, though paid, was not incurred in the year ending 31st march, 1996 and the expenditure incurred in that year was Rs. 74,250. in this context, the Court further observed as under [Page 118]:
“… What we would like to emphasise is that, therefore, ordinarily revenue expenditure incurred only and exclusively for business purposes must be allowed in its entirety in the year in which it    is incurred. However, in a given case, like the present one, the facts may justify the Assessing Officer to spread the expenditure over the life    of the debentures because allowing the entire expenditure in one year might give a distorted picture of the profit of a particular year…    ”

2.6.2.5    Considering the overall facts of the assessee, the Court took the view that the assessee has received the borrowed funds for a period of five years and it is a continuing benefit to the business of the assessee over the entire period of debentures and therefore, the liability was required to be spread over the period of debentures.  the Court also noted that the assessee itself has applied    a ‘matching concept’ qua the claim of premium payable on redemption of debentures. As such,  in this very case, the  assessee  has  invoked  the ‘matching concept’ qua premium but not for interest.

2.7    The Court then proceeded to consider the second concept, viz., discount rate. in this context, the Court noted that the ao had taken a view that the upfront payment made by the assessee had to be discounted as these payments represent present value of the interest liability and were deferred revenue  expenditure.  For  this  purpose,  the  ao applied 18% as the discount rate which was effectively based on one of the options available for payment of interest over a period of five years. On this basis, the ao determined the annual liability  of  interest  at  Rs.  89,10,000  in  respect of borrowing of Rs. 495 lakh and Rs. 18 lakh in respect  of  borrowing  of  Rs.  100  lakh.    on  this basis, the ao allowed deduction of Rs. 74,250 for three days for the assessment year 1996-97 and Rs. 1,03,20,410 for the assessment year 1997-98 (i.e. Rs. 89,10,000 for the first set of debenture and Rs. 14,10,410 for the second set of debenture on a proportionate basis for part of the financial year 1996-97). in the subsequent years,it seems, the ao had allowed deduction on this basis for the full year.   The assessee had questioned the discount rate applied by the ao for determining the amount of deduction. After considering the factual position, the Court did not find any defect in the method of determining the amount of deduction adopted by the ao.

2.8    After considering both the above concepts, viz., ‘matching concept’ and discount rate, the Court stated that if they are kept in mind, the matter stands resolved in law.  For this purpose, the Court then analysed the annual accounts of three years under appeal and noted that in each of the years, the assessee has treated the upfront payments made in the first year as deferred expenditure and written off the same on  that  basis  during the life of the debentures. After analysing these annual accounts for three years, the Court also noticed that even this method continued in the subsequent accounting years upto 31st march, 2001 and finally, the debentures were repaid during the accounting year 2001-02.

2.8.1    Based on the analysis of the above referred annual accounts, the Court noted that this analysis indicates two things. Firstly, in the accounts, the upfront payment has been written off over the period of debentures by creating an asset in respect thereof on the basis that interest for five years is paid in advance in the first year. Secondly, the accounts show that the premium payable by the assessee on redemption was Rs. 60 lakh and in each year, 20% thereof has been charged to the profit and loss account. On this basis, the Court felt that the acceptance  of  claim  of  deduction of the full amount in the first year would result into distortion.

2.9    The   Court   then   noted   the   contention   of   the assessee that good accounting is not necessarily correct law.   For this, on behalf of the assessee, apart from the other authorities, heavy reliance was placed on the judgment of the Apex Court in tuticorin’s case to contend that the deduction of expenses in computation of income under the act does not depend on its accounting treatment but  depends  on  the  provisions  of  the  law.  For this, the Court considered the relevant provisions contained in section 36(1)(iii) read with section 43(2) and stated that, from this, it would  be  clear that question of allowance permitted to be deducted under the head profits and gains would differ according to the system of accounting adopted by the assessee.  For this purpose, one has to estimate the expenditure by applying the ‘matching concept’ and a proper discount rate. Referring to the judgment of the Apex Court in the case of A. Krishnaswamy Mudaliar [53 ITR 122], the Court stated that profits of the business should be determined according to the ordinary principles of commercial accounting so far as they are applicable.  The Court then stated that there is no merit in the argument advanced on behalf of the assessee that good accounting is not necessarily good law.

2.10    Finally, explaining the effect of judgment in tuticorin’s  case,the  Court  held  as  under  [Page 125]:
“………one of the points which arose for determination was whether interest received by the assessee on short-term deposits during pre-commencement of business could be capitalised as accretion to capital and, therefore, nontaxable.   Therefore,  in  the  case,  the  issue  was on the nature of the receipt. Hence, that case  has no application. On the contrary, it has been held that the accounting principles are relevant for ascertainment of profits made by a company or for ascertainment of value of assets of the company but, not for determining the nature of receipt. Therefore, the said judgment supports the view which we have taken as in this case,  we are concerned with computation of income.

It is important to note that the deferred revenue expenditure is of revenue nature but, because of its special features, it is spread over a number of years during which the benefit of expenditure is expected to arise to the business. on the facts, we hold that the liability was a continuing liability to pay interest spread over for a period of five years…    ”

2.11    In view of the above, the Court took the view that the ao was right in spreading the deduction over the period of five years which was the life of the debentures. Accordingly, the Court decided the question referred to in para 2.2. above in favour of the revenue and against the assessee.

2.12    On the above basis, appeals of the assessee for all  the  three  years  were  dismissed.   the  Court also noted that the three appeals preferred by the  revenue,  relate  to  the  ground  that  upfront payments represented repayment of borrowed capital and therefore, the assessee was not entitled to deduction u/s. 36(1)(iii) in respect thereof. In this respect, the Court clarified that the AO has recorded the finding of fact that the upfront payments were on revenue account and that has been confirmed by the Tribunal and therefore, the Court has decided these matters on the basis of that finding of fact. Accordingly, on this basis, the Court preferred not to answer the questions raised in the three appeals filed by the Revenue.

1.2 Section 9(1) of the Income-tax Act, 1961 (the Act) provides a deeming fiction to effectively treat foreign income of an assessee as deemed to accrue or arise in India under certain circumstances in the situations provided therein. Technically, section 9 applies to resident as well as the non-resident assessees. However, applicability thereof to a resident is not of much relevance in the context of taxability of income in India, except in case of an assessee, who is not ordinarily resident. Where income actually accrues or arises in India, such a fiction is not needed to create a situation which exists in reality and therefore, in such cases, this fiction has no relevance. This also effectively does not apply to the income received in India, as such income are chargeable u/s. 5 in case of resident as well as non-resident assessees irrespective of the place of accrual of income. Therefore, effectively, a foreign income of a non-resident assessee, which is not received in India would not be chargeable to tax under the Act, unless it accrues or is deemed to accrue in India.

1.3 Clauses (i) to (iv) of section 9 provide for such deeming fiction in respect of certain income under the circumstances specified therein, such as income accruing or arising, directly or indirectly, through or from any business connection in India or from any property in India, etc. These provisions are considered valid as varieties of nexus set out therein are based on sufficient and real territorial connection. This is mainly based on the general principle that once there is a sufficient territorial connection or nexus between the persons sought to be taxed and the country seeking to tax, the income-tax may appropriately be levied on that person in respect of his foreign income. Primarily, we are not concerned with these provisions in this write-up, though they have continued in section 9(1) with some changes even after introduction of clauses (v) to (vii).

1.4 Clauses (v) to (vii) were inserted by the Finance Act, 1976 (w.e.f. 1-6-1976) deeming interest, royalty and Fees for Technical Services (FTS) to accrue or arise in India effectively making the non-resident recipient of such income chargeable to tax in cases where such non-resident had no tax liability in respect of such income under the pre-existing provisions (hereinafter income specified in these clauses is referred to as the Specified Income). Under these provisions, the law also seeks to charge a non-resident in respect of his income outside India merely because the payment thereof is made by Indian resident with some exceptions. Accordingly, the residential status of the payer became relevant to detriment the situs of income. Further, under these provisions, the law also seeks to charge Specified Income arising from transactions between two non-residents outside India under certain circumstances and so on. This had raised doubts as to the validity of these provisions which came up for consideration before the Courts in India, mainly in the context of provisions relating to FTS.

1.5 In the context of taxability of FTS under clause (vii)(b) of section 9(1), a new dimension was given by the Apex Court in the case of Ishikawajima- Harima Heavy Industries Ltd. (288 ITR 408) wherein while dealing with the taxability of income from offshore services, the Court, inter alia, held that for such income to be regarded as accruing or arising in India, it is necessary that services not only are utilised within India, but also are rendered in India. Such a condition for taxability of such income was by and large not considered as relevant prior to this judgment and the same was also found against the very object for which these provisions were introduced by the Finance Act, 1976. Accordingly, Explanation to section 9 has been inserted/sustituted by the Finance Act, 2010 with retrospective effect from 1-6-1976 to overcome the possible effect of the position emerging from this part of the judgment of the Apex Court. Some doubts have also been raised with regard to validity of this new Explanation.

1.6 In the context of validity of the provisions contained in clauses (v) to (vii) of section 9(1), the debate continued with regard to extent of the Parliament’s powers to enact a law having extra-territorial operations.

1.7 Recently, the Constitution Bench of the Apex Court has dealt with this issue and decided the scope of powers of the Parliament to enact a law having extra-territorial operations. In this context, this has settled the general principle in this regard. This judgment will have implications not only with regard to the Income-tax Act, but also with regard to other laws enacted by the Parliament. In this write-up, we are only concerned with the effect of this judgment in the context of the above-referred deeming fiction provided in the Act in respect of the Specified Income.

Electronics Corporation of India Ltd., (ECIL) v. CIT & Anr. — 183 ITR 44 (SC):

2.1 The issue referred to in para 1.6 above came up before the Andhra Pradesh in the context of section 9(1)(vii). In this case, the brief facts were:

The assessee company (ECIL) had entered into an agreement with Norwegian Co. (NC) under which, for the agreed consideration, the N.C. was to provide technical services including facilities for training of personnel of the ECIL in connection with the manufacture of computers by ECIL. For the purpose of remitting the amount payable to NC, the ECIL had approached the Income Tax Officer (ITO) for grant of No Objection Certificate (NOC) as contemplated in section 195(2) of the Act for remittance without deduction of tax at source (TDS). When ITO expressed inability to issue such NOC, the ECIL approached the Commissioner of Income Tax (CIT) for directing ITO to issue the NOC. The CIT declined to issue such direction as according to him, the said payment was income which is deemed to accrue or arise in India u/s.9(1)(vii) and was liable to TDS u/s.195. Against this, ECIL had filed a writ petition before the High Court.

2.2 Before the High Court, various contentions were raised including validity of provisions of section 9(1)(vii) on the ground that it has extraterritorial operation without any nexus between the persons sought to be taxed (i.e., NC) and the country (i.e., India) seeking to tax under a fiction of deemed income arising in India. In this write-up, we are not concerned with the other contentions raised in this case. For the purpose of deciding the issue, the Court referred to historical background of the Income-tax Act and noted that the Indian Income-tax Act, 1922 was passed by the Indian Legislature in exercise of its powers conferred by the British Parliament under the Government of India Act, 1915-1919 which was replaced by the Government of India Act, 1935. The Court then noted that section 99 of the Government of India Act, 1935, inter alia, empowered the Federal Legislatures to make law for the whole or any part of British India. Comparing these provisions with provisions of Article 245 of the Constitution, the Court noted that there was no provision like Article 245(2) in the Government of India Act. The Court then pointed out that the Income-tax Act, 1961 is a post-Constitution law made by the Parliament.

2.3 It was contended on behalf of the ECIL that the NC does not have any Office in India, nor does it have any business activity in this country. The Parliament is not competent to enact section 9(1)(vii)    as it has extra-territorial operation by creating a fiction of income accruing in India without any nexus between the NC and India. For this, reliance was placed on various judgments including the judgment of the Apex Court in the case of Carborandum Co. (108 ITR 335) as well on the commentary given in the book (i.e., Law and Practice of Income Tax) written by the learned authors Kanga & Palkhivala.

2.4 For the purpose of deciding the issue, the Court stated that various judgments relied on by the counsel of the petitioner were rendered under the Indian Income-tax Act, 1922. The Court also noted that the facts of the case under consideration show that the payment is made by an Indian company to a foreign company for FTS and know-how, which is to be used by the Indian company in its business in India. For the purpose of the Income-tax Act, the fiction of income deemed to arise in the country where tax is levied is not uncommon. The narrow test of territorial nexus evolved by the courts in England may not be suitable for application by a developing country like India in the developments which are taking place. The language and spirit of Article 245(2) of the Constitution is clear. The Court will be slow in striking down the law made by the Parliament merely on the ground of extra-territorial operation. India has entered into agreements with several other nations providing for double taxation relief and if there is a real apprehension of deterrence to foreign collaborations as contended on behalf of the petitioner, it will be expected that the Government will take suitable action. Finally, the Court did not agree with the contention of the petitioner that the impugned provisions are beyond the legislative competence of the Parliament.

2.5 When the above judgment of the High Court came up for consideration before the Apex Court, the Court noted that the Revenue is proceeding on the basis that the NC is liable to tax and therefore, the ECIL is obliged to deduct tax at source while making the payment. The case of the Revenue rests on section 9(1)(vii)(b) of the Act and the question is whether, on the terms in which the provision is couched, it is ultra vires.

2.5.1 To decide the issue, the Court noted the constitutional scheme to make laws which operate extra-territorially and referred to the provisions contained in Article 245 and stated that considering provisions of Article 245(2), which provides that no law made by the Parliament shall be deemed to be invalid on the ground that it will have extra-territorial operation, a Parliamentary statute having extra-territorial operation cannot be ruled out from contemplation. Therefore, according to the Court, the operation of the law can extend to persons, things and acts outside the territory of India and for this purpose, the Court also noted the judgment of the Privy Council in the case of British Colombia Electric Railway Co. Ltd. wherein it was held that the problem of inability to enforce the law outside the territory cannot be a ground to hold such law invalid. The nation enacting a law can order that the law requiring any extra-territorial operation be implemented to the extent possible with the machinery available. This principle clearly falls within the ambit of pro-visions of Article 245(2). The Court then observed as under (page 55):

“In other words, while the enforcement of the law cannot be contemplated in foreign State, it can, none the less, be enforced by the courts of the enacting State to the degree that is permissible with the machinery available to them. They will not be regarded by such courts as invalid on the ground of such extra-territoriality.”

Accordingly, the Court drew the distinction between the power to ‘make Laws’ and ‘operation’ of laws. The Court also took the view that the operation of the law enacted by the Parliament can extend to persons, things and acts outside the territory of India.

2.5.2 Finally, the Court felt that the issue should be decided by the Constitution Bench considering its implications and held as under (page 55):

“But the question is whether a nexus with some-thing in India is necessary. It seems to us that, unless such nexus exists, the Parliament will have no competence to make the law. It will be noted that Article 245(1) empowers the Parliament to enact laws for the whole or any part of the territory of India. The provocation for the law must be found within India itself. Such a law may have extra-territorial operation in order to subserve the object and that object must be related to something in India. It is inconceivable that a law should be made by the Parliament in India which has no relationship with anything in India. The only question then is whether the ingredients, in terms of the impugned provision, indicate a nexus. The question is one of substantial importance, specially as it concerns collaboration agreements with foreign companies and other such arrangements for the better development of industry and commerce in India. In view of the great public importance of the question, we think it desirable to refer these cases to a Constitution Bench, and we do so order.”

2.5.3 From the above, it would appear that the Court held the view that the Parliament does not have power to make extra-territorial law unless a nexus exists with something in India. In the context of Article 245(1), the observations of the Court that the provocation for the law must be found within India itself and the object for which the law having extra -territorial operation is made must be related to something in India, raised an issue as to whether this could mean that such provocation and object must arise only within India.

2.5.4 It seems that the petitioner (i.e., ECIL) did to pursue the above matter further and hence the issue remained to be decided by the Constitution Bench.