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Time of Supply under Reverse Charge Mechanism of GST

Time of Supply under Reverse Charge Mechanism of GST

Query:

Does reverse charge liability under GST arise on provisions for expenses booked in accounts?

Our opinion is sought keeping in view:

  • Provisions of CGST Act, 2017 read with CGST Rules, 2017
  • Indian Accounting Standard-37 “Provisions, Contingent Liabilities and Contingent Assets”

Analysis and Facts:

To further analyze the query, it is imperative to quote the relevant provisions under Indian Accounting Standard-37, at this juncture-

Creation of provisions in the books is a normal accounting practice and this is religiously followed upon at end of a financial year / period. The provisions are required to be made in accordance with the applicable IndAS. Our advice has been sought upon the reverse charge liability under GST arise on provision for expenses recognized in Books of Accounts.

As per Indian Accounting Standard 37 “Provisions, Contingent Liabilities and Contingent Assets”

A provision is a liability of uncertain timing or amount.

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

A provision shall be recognized when:

  1. an entity has a present obligation (legal or constructive) as a result of a past event;
  2. it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
  3. a reliable estimate can be made of the amount of the obligation.

If these conditions are not met, no provision shall be recognized.

As per the definition of ‘provision’ as given in IndAS 37 as stated supra it can be said that provision is made in respect of any expense (capital as well as revenue) incurred by an entity. Also, provision is recognized only in cases where the goods or services have actually been received or partially received because as per IndAS 37, ‘provision’ is to be recognized when it has a present obligation as result of past event.

Further in cases where provision is recognized and the invoice has not been raised / received by the supplier / recipient, as in situations where invoice has actually been raised and received, a ‘liability’ will be accounted for the amount of invoice and there would be no role of any estimation. Needless to mention here that for recognizing a ‘provision’ a reliable estimate is required to be made.

As regards treatment of ‘provision’ under GST law is concerned, implication upon the recipient of supply on recognizing the provision for expenses in respect of receipt of goods or services or both is explained below.

GST implications on Provision for expenses made in books of accounts in respect of receipt of goods or services or both (covered under reverse charge mechanism):

a) Payment of GST:

Under reverse charge mechanism the liability of deposition of tax is on the recipient. In this regard the payment of tax depends upon the time of supply which is determined as per Section 12 and 13 of CGST Act, 2017. The GST implications on recipient is explained below:

  1. Goods: As enumerated in Section 12(3) of CGST Act 2017, In case of supplies in respect of which tax is paid or liable to be paid on reverse charge basis, the time of supply shall be the earliest of the following dates, namely:
  1. the date of the receipt of goods; or
  2. the date of payment as entered in the books of account of the recipient or the date on which the payment is debited in his bank account, whichever is earlier; or
  3. the date immediately following thirty days from the date of issue of invoice or any other document, by whatever name called, in lieu thereof by the Supplier.

Provided that where it is not possible to determine the time of supply under clause (a) or clause (b) or clause (c), the time of supply shall be the date of entry in the books of account of the recipient of supply.

2. Services: As enumerated in Section 13(3) of CGST Act 2017, In case of supplies in respect of which tax is paid or liable to be paid on reverse charge basis, the time of supply shall be the earlier of the following dates, namely:––

    1. the date of payment as entered in the books of account of the recipient or the date on which the payment is debited in his bank account, whichever is earlier; or
    2. the date immediately following sixty days from the date of issue of invoice or any other document, by whatever name called, in lieu thereof by the supplier:

Provided that where it is not possible to determine the time of supply under clause (a) or clause (b), the time of supply shall be the date of entry in the books of account of the recipient of supply:

Provided further that in case of supply by associated enterprises, where the supplier of service is located outside India, the time of supply shall be the date of entry in the books of account of the recipient of supply or the date of payment, whichever is earlier.

b) Input Tax Credit:

ITC can be availed by recipient in regard to tax paid under reverse charge mechanism in case other conditions for availing the ITC are fulfilled.

Conclusion:

It is pertinent to note that date of Receipt of Services is deliberately omitted in Section 13(3) while deciding TOS in case of RCM of services visavis Date of Receipt of goods is the first criteria when TOS is decided in case of RCM of goods. It leads to clear understanding that as in cases where provision for services is made in books of accounts, but invoice has not been received by recipient / issued by supplier, accordingly the time of supply would not be attracted in case payment of any advance has not been made. Consequently, tax would not be required to be deposited by the recipient of supply. However, whenever payment is made to supplier or in case invoice is received and not paid within 60 days of the date of invoice, the 61st day would be regarded as time of supply and payment of tax would be required to be made accordingly.

However if the services are received and there is inordinate delay in receipt of Invoice it is advisable that the first proviso to Section 13(3) is referred to-

Provided that where it is not possible to determine the time of supply under clause (a) or clause (b), the time of supply shall be the date of entry in the books of account of the recipient of supply:

In case the recipient has recognized provision for expenses towards receipt of services in his books of accounts, the date of entry in books by the recipient would be regarded as time of supply and thus payment of tax would be required to be made by the supplier. This situation may be applicable in lesser cases and rather could be used as a tool by the Tax Department to raise demands.

Disclaimer:

Our conclusions are based on the completeness & accuracy of the facts stated therein & assumptions, which if not entirely complete or accurate, should be communicated to us, as the inaccuracy or incompleteness could have a material impact on our conclusions. The conclusions reached & views expressed in the note are based on our understanding of the law & regulations prevailing as of the date of this note as well as our past experience with the tax and / or regulatory authorities. However, there can be no assurance that the tax authorities or regulators will concur with our views.

Legislation, its judicial interpretation & the policies of the tax and / or regulatory authorities are subject to change from time to time & these may have a bearing on the advice that we have given. Accordingly, any change or amendment in the law or relevant regulations would necessitate a review of our comments & recommendations contained in this note. Unless specifically requested, we have no responsibility to carry out any review of our comments for changes in laws or regulations occurring after the date of this note.

Without prior permission of DMCGLOBAL SERVICES LLP, the contents of this study / note may not be quoted in whole or in part or otherwise referred to in any documents. This document is for the specific purpose and we accept no responsibility or liability to any party.

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Section 197 of Income Tax Act, 1961

Section 197 of Income Tax Act, 1961

Background & Facts:

Section 197 of the Income Tax Act, 1961 provides for the facility of NIL deduction of tax at source or at a deduction at a Lower rate of tax. To avail of this benefit the assessee whose TDS is likely to be deducted on certain receipts should make an application before the TDS Assessing Officer who has a jurisdiction over his/ her/ its case. The assessee/ deductee concerned may apply for a certificate for Nil or lower deduction of TDS on their receipts in Form No 13.

The issue under consideration is what should be rate of TDS applicable that is the Rate prescribed under various sections of the Act 192, 193, 194, 194A, 194C, 194D, 194G, 194H, 194I, 194J, 194K, 194LA, 194LBB, 194LBC, 194M and 195 of the Act hereinafter called as “Normal Rate”

OR

The lower rate as given in certificate under Section 197 of the Act when the below three events happen at different dates may be all or any prior to the date of certificate u/s 197 or all or any after the date of lower tax certificate hereinafter called as “Lower Rate”.

  • Date of Invoice
  • Date of Payment
  • Period of service provided

Our advice has been sought keeping in view:

  • Provisions of Income Tax Act, 1961 read with Income tax rules 1962
  • Circular issued by CBDT
  • Judgments of courts/Tribunal on similar issue
  • Accounting Standards as prescribed by ICAI

Analysis:

In order to further analyze the query it is imperative to quote the relevant provisions of law, Circular issued under Income Tax and Accounting Standard at this juncture –

Payments to contractors.

194C. (1) Any person responsible for paying any sum to any resident (hereafter in this section referred to as the contractor) for carrying out any work (including supply of labour for carrying out any work) in pursuance of a contract between the contractor and a specified person shall, at the time of credit of such sum to the account of the contractor or at the time of payment thereof in cash or by issue of a cheque or draft or by any other mode, whichever is earlier, deduct an amount equal to—

  1. one per cent where the payment is being made or credit is being given to an individual or a Hindu undivided family;
  2. two per cent where the payment is being made or credit is being given to a person other than an individual or a Hindu undivided family,

of such sum as income-tax on income comprised therein

Insurance commission.

194D. Any person responsible for paying to a resident any income by way of remuneration or reward, whether by way of commission or otherwise, for soliciting or procuring insurance business (including business relating to the continuance, renewal or revival of policies of insurance) shall, at the time of credit of such income to the account of the payee or at the time of payment thereof in cash or by issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax thereon at the rates in force :

Provided that no deduction shall be made under this section from any such income credited or paid before the 1st day of June, 1973.

[Provided further that no deduction shall be made under this section in a case where the amount of such income or, as the case may be, the aggregate of the amounts of such income credited or paid or likely to be credited or paid during the financial year to the account of, or to, the payee, does not exceed fifteen thousand rupees.]

Commission or brokerage.

194H. Any person, not being an individual or a Hindu undivided family, who is responsible for paying, on or after the 1st day of June, 2001, to a resident, any income by way of commission (not being insurance commission referred to in section 194D) or brokerage, shall, at the time of credit of such income to the account of the payee or at the time of payment of such income in cash or by the issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax thereon at the rate of five per cent :

Provided that no deduction shall be made under this section in a case where the amount of such income or, as the case may be, the aggregate of the amounts of such income credited or paid or likely to be credited or paid during the financial year to the account of, or to, the payee, does not exceed fifteen thousand rupees:

Fees for professional or technical services.

194J. (1) Any person, not being an individual or a Hindu undivided family, who is responsible for paying to a resident any sum by way of—

    1. fees for professional services, or
    2. fees for technical services, or
      1. b(a).any remuneration or fees or commission by whatever name called, other than those on which tax is deductible under section 192, to a director of a company, or
    3. royalty, or
    4. any sum referred to in clause (va) of section 28.

shall, at the time of credit of such sum to the account of the payee or at the time of payment thereof in cash or by issue of a cheque or draft or by any other mode, whichever is earlier, deduct an amount equal to ten per cent of such sum as income-tax on income comprised therein:

Section 197 Certificate for deduction at lower rate

(1) Subject to rules made under sub-section (2A), where, in the case of any income of any person [or sum payable to any person], income-tax is required to be deducted at the time of credit or, as the case may be, at the time of payment at the rates in force under the provisions of section 192,  193, 194, 194A, 194C, 194D, 194G, 194H, 194-I, 194J, 194K, 194LA, 194LBB, 194LBC, 194M and 195, the Assessing Officer is satisfied that the total income of the recipient justifies the deduction of income-tax at any lower rates or no deduction of income-tax, as the case may be, the Assessing Officer shall, on an application made by the assessee in this behalf, give to him such certificate as may be appropriate.

(2) Where any such certificate is given, the person responsible for paying the income shall, until such certificate is cancelled by the [Assessing] Officer, deduct income-tax at the rates specified in such certificate or deduct no tax, as the case may be.

[(2A) The Board may, having regard to the convenience of assessees and the interests of revenue, by notification in the Official Gazette, make rules specifying the cases in which, and the circumstances under which, an application may be made for the grant of a certificate under sub-section (1) and the conditions subject to which such certificate may be granted and providing for all other matters connected therewith.]

Whether certificate issued under section 197(1) will be applicable only in respect of credit or payments, as the case may be, subject to tax deduction at source, made on or after date of such certificate

CIRCULAR NO.774, DATED 17-3-1999

1 Section 197(1) of the Act envisages that, where tax is deductible at source in terms of sections 192, 193, 194, 194A, 194D, 194-I, 194K and 195 of the Income-tax Act, and the recipient justifies the deduction of tax at any lower rate or no deduction of tax to the satisfaction of the Assessing Officer, the

Assessing Officer shall issue an appropriate certificate. It has come to the notice of the Board that in certain charges a practice has developed to issue certificates under section 197(1) of the Income-tax Act even after the credit or payment of amounts subject to tax deduction at source. This is not in accordance with the provisions of law.

  1. It is, therefore, clarified that the certificate issued under section 197(1) of the Income-tax Act will be applicable only in respect of credit or payments, as the case may be, subject to tax deduction at source, made on or after the date of such certificate. Therefore, no certificate under section 197(1) of the Income-tax Act should be issued after the amounts subject to tax deduction at source stand credited or paid, whichever is earlier.
  2. In other words, henceforth, application requesting for certificate under section 197(1) should not be acted upon if submitted after credit/payment of the amount subject to tax deduction at source. However, assessees having genuine hardship in submitting such applications on time may refer to the Board for condonation of delay in terms of section 119(2)(b) of the Income-tax Act.

On perusal of each of Section that is Section 194C, 194H, 194D and 194 J the language of the law and the circular is unambiguous which states that –

“shall, at the time of credit of such income to the account of the payee or at the time of payment of such income in cash or by the issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax thereon at the rate in force”.

Thus it is very clearly defined in the law that the relevant date for considering the rate in force or the rate specified shall be the date on which credit to the account of payee or to any suspense account or by any other name

OR

at the date of payment

whichever is earlier.

Accounting Standard 9 - Revenue Recognition

  1. Effect of Uncertainties on Revenue Recognition

9.1 Recognition of revenue requires that revenue is measurable and that at the time of sale or the rendering of the service it would not be unreasonable to expect ultimate collection.

9.2 Where the ability to assess the ultimate collection with reasonable certainty is lacking at the time of raising any claim, e.g., for escalation of price, export incentives, interest etc., revenue recognition is postponed to the extent of uncertainty involved. In such cases, it may be appropriate to recognise revenue only when it is reasonably certain that the ultimate collection will be made. Where there is no uncertainty as to ultimate collection, revenue is recognised at the time of sale or rendering of service even though payments are made by instalments.

 9.3 When the uncertainty relating to collectability arises subsequent to the time of sale or the rendering of the service, it is more appropriate to make a separate provision to reflect the uncertainty rather than to adjust the amount of revenue originally recorded.

9.4 An essential criterion for the recognition of revenue is that the consideration receivable for the sale of goods, the rendering of services or from the use by others of enterprise resources is reasonably determinable. When such consideration is not determinable within reasonable limits, the recognition of revenue is postponed.

9.5 When recognition of revenue is postponed due to the effect of uncertainties, it is considered as revenue of the period in which it is properly recognised.

  1. Revenue from service transactions should be recognised when the requirements as to performance set out in paragraph 12 are satisfied, provided that at the time of performance it is not unreasonable to expect ultimate collection. If at the time of raising of any claim it is unreasonable to expect ultimate collection, revenue recognition should be postponed.
  2. In a transaction involving the rendering of services, performance should be measured either under the completed service contract method or under the proportionate completion method, whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of the consideration that will be derived from rendering the service.

Thus from above it is clearly implied that revenue against rendering of services should be recognized when the –

  1. Rendering of service is completed and
  2. Revenue is measurable and
  3. There is reasonable certainty exists regarding the ultimate collection that will be derived from rendering the service.

Now different type of Scenarios could be tabulated as under –

S. NoParticularsType of TDS Applicable
1.Services are completed before cutoff date however Uncertainty exist regarding ultimate collection or the revenue is not measurable till the cutoff date and the invoicing is done after cutoff dateLower Rate
2.Services are completed before cutoff date and there is uncertainty of ultimate collection till cutoff date though the revenue is measurable before cutoff date and the invoicing is done after cutoff date

 

Lower Rate
3.Services are completed before cutoff date and there is reasonable certainty of ultimate collection and the revenue is measured. Also the Invoice is raised before the cutoff date but the customer has booked the invoice on or after cutoff dateThis is debatable. Strictly according to interpretation of law which speaks of credit or payment whichever is earlier and not provision of service this should be lower rate however this could be contested by Income Tax Authorities if or otherwise there is malafide intention observed  to get TDS deducted at lower rate.
4.Services are completed on or after cutoff date and invoicing and payment is on or after cut off dateLower Rate
5.Services are completed before Cutoff date and Invoice is also credited in customer books or advance is paid before cutoff date.Normal Rate

Disclaimer:

Our conclusions are based on the completeness & accuracy of the facts stated therein & assumptions, which if not entirely complete or accurate, should be communicated to us, as the inaccuracy or incompleteness could have a material impact on our conclusions. The conclusions reached & views expressed in the note are based on our understanding of the law & regulations prevailing as of the date of this note as well as our past experience with the tax and / or regulatory authorities. However, there can be no assurance that the tax authorities or regulators will concur with our views.

Legislation, its judicial interpretation & the policies of the tax and / or regulatory authorities are subject to change from time to time & these may have a bearing on the advice that we have given. Accordingly, any change or amendment in the law or relevant regulations would necessitate a review of our comments & recommendations contained in this note. Unless specifically requested, we have no responsibility to carry out any review of our comments for changes in laws or regulations occurring after the date of this note.

Without prior permission of DMCGLOBAL SERVICES LLP, the contents of this study / note may not be quoted in whole or in part or otherwise referred to in any documents. This document is for the specific purpose and we accept no responsibility or liability to any party.

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Section 14A read with Rule 8D under Income Tax Act, 1961

Section 14A read with Rule 8D under Income Tax Act, 1961

Introduction and Legislative History of Section-14A

Section 14A is a disallowance provision. This section provides that while computing the total income of any assessee, no deduction will be permitted in respect of any expense incurred in relation to any income which is exempt from income tax.

Position prior to the introduction of Section 14A:

Prior to the introduction of section 14A, the nature of the business was an important factor for determining the disallowance of expenditure incurred on earning exempt income. The businesses were broadly classified into two categories:

  • a composite and indivisible business; or
  • a divisible business

The settled law at the material time was that, when an assessee has a composite and indivisible business i.e. the business has elements of both taxable and non-taxable income, the entire expenditure in respect of the said business is deductible and, in such a case, the principle of apportionment of the expenditure relating to the non-taxable income did not apply.

However, where the business was divisible, the principle of apportionment of the expenditure was applicable and the expenditure apportioned to the ‘exempt’ income or income not liable to tax, was not allowable as a deduction.

Objective behind insertion of Section 14A with retrospective effect:

The basic principle of taxation is to tax the net income, i.e. gross income minus the expenditure and on the same analogy the exemption, if any, is also in respect of net income. In other words, where the gross income did not form part of total income, its associated or related expenditure also, could not be permitted to be debited against other taxable income.

The stated intention of the Parliament, while introducing section 14A, was that it should appear in the statute book, right from its inception that, expenditure incurred in connection with income, which does not form part of total income is not intended to be allowed as a deduction. By introducing this section retrospectively, the Parliament was only acting on this intention.

It can be said that the insertion of section 14A with retrospective effect reflects a serious attempt on the part of the Parliament not to allow deduction in respect of any expenditure incurred by the assessee in relation to income, which does not form part of the total income under the Act against the taxable income. It is understood that in the case of an income like dividend income which does not form part of the total income, any expenditure/deduction relatable to such (exempt or non-taxable) income, even if it is of the nature specified in sections 15 to 59 cannot  be allowed against any other income which is includible in the total income.

Analysis of Tax on Exempt Income u/s 14A Read with Rule 8D under Income Tax Act, 1961:

  1. Section 14 is the first provision under this Chapter- IV and enumerates five heads of income within which all incomes are to be classified. Under the scheme of the Act, certain types of incomes are exempt from tax and, in this behalf, specific provisions are made stipulating that such incomes would not form part of the total income under the Act, they are not included under any of the heads of income and, therefore, no taxes are levied on such exempted incomes. It is in this backdrop, that Section 14A of the Act clarifies that if any expenditure is incurred in earning that income which does not form part of the total income, such expenditure shall also not be allowed as deduction.
  2. Section 14A of the Income-tax Act, 1961 (‘Act’) was introduced by the Finance Act, 2001 with retrospective effect from 1 April 1962, which is as under:

“Section 14A – For the purposes of computing the total income under this Chapter, no deduction

shall be allowed in respect of expenditure incurred by the assessee in relation to income which

does not form part of the total income under this Act.”

It is well established governing principle of income tax act where it is very clear not to tax-exempt income, however, it is always a part of the dispute in between taxpayer and department regarding allow or not to allow expenses incurred for exempt income. Over time, based on various issue and its decision as of now, the government has already notified the section 14A but due to initiation of provision with the statement “No deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under this Act.]” is always been problematic for both assessee and officer. Therefore Rule 8D come into the picture to analyses the allowance and disallowance of expenditure incurred for exempt income by assessed.

It starts with “No”, means in a first instance whatever may be the expenses incurred for exempt income deduction is not allowed. Therefore in most of the cases Assessing Officer is always of concern to disallow the expenditure in totality irrespective the fact of involvement of exempt income on totality in the computation of income and tax thereon. In the 2 instance of the provision of Income-tax stated in Section 14A, Assessing Officer should follow Rule 8D to determine the amount of expenditure incurred in relation to such exempt income.

Section-14A:

[Expenditure incurred in relation to income not includible in total income]

[(1)] For the purposes of computing the total income under this Chapter, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under this Act.]

[(2)] The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under this Act. 

[(3)] The provisions of sub-section shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act.

[Provided that nothing contained in this section shall empower the Assessing Officer either to reassess under section 147 or pass an order enhancing the assessment or reducing a refund   already made or otherwise increasing the liability of the assessee under section 154, for any assessment year beginning on or before the 1st day of April, 2001.]

Rule-8D:

(Method for determining amount of expenditure in relation to income not includible in total income)

(1) Where the Assessing Officer, having regard to the accounts of the assessee of a previous year, is not satisfied with—

         (a) the correctness of the claim of expenditure made by the assessee; or

         (b) the claim made by the assessee that no expenditure has been incurred,

in relation to income which does not form part of the total income under the Act for such previous year, he shall determine the amount of expenditure in relation to such income in accordance with the provisions of subrule (2).

22 [(2)] The expenditure in relation to income which does not form part of the total income shall be the aggregate of following amounts, namely:—

  • the amount of expenditure directly relating to income which does not form part of total income; and
  • an amount equal to one per cent of the annual average of the monthly average of the opening and closing balances of the value of investment, income from which does not or shall not form part of total income :

Provided that the amount referred to in clause (i) and clause (ii) shall not exceed the total expenditure claimed by the assessee.]

21.Inserted by the IT (Fifth Amdt.) Rules, 2008, w.e.f. 24-3-2008.

  1. Sub-rule (2) substituted by the Income-tax (Fourteenth Amendment) Rules, 2016, w.e.f. 2-6-2016. Prior to its substitution, said sub-rule, as inserted by the IT (Fifth Amdt.) Rules, 2008, w.e.f. 24-3-2008, read as under:

“(2) The expenditure in relation to income which does not form part of the total income shall   be the aggregate of following amounts, namely:—

        (i) the amount of expenditure directly relating to income which does not form part of total  income;

        (ii) in a case where the assessee has incurred expenditure by way of interest during the    previous year which is not directly attributable to any particular income or receipt, an amount computed in accordance with the following formula, namely:—

                                                                A × B /C

              Where A = amount of expenditure by way of interest other than the amount of interest included in clause (i) incurred during the previous year;

B = the average of value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year;

              C = the average of total assets as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year;

       (iii) an amount equal to one-half per cent of the average of the value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year.”

  1. Sub-rule (3) omitted by the Income-tax (Fourteenth Amendment) Rules, 2016, w.e.f. 2-6-2016. Prior to its omission, said sub-rule, as inserted by the IT (Fifth Amdt.) Rules, 2008, w.e.f. 24-3-2008, read as under:

“(3) For the purposes of this rule, the “total assets” shall mean, total assets as appearing in the balance sheet excluding the increase on account of revaluation of assets but including the decrease on account of revaluation of assets.”

We find two sets of wordings in the sub-section (1) of Section 14A these are given in first column and in second column significance is discussed:

 

           Word Used            Significance
total income under this Chapter,This expression is used in relation to total income of assessee which is computed as per provisions of the Chapter IV that is Sections 14- 59.

 

which does not form part of the total income under this Act.It means any income on which tax is not imposed under the entire Act whether directly or indirectly.

This also indicates that for invoking disallowance under section 14A, it is not material that assessee should have earned such exempt income during the financial year under consideration.

The Assessing Officer shall determine the amount of expenditure incurred in relation to

such income which does not form part of the total income under this Act

The AO can determine disallowable expenditure only when any ‘income does not form part of total income under the Act’ and not merely when any income is not included in total income of assessee.

It becomes imperative to update oneself with the currently prevailing view / decision on the various aspects of section 14A / Rule 8D litigation.

Section 14A was inserted by Finance Act 2001 with retrospective effect from 1 April 1962. The Supreme Court in the case of Rajasthan State Warehousing Corpn. v. CIT [2000] 109 Taxman 145/242 ITR 450 had held that the expenses incurred wholly or exclusively for carrying out indivisible business cannot be apportioned artificially between taxable and non-taxable income, and accordingly, entire expenditure is allowable as a deduction. In a pre-introduction of the Section14A regime, where the business was divisible, the principle of apportionment of the expenditure was applicable and the expenditure apportioned to the ‘exempt’ income or income not liable to tax, was not allowable as a deduction. The provision of Section 14A of the Income Tax Act, 1961 (the Act) was thus inserted to overrule the said Supreme Court ruling and clearly lays down the intent that any expenditure incurred by the taxpayer in relation to income which does not form part of total income (exempt income), is not allowed as a deduction.

Sub-sections (2) and (3) were inserted in section 14A by the Finance Act, 2006. As per Section 14(2) of the Act, if the Assessing Officer is not satisfied with the claim of the taxpayer, the Assessing Officer shall determine the amount of expenditure to be disallowed under Section 14A of the Act in accordance with Rule 8D of the Income Tax Rules, 1962 (‘the Rules’). Further, as per Section 14(3) of the Act, the provisions of Section 14(2) of the Act shall also apply if the taxpayer claimed that no expenditure has been incurred in relation to the exempt income.

There has been a plethora of issues in litigation relating to the applicability of Section 14A of the Act and also apportionment of the expenditure incurred in relation to earning the exempt income. Recently, the Supreme Court, in a landmark decision in the case of Maxopp Investment Ltd. v. CIT [2018] 91 taxmann.com 154, has laid down the law with applicability of Section 14A of the Act in the case of investments made by entities with controlling interest in a company (i.e. strategic investments)/investment for trading purposes (i.e. held as stock-in-trade).

Judicial Pronouncements:

Sr. No.Name of the decision and citation where reportedIssue under

Consideration

 

Direction / decision of the Court

1.Maxopp Investment  Ltd.v/s. CIT [2018] (SUPREME COURT)

 

 

 

 

 

 

 

Applicability of section 14A to shares held to gain controlling interest / in group companies /as stock-in tradeThe Supreme Court has held that while determining the disallowance, the dominant purpose or the intention while making the purchase of such investment is not relevant.

 

If an income is considered exempt, expenses  incurred for earning such Dividend income have to appropriately apportioned and disallowed.

 

The Supreme Court has also held that when the shares are held as stock-in-trade, dividend income is earned, which is exempt under  section 10(34) of the Act. The same also triggers applicability of Section 14A of the Act and the depending upon the facts of each case, expenses have to be apportioned between taxable and non-taxable income.

Key Takeaway:

In light of this unequivocal view of the Supreme Court, arguments made to justify the business needs for making the investment to avoid disallowance under section 14A is no longer available and one will have to fall back / explore other arguments depending on the facts of its case.

2.Godrej & Boyce Manufacturing   Company Ltd. v/s. DCIT [2017] (SC)Applicability of disallowance under section 14A in the case of dividend income on which tax is payable under section 115-OSupreme Court ruled in favour of Revenue and held that section 14A of the Act would apply to dividend income on which tax is payable under section 115-O since the liability to pay tax under section 115-O in respect of the dividend is on the dividend paying company and the shareholder / assessee has no connection with the same.
Key Takeaway:

What is necessary for invoking the disallowance is the exemption of dividend income in the hands of the shareholder.

Discussion on the decision of Hon'ble Mumbai ITAT in case of Asha Lalit Kanodia v. Additional Commissioner of Income-tax, Range-12 (2), Mumbai

Section 14A of the Income-tax Act, 1961, read with rule 8D of the Income-tax Rules, 1962 – Expenditure incurred in relation to income not includible in total income (Onus of proof) – Assessment year 2008-09 – Assessee had earned tax-exempt income, being dividend on units, shares and securities and long-term capital gain – She had also earned exempt dividend income from proprietary concern – Assessing Officer made disallowance under section 14A, read with rule 8D(2)(iii), i.e., toward indirect administrative expenditure discarding assessee’s contention that no expenditure had been incurred by her – Whether since assessee had claimed that no expenditure was incurred to earn exempt dividend income, onus was on assessee which had to be substantiated with her accounts – Held, yes – Whether since assessee failed to discharge her onus, disallowance made under section 14A, read with rule 8D was justified – Held, yes (Para 4.4) [In favour of revenue]

Facts of the Case:

“The assessee earned tax-exempt income, being dividend on units, shares and securities and long-term capital gain (LTCG). The assessee had also earned another sum as dividend income in a proprietary concern, DFSS Ltd. and claimed exemption under section 10(34). The disallowance effected by the Assessing Officer was under section 14A, read with rule 8D(2)(iii), i.e., toward indirect administrative expenditure, for which the rule prescribes a rate of 0.5 per cent of the relevant investment held during the year.

■ On the assessee’s appeal, the Commissioner (Appeals) confirmed the disallowance.

■ Before the Tribunal, the assessee contended that:

– No expenditure had been incurred by the assessee in the first place. The assessee had maintained two sets of accounts, i.e., for personal transactions and her business of recruitment agency. No expenditure had been claimed in the personal accounts, reflecting an investment in tax-free securities, i.e., securities yielding or liable to yield income which is tax-exempt, the direct expenditure in the form of depository charges and securities transaction tax/service charges being debited to her capital account.

– As regards the accounts of the business, as evident from the balance sheet (as on 31.3.2008) of

DFSS Ltd., the expenditure pertained only to the assessee’s business.

– There could be no presumption with regard to the assessee having incurred expenditure in relation to the income not forming part of the total income, i.e., merely because the assessee had earned such income.

– The Assessing Officer could not proceed mechanically to apply rule 8D, but had to record his dissatisfaction with the correctness of the assessee’s claim, giving cogent reason for not accepting the same.”

Held:

“Clearly, it is only where the expenditure has been incurred in the first place, that there could be a disallowance u/s. 14A, which is only of expenditure – direct or indirect, incurred by the assessee, in-so-far as and to the extent it relates to the income not forming part of the total income, i.e., qua the activity yielding or liable to yield such income. The statement is in fact axiomatic, on which there could be no dispute or two views. The question is one of onus. True, a claim by the assessee, including as to no expenditure having been incurred, is to be rebutted by the A.O. where not satisfied, with reference to the assessee’s accounts. This is as only its’ accounts could reveal the existence of expenditure – direct or indirect, that could be said to be incurred by the assessee toward or in pursuing such activity. The assessee’s claim, however, cannot be a bald claim, made in the face of expenditure being incurred and claimed. How could, one may ask, the correctness of a bald claim be examined? Such a claim has no sanction in law, and no cognizance could be given therein to it. It is only where the claim, again, with reference to its accounts, is made by the assessee that the A.O. could, having regard thereto, examine the same as to its correctness and express his satisfaction or, as case may be, dissatisfaction therewith, proceeding to invoke rule 8D in case of the latter. Rule 8D is toward an estimation of such expenditure, and mandatory in its application, so that the A.O. has no discretion in the matter once the rule gets attracted. The plea of no expenses having been incurred cannot, therefore, be lightly made, much less without any substance, as in the present case. It is toward this that the assessee’s accounts are relevant and gain primacy. The disallowance u/s. 14A, it needs to be appreciated, is a statutory disallowance. The issue also has been examined, in the fact situation of the given case by the tribunal in different decisions, and toward which we may advert to its order in AFL (P.) Ltd. v. Asstt. CIT [2013] 60 SOT 63/37 taxmann.com 274 (Mum. – Trib.), reproducing from its relevant part:

‘6.3 It is, therefore, clear that the initial onus, even as stated by the ld. CIT (A), to make a claim in respect of the expenditure incurred in relation to the income that does not form part of the total income, is on the assessee. Once the assessee makes such a claim with reference to its accounts, the A.O. is bound to examine the same for the purpose of satisfying himself with regard to its correctness or otherwise, and where not satisfied, determine the same in accordance with the prescribed method. Further, therefore, though there is no specific requirement of recording dissatisfaction, it is incumbent on A.O. to do so, as in its absence it cannot be ascertained if he had actually examined the assessee’s claim or proceeded mechanically. Two, his order being appealable, it is only where it bears his reasons, could the validity thereof and, thus, of his action of disallowance u/r. 8D, be subject to judicial review. It is in this context that it has been held that the said dissatisfaction has to be explicit and informed. The same, thus, is not a jurisdictional requirement, but toward completing the inbuilt fairness of the procedure as provided for. The requirement of recording dissatisfaction predicates on the discharge of the onus cast on the assessee, and which may not always obtain. The Revenue on its part could only extend opportunity to the assessee for the discharge of the said onus. In a particular case, the assessee may not produce the accounts. How could the A.O. possibly verify the correctness of the assessee’s claim in such a case? In another, the assessee does not state the basis of its claim or makes the same de hors the expenses incurred and claimed. The A.O. could not possibly verify the correctness of such an incoherent or infirm claim.

True, no disallowance would ensue in the absence of any nexus or proximity between the expenditure and the related activity. The law does not presume a nexus or proximity – which is a matter of fact; but where one is inferable or not excluded on the facts, sanctions apportionment of the expenditure. This aspect stands abundantly clarified by the Hon’ble jurisdictional High Court in Godrej & Boyce Mfg. Co. Ltd. v. Dy. CIT [2010] 328 ITR 81/194 Taxman 203 (Bom.), on which extensive reliance is placed, stating that the theory of apportionment has since been widened, i.e., by the introduction of section 14A, further relying on the decision in the case of CIT v. Walfort Shares & Stock Brokers (P.) Ltd. [2010] 326 ITR 1/192 Taxman 211 (SC). Reliance toward this is also placed on the decisions by the tribunal, as in the case of Dy. CIT v. Damani Estates & Finance (P.) Ltd. [2014] 41 taxmann.com 462 (Mum. – Trib.) and Kunal Corpn. v. Asstt. CIT [2015] 55 taxmann.com 339 (Mum. – Trib.).

4.4 Under the circumstances and, in view of the foregoing, we find little merit in the assessee’s case and, accordingly, uphold that of the Revenue, dismissing the assessee’s appeal. We decide accordingly.”

Discussion on the decision of Hon'ble Amritsar ITAT in case of Lally Motors India (P.) Ltd. v. Pr. CIT

“This decision of ITAT which is in favour of Department has come in a period when various Courts are deciding the issue in favour of Assessees. The Hon’ble Court has held as under: “Section 14A of the Income-tax Act, 1961 – Expenditure incurred in relation to income not includible in total income (Scope of) – Assessment year 2012-13 – Whether applicability of section 14A does not hinge on actual earning of tax-exempt income – Held, yes – Assessee made investment in shares – Assessee claimed that it had not earned any income by way of dividend on

said shares, thus, section 14A would not apply – Further, it had not incurred any expenditure in relation to said investment in shares, so that section 14A would even otherwise would not apply –

It was noted that assessee firm had negative net worth during relevant year and entire investment was financed by borrowed capital and, administrative expenditure was incurred by assessee – Whether section 14A would apply even if no tax-exempt income (i.e., income not forming part of total income) had in fact been earned, as long as expenditure was incurred for earning such income – Held, yes – Whether, therefore, administrative expenses incurred on money borrowed for investment in shares, which had not yielded any dividend, was not to be allowed – Held, yes [Para 4.2] [In favour of revenue]”

“The second, equally relevant, aspect of the matter is if the provision could be invoked in the absence of any tax-exempt income. Toward this, while the Pr. Commissioner relies on the Board

Circular 5/2014, the assessee was during hearing at pains to emphasize that the same stands since ‘torn apart’ by the High Courts, so that it is bereft of any value. On being asked if the same had been set aside or stayed by any High Court, he would though admit of it being not the case. The question is not which of the two is correct (view) or more correct, but if same is binding on the A.O. as an Assessing Authority. The reason is simple. The Assessing Officer, despite an order by the revisionary authority directing him to do so, cannot pass an order consistent with the Board Circular where the same has been struck down by a competent court, unless, of course, the same stands, at the same time, upheld by the jurisdictional High Court. In fact, even a decision by the said court (or by the Apex Court) contrary to the dictum of the said Circular, i.e., without it being stayed or struck down by any court, shall have same effect, so that the said circular would in that case loose its binding force on the Assessing Officer. Further, a decision by a non-jurisdictional High Court shall not have the same effect inasmuch as the same is not binding on the Assessing Officer. No such decision by either the jurisdictional High Court or the Apex Court has been brought to notice. The moot question therefore is if the said Circular is in conformity with the law.

The principle that it is the net income, i.e., net of expenditure relatable thereto, which is subject to tax and, correspondingly, not liable to tax, i.e., where it does not form part of the total income, is well established. Equally well settled is the principle that once an income is liable (or not liable) to tax, all expenditure relatable thereto is to be reckoned, and it matters little that the said expenditure has indeed resulted in a positive income, or in whatever sum. It is in fact this, i.e., the expenditure being higher than the gross income, which could be nil, that leads to the phenomenon of loss, which could therefore be across both the categories income, i.e., taxable or non-taxable, being essentially a matter of fact. The interpretation of the words ‘for earning such income’ stands already settled by the Apex Court in Rajendra Prasad Moody’s case (supra). To therefore recognize relatable expenditure where it fructifies in a positive income is misconceived. It is, it may be appreciated, the quality of the expenditure that determines its deductibility and not its quantum or effect, i.e., where it stands incurred for the stated purpose. Given the premise of section 14A, i.e., to exclude income not forming part of the total income in computing the ‘total income’, with a view to determine the latter correctly, and the two principles afore-referred, the proposition under reference, i.e., to exclude all expenditure relatable to the earning of income not forming part of the total income, irrespective of its quantum, becomes axiomatic, even as noted by the Hon’ble Apex Court in Maxopp Investment Ltd.’s case (supra). Para 32 thereof reads as under:

’32. In the first instance, it needs to be recognized that as per section 14A(1) of the Act, deduction of that expenditure is not to be allowed which has been incurred by the assessee “in relation to income which does not form part of the total income under this Act”. Axiomatically, it is that expenditure alone which has been incurred in relation to the income which is (not) includible in total income that has to be disallowed. If an expenditure incurred has no causal connection with the exempted income, then such an expenditure would obviously be treated as not related to the income that is exempted from tax, and such expenditure would be allowed as business expenditure. To put it differently, such expenditure would then be considered as incurred in respect of other income which is to be treated as part of the total income.’

Where, one wonders, then, is the scope for two views. Relying extensively on its decision in Walfort Share & Stock Brokers (P.) Ltd.’s case (supra), the Apex Court upheld the theory of apportionment, discountenancing the theory of predominant object. The uncertainty of earning the dividend income, or of it being earned incidentally, was also noted by it, though to no moment. It was immaterial if dividend income was actually earned or not, which, rather, may be a consideration where the shares, as in the present case, are held to retain control over the investee company, i.e., for strategic reasons, as was the case with regard to the investment by Maxopp Investment Ltd. – one of the assessees in that case. The related expenditure has to be reckoned on an expansive basis, i.e., as attributable thereto. The constitutionality of r.8D, providing for rules of apportionment of both direct and indirect expenditure, stands already upheld by the Hon’ble High Court in Godrej & Boyce Mfg. Co. Ltd. (supra). Earlier, in Godrej & Boyce Mfg. Co. Ltd. v. Dy. CIT [2017] 81 taxmann.com 111/247 Taxman 361/394 ITR 449 (SC), with reference to the language of section 14A, the title of which is itself clarificatory, the Apex Court clarified that income must not be includible in the total income, so that once this condition is satisfied, the expenditure incurred in earning the same cannot be allowed to be deducted. The AO in the present case has clearly failed to apply the law in the matter, which gets reiterated time and again by the Hon’ble Apex Court.

In view of the foregoing, there is no merit in the assessee’s case. The impugned order is upheld both on the aspect of lack of inquiry by the Assessing Authority, as well as his non-observance of the Board Circular 5/2014, which one has found to be in consonance with the law as explained by the Apex Court. The impugned order being after the date of amendment (by way of Explanation 2) to section 263, i.e., 1-6-2015, the same is an equally valid ground for the exercise of revisionary power under section 263. It is this power, i.e., to deem an order as erroneous in-so-far as it is prejudicial to the interests of the revenue, that stands conferred with effect from 1-6-2015. That is, the law, with effect from 1-6-2015, deems an order as so, where any of the circumstances specified is, in the opinion of the competent authority, satisfied. It has nothing to do with the date of the passing of the order deemed erroneous, or the year to which it pertains. Being a part of the procedural law, the provision shall have effect from 1-6-2015. The assessment does not represent a correct application of the law, furnishing one more ground, albeit parimateria, for the assessment being liable for revision under section 263. [Para 6]”

(b) In the above referred to decision the Hon’ble ITAT has also referred to decision of the Hon’ble Supreme Court in the case of Maxopp Investment Ltd. v. CIT [2018] 91 taxmann.com 154/254 Taxman 325 and relevant part of said decision is reproduced herein below.

“Reference in this regard may finally be made to the recent decision by the Hon’ble Apex Court in Maxopp Investment Ltd. v. CIT [2018] 91 taxmann.com 154. For our purposes, para 3 of the

Judgment is of prime relevance, and which we reproduce as under:

‘3. Though, it is clear from the plain language of the aforesaid provision that no deduction is to be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under the Act, the effect whereof is that if certain income is earned which is not to be included while computing total income, any expenditure incurred to earn that income is also not allowed as a deduction. It is well known that tax is leviable on the net income.

Net income is arrived at after deducting the expenditure incurred in earning that income. Therefore, from the gross income, expenditure incurred to earn that income is allowed as a deduction and thereafter tax is levied on the net income. The purpose behind Section 14A of the Act, by not permitting deduction of the expenditure incurred in relation to income, which does not form part of total income, is to ensure that the assessee does not get double benefit. Once a particular income itself is not to be included in the total income and is exempted from tax, there is no reasonable basis for giving benefit of deduction of the expenditure incurred in earning such an income. For example, income in the form of dividend earned on shares held in a company is not taxable. If a person takes interest bearing loan from the Bank and invests that loan in shares/stocks, dividend earned therefrom is not taxable. Normally, interest paid on the loan would be expenditure incurred for earning dividend income. Such an interest would not be allowed as deduction as it is an expenditure incurred in relation to dividend income which itself is spared from tax net. There is no quarrel upto this extent.’ (Emphasis, Ours) The principle behind section 14A and its applicability, and toward which the Hon’ble Court cites an example – which is the same as that obtains in the present case, is so well established that the Apex Court itself finds the same as settled and not disputed. The applicability of sec. 14A does not hinge on the actual earning of the tax-exempt income………………………..”

(c) The Hon’ble ITAT has referred to Circular 5/2014 and held that disallowance under Section 14A can be made even if no exempt income is earned. In the above referred case, facts as discussed by Hon’ble ITAT in para 3 are that assessee has made investment in shares but has not earned any exempt income. During the course of assessment proceedings, assessee has relied upon decision of Hon’ble Delhi High Court in the case of Cheminvest Ltd. (supra) and same was accepted by AO as he did not make any disallowance. However, in Section 263 proceedings, Principal CIT has referred to Circular No. 5/2014 issued by CBDT and directed AO to re-examine the issue of disallowance under Section 14A. With reference to such circular the Hon’ble ITAT has held: “The A.O., despite an order by the revisionary authority directing him to do so, cannot pass an order consistent with the Board Circular where the same has been struck down by a competent court, unless, of course, the same stands, at the same time, upheld by the Hon’ble jurisdictional High Court. In fact, even a decision by the said Court (or by the Hon’ble Apex Court) contrary to the dictum of the said Circular, i.e., without it being stayed or struck down by any court, shall have same effect, so that the said Circular would in that case loose its binding force on the AO. Further, a decision by a non-jurisdictional High Court shall not have the same affect in-as-much as the same is not binding on the AO”

Discussion on the decision of Hon'ble Mumbai ITAT in case of D.H. Securities (P.) Ltd. v. Deputy Commissioner of Income-tax -4(1):

Section 14A of the Income-tax Act, 1961 read with rule 8D of the Income-Tax Rules, 1962 – Expenditure incurred in relation to income not includible in total income [Shares] – Assessment year 2008-09 – Whether disallowance under section 14A can be made even in cases where dividend income has been earned on shares held as stock-in-trade – Held, yes [Para 12][In favour of revenue]

Facts of the Case:

These are cross appeals, i.e., by the Assessee and the Revenue, in respect of the assessee’s assessment for the assessment year (A.Y.) 2008-09 vide order u/s. 143(3) of the Income-tax Act, 1961 (‘the Act” herein) dated 30.11.2010, following the order by the first appellate authority, being the Commissioner of Income Tax (Appeals)-8 Mumbai (‘CIT(A)’ for short) dated 11.05.2011.

The Revenue’s Appeal (ITA No. 5163 /Mum/2011)

  1. The only issue raised in the Revenue’s appeal is the non-allowance of the credit of Securities Transaction Tax (STT) u/s. 88E of the Act in view of the assessee’s tax liability for the current year being determined u/s 115 JB of the Act. In view of the Assessing Officer (AO) the said rebate in tax would only arise where the assessee’s tax liability is worked out under the regular provisions of the Act. The ld. CIT(A) has allowed the assessee’s claim in its respect following the decision by the Tribunal in the case of Horizon Capital Ltd. v. ITO [IT Appeal No. 592(Bang.) of 2010 dated 16.07.2010] discussing the matter in detail vide paras 2.1 to 2.3 (pages 4-8) of his order

The argument as being advanced in the instant case stood also raised in the case of Daga CapitalManagement (P.) Ltd. (supra); in fact, finding favour with the dissenting member of the constitution, though did not find approval of the larger Bench. The said decision stands impliedly approved in Godrej & BoyceMfg. Co. Ltd. (supra); the hon’ble court striking it down insofar only as the retrospective operation of rule 8D is concerned.

In fact, as its reading would show, Rule 8D putting in place or articulating a method for estimating the expenditure that can be regarded as relating to income that does not form part of the total income, was also responsible for the Hon’ble court for holding that the said rule is not retrospective. Further, what better proof of pudding than in its eating? Rule 8D, which only seeks to give effect to the provision of section 14A(1), since held as constitutionally valid by the hon’ble court, only seeks to apportion not only direct but also indirect expenditure, so that the latter also falls within the scope of the words ‘in relation to’ occurring in section 14A(1). Reference in this context may also be drawn to the discussion by the hon’ble court under the head lC5 The order of restoration passed by the Tribunal’ at pages 134 to 137 of the judgment. Repelling the argument that investment in shares yielding tax free dividend income has been made out of the own funds, so that no interest expenditure has been incurred in relation to the dividend income, it clarified that the said fact was no longer dispositive of the matter, and that, even so, a disallowance in respect of interest would have to be made, and no presumption of investment of own funds, on ground of its sufficiency, could be drawn, distinguishing its own decision in the case of CIT v. Reliance Utilities & Power Ltd. [2009] 313 ITR 340/178 Taxman 135 (Bom.); its relevant observations (at placitum 5, pg. 135) reading as under :

     “In all these decisions, the Tribunal held that no nexus had been established between borrowed funds and investments by the assessee in dividend yielding shares/income yielding mutual funds. Now assuming that this is so, the only conclusion which emerges is that the assessee had utilized its own funds for the purpose of making the investments. The fact that the assessee has utilized its own funds in making the investments would not be dispositive of the question as to whether the assessee had incurred expenditure in relation to the earning of such income. Even if the assessee has utilized its own funds for making investments which have resulted in income which does not form part of the total income under the Act, the expenditure which is incurred in the earning of that income would have to be disallowed. That is exactly a matter which the Assessing Officer has to determine.”

6.5 We may now come to the actual apportionment, for which rule 8D has been provided and, as held in the case of Godrej & BoyceMfg. Co. Ltd. (supra), operative w.e.f A.Y. 2008-09. At the outset, though, we may set at rest an argument by the assessee that rule 8D, which is mandatory, would not apply in a case where the shares are held as stock-in-trade. That is, even though section 14A may be applicable, rule 8D would not be inasmuch as words used in the rule, specifying the apportionment formula, is the ‘value of investment’, so that it would apply only where the shares are held as investment. Reliance has been placed in the matter on the decision in the case of Dy. CIT v. Gulshan Investment Co. Ltd. [2013] 142 ITD 89/31 taxmann.com 113

(Kol.). This argument was specifically taken before the Special Bench in the case of Daga CapitalManagement (P.) Ltd. (supra), and rejected by the Tribunal, clarifying that the words used are ‘value of investment’ and not ‘held as investment’. We may reproduce the relevant part of the order for the sake of better clarity: (pg. 233 of the report in ITD)

 “23.9 The learned Counsel for the assessee…………….. We are not impressed with this submission raised on behalf of the assessee for the out-and-out reason that the reference in this rule is to the ‘value of investment’ and not the assets ‘held as investment’. A person may make investment in shares and the shares so purchased may be held either as “Stock-in-trade’ or ‘Investment’. The word ‘investment’ in this rule refers to the making of purchase of shares and not holding it as investment.”

Continuing further, with regard to the actual apportionment of costs, we find that rule 8D(2), which provides the formula for apportionment; rule 8D(1) stating the basis for the application of rule 8D itself, consists of three parts, each in relation to a separate set of expenditure. The first sub-clause (i) is in respect of direct expenditure relating to income which does not form part of the total income. The second, i.e., sub-clause (ii), concerns the interest expenditure (other than that directly attributable to any particular income or receipt), while sub-clause (iii), which is qua indirect expenditure, provides for an amount equal to one half per cent of the average value (as appearing in the books of account) of the investment, income from which does not form part of the total income. The rule is self- explanatory. There could be no quarrel with regard to the allocation of direct expenditure, which in fact states the obvious, and would in any case warrant a disallowance, i.e., even in the absence of the rule. Similarly, the part of the rule prescribing the ratio in respect of indirect expenditure (rule 8D(2)(iii)) cannot be altered on account of (say) hardship. This is as the rule prescribes the same as the ratio of indirect expenditure required to support an investment. In fact, the same, at 0.5%, is very nominal, recommending itself to an easy acceptance, eschewing the charge of being harsh. It is the third component, qua interest expenditure in rule 8D(2)(ii), which, however, presents a problem in the instant case.

This is as the same, as would be readily seen, seeks to quantify the interest on the investments, income from which is not taxable, on a proportionate basis, and which though is not only understandable, but as appropriate and justifiable as a general formula could be. However, in the instant case, shares, which yield the tax exempt dividend income, interest qua which is to be disallowed, being held as stock-in-trade, also yield share trading income, which is taxable. Therefore, to say that the entire interest relatable to the average share holding is to be attributed to the tax exempt dividend income would be patently incorrect on facts. That, in fact, the shares are bought and held primarily for share trading income, further accentuates the apparent incongruity of the situation arising on the mechanical application of r. 8D(2)(n). Clearly, therefore, the amount as per rule 8D(2)(ii) would need to be scaled down, bifurcating the expenditure so arrived at as between these two incomes. As regards the ratio of such scaling down, no hard and fast rule for the purpose would hold, each fact situation being different. However, considering that the dominant objective of the share holding, which in our view should be dispositive of the matter, is the share trading income, we propose a ratio of 20% toward the tax exempt dividend income. One could argue that the percentage suggested by us is ad hoc or not scientific. We have already explained that an indirect expenditure, including interest, has no direct relation with the income, much less its quantum, allocating it on the basis of the income generated or arising would not be appropriate, and neither does rule 8D support the same. Further, that in arriving at the suggested rate of 20%, we have been guided principally by the fact that the share trading is the dominant object of the share holding. We also consider it pertinent to mention though the average share holding would be the same, the share composition, in view of the share trading activity, would vary continuously; the turnover for a year being easily in the range of 4 to 5 times the average share holding. Accordingly, in arriving at the disallowance under rule 8D, the amount as per rule 8D(2)(ii) would stand to be restricted to 20% thereof. Further, as regards the legal mandate for the same, we have again already clarified of the manifestly incorrect, if not absurd results that would otherwise follow. In fact, in our view, the language of rule 8D(2)(ii) itself provides the mandate inasmuch as it prescribes or authorizes a disallowance only qua investment income from which is not taxable, so that in limiting the amount worked out with reference to the total investment; the same also yielding taxable income, we have only sought to operationalize the said rule. It would also be appreciated that not doing so would also violate the principle of only net income (from any source) being subject to tax inasmuch as a disallowance for the total interest as per rule 8D(2)(ii) would in effect bring the share trading income to tax without deduction of the interest expenditure allocable or attributable thereto.

Supreme Court: Section 14A is applicable to dividend income irrespective of Dividend Distribution Tax (DDT) payment :

Section 14A of the Income Tax Act, 1961 (Act) provides for disallowance of expenditure incurred in relation to income which is not included in the total income of the assessee. In a recent judgement, the issue before the Supreme Court (SC) was whether Section 14A would be applicable to dividend income irrespective of the fact that DDT is paid by the company.

Some other Decisions in favour of the Revenue:
  1. In case of United Breweries Ltd. v. Dy. CIT [2016], the Hon’ble High Court held that section 14A is applicable even where motive of acquiring shares is to obtain controlling interest in companies.
  2. In case of Haldia Petrochemicals Ltd. v. Jt. CIT [2016], said that for the purpose of calculating book profit u/s 115JB, the expenditure incurred to earn exempt income, which had been disallowed under section 14A, had to be added back to book profit. Provisions of section 14A are also applicable to the case of calculating book profit under section 115JB of the Act.
Facts of the case:

The taxpayer declared dividend income of INR 343.4 million,

The Assessing Officer (AO) had disallowed a portion of the total interest expenses on a notional basis in the ratio of cost of investment in shares and units to the cost of total assets appearing on the balance sheet. The Commissioner of Income Tax (Appeals) (CIT(A)) reversed the order of the AO following the stand taken in the earlier order.

The Income Tax Appellate Tribunal (ITAT) upheld the order of the CIT(A) on the premise that the AO failed to establish any nexus between investments in shares/mutual funds and the borrowed funds. However, the ITAT remanded the order to the AO for a fresh adjudication in light of the amendments made under Section 14A read with Rule 8D of the Income Tax Rules, 1962.

On being aggrieved by the order of the ITAT, an appeal was filed before the High Court (HC). The HC held that the amendment in Rule 8D were to be applied prospectively and accordingly the same would not apply to the year under consideration (Assessment Year 2002-03). The HC further held that on a plain reading of the section, the same also applies to dividend income subjected to DDT on the premise that it is not includible in the total income of the taxpayer.

Taxpayer’s contentions:

Section 14A of the Act applies only in circumstances where income is tax-free, nontaxable and there is no incidence of tax on such income.

The fact that dividend is paid by the dividend-paying company and not by the recipient of such dividend is insignificant. Accordingly, the person paying the tax is not relevant for the purposes of Section 14A read with Section 115-O of the Act as the DDT is paid by the dividend-paying company. Thus, dividend income was being taxed in one way or the other and hence, the same cannot be regarded as totally exempt from tax.

A literal interpretation of Section 14A is not required as the same could result in an absurd interpretation of the law by placing reliance on the decision of this court in the case of K P Varghese vs Income Tax Officer.

Revenue’s contentions:

The purpose behind the insertion of Section 14A in the Act was to counterpoise various judicial pronouncements that allowed the entire expenditure irrespective of the taxpayer earning exempt/taxable income.

The Revenue relied on the Memorandum explaining the provisions of the Finance Bill, 2001 and Circular No. 14 issued by the Central Board of Taxes (CBDT) explaining the purpose of inserting Section 14A in the Act.

No deduction for expenditure incurred in respect of exempt income against taxable income

25.1 Certain incomes are not includible while computing the total income, as these are exempt under various provisions of the Act. There have been cases where deductions have been claimed in respect of such exempt income. This in effect means that the tax incentive given by way of exemptions to certain categories of income, is being used to reduce also the tax payable on the non-exempt income by debiting the expenses incurred to earn the exempt income against taxable income. This is against the basic principles of taxation whereby only the net income, i.e., gross income minus the expenditure, is taxed. On the same analogy, the exemption is also in respect of the net income. Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income.

25.2 Through Finance Act, 2001, a new section 14A has been inserted so as to clarify the intention of the legislature since the inception of the Income-tax Act, 1961, that no deduction shall be made in respect of any expenditure incurred by the assessee in relation to income which does not form part of the total income under the Income-tax Act.

25.3 It is also being clarified that the assessments where the proceedings have become final before the first day of April, 2001 should not be reopened under section 147 of the Act to disallow expenditure relatable to the exempt income by applying the provisions of section 14A of the Act.

25.4 This amendment takes effect retrospectively from 1st April, 1962, and accordingly, applies in relation to the assessment year 1962-1963 and subsequent assessment years.

On a plain reading of the provisions of Section 14A, an essential principle was enshrined by the Act that expenses are allowable only to the extent the same has a nexus to the earning of taxable income. Pursuant to the provisions of Section 115-O of the Act, it is evident that the tax paid on dividend by the dividend-paying company cannot assume the character of tax paid on dividend income by the taxpayer. The situation is further fortified by the fact that the provisions of Section 199 of the Act do not provide for credit of DDT in any manner in the hands of the recipient of dividend (the taxpayer).

Issues before the Supreme Court :

Whether the phrase ‘income which does not form part of total income under this Act’ appearing in Section 14A includes dividend income on which DDT is payable within its scope.

Whether the disallowance under Section 14A is attracted in spite of the favorable order of earlier years passed by Tax Authorities based on similar facts.

Key observations of Supreme Court:

The SC upheld the literal interpretation of the provisions of Section 14A of the Act on the premise that the language used was clear and free from any ambiguity. Accordingly, it was not necessary to apply any other principles of interpretation by placing reliance on the host of judicial decisions.

The SC further observed that the deletion and reintroduction of Section 10(33) and the Section 115-O respectively, does not make any difference with respect to the applicability of Section 14A of the Act. In fact, the above serves as a countenance for holding that the dividend income would be exempt in the hands of the recipient only when the same is being taxed in the hands of the dividend-paying company.

As far as the second issue is concerned, the SC noted that there was no change in the facts of the case pertaining to the year under consideration vis-a-vis earlier Assessment Years where the Revenue failed to establish a nexus between expenditure disallowed and dividend income and thereby granted the benefit of full exemption applying the rule of consistency.

Conclusion of the Case:

The SC held that based on the observations and the facts of the case, the provisions of Section 14A of the Act would apply to dividend income on which tax is payable under Section 115-O of the Act.

[1] Godrej and Boyce Manufacturing Company Limited vs Deputy CIT and Another Civil Appeal No. 7020 of 2011

[2] (1981) 131 ITR 597 (SC)

[3] CIT vs Calcutta Knitwears (2014) 6 SCC 444, CIT vs Tara Agencies (2007) 292 ITR 444 (SC), Cape Brandy Syndicate vs IRC (1921) 1 KB 64

Comments:

It is pertinent to mention that the Central Board of Direct Taxes, vide Circular No. 5/2014, dated 11 February, 2014, had clarified that disallowance of expenditure for earning exempt income under section 14A read with Rule 8D is called for even if no exempt income has been earned during the financial year, placing reliance on usage of the term ‘includible’ in the heading to section 14A of the Act and also the heading to Rule 8D of the Income-tax Rules, 1962. The Circular also emphasized the fact that section 14A does not use the expression ‘income of the year’ but ‘income under the Act’.

The assessees should make disallowance under section 14A of the Act on a reasonable basis in the light of actual expenses incurred. The basis should be duly disclosed in the return and it should be such a disclosure which the assessee will be able to substantiate when a question is raised by the Assessing Officer. In the light of facts and the holdings in the various decisions mentioned above, the basis can be volume and the frequency of the transactions. It can be the receipts of exempt income to the receipts/turnover of other activities or any other basis as may be suitable in the facts of the case. The Assessing Officer, while examining the claim of the assessee, should carefully go into the facts of the case and also the basis adopted by the assessee. In case the basis and the quantum of disallowance made by the assessee are justified in the light of the facts of the case, same should be accepted. In case the basis adopted by the assessee is not correct in view of the Assessing Officer, he should give a holding as regards the facts as to why the basis adopted by the assessee is not correct and how another basis would be more appropriate. Further, he should also determine the quantum of an expenditure as has been incurred in his view, either on the basis adopted by the assessee or on another basis, which is appropriate in his view. In case quantum of expenditure incurred, as is estimated by the Assessing Officer, is more than the amount of disallowance offered by the assessee, the Assessing Officer should make the disallowance on the basis of his estimate of actual expenditure, in case same is lower than the disallowance as per Rule 8D. If estimated actual expenditure is more than the disallowance as per Rule 8D, the Assessing Officer should make the disallowances as per Rule 8D.

Disclaimer:

Our conclusions are based on the completeness & accuracy of the facts stated therein & assumptions, which if not entirely complete or accurate, should be communicated to us, as the inaccuracy or incompleteness could have a material impact on our conclusions. The conclusions reached & views expressed in the note are based on our understanding of the law & regulations prevailing as of the date of this note as well as our past experience with the tax and / or regulatory authorities. However, there can be no assurance that the tax authorities or regulators will concur with our views.

Legislation, its judicial interpretation & the policies of the tax and / or regulatory authorities are subject to change from time to time & these may have a bearing on the advice that we have given. Accordingly, any change or amendment in the law or relevant regulations would necessitate a review of our comments & recommendations contained in this note. Unless specifically requested, we have no responsibility to carry out any review of our comments for changes in laws or regulations occurring after the date of this note.

Without prior permission of DMCGLOBAL SERVICES LLP, the contents of this study / note may not be quoted in whole or in part or otherwise referred to in any documents. This document is for the specific purpose and we accept no responsibility or liability to any party.

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Research and Analysis on reporting of certain transactions in as envisaged

Research and Analysis on reporting of certain transactions in as envisaged

Research and Analysis on reporting of certain transactions in as envisaged u/s 40A(2)(b) of the Income Tax Act, 1961.

Section 40A(2) of Income Tax Act, 1961 deals with payments to relatives and associated persons. It provides that where the assessee incurs any expenditure in respect of which payment is to be made to a specified person and the Assessing Officer is of the opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as deduction.

The question under consideration is whether the transaction of loans, advances or similar nature which are not deductible from Income of the assessee   will be reported under Section 40A(2)(b) of the Act, Clause-23 of Tax Audit Report?

Hence to understand it one needs to refer the different provisions of Income Tax Act, 1961 which is stated below in this study.

Query:

Our advice has been sought under Income Tax Act 1961 on the  below query:

  • Whether the Transactions mentioned above will be reported under Section 40A(2)(b), Clause 23 of Tax Audit report?

Analysis and Facts:

In order to further analyze the query, it is imperative to quote the relevant provisions of law under Income Tax Act, 1961 at this juncture-

Particulars of payments made to persons specified under section 40A(2)(b). [Clause 23]

40.1 Section 40(A)(2) provides that expenditure for which payment has been or is to be made to certain specified persons listed in the section may be disallowed if, in the opinion of the Assessing Officer, such expenditure is excessive or unreasonable having regard to:

  1. the fair market value of the goods, services or facilities for which the payment is made; or
  2. for the legitimate needs of business or profession of the assessee; or
  3. the benefit derived by or accruing to the assessee from such expenditure.

40.2 The section enjoins on the Assessing Officer the power to fix the quantum of Under this clause, the particulars of payments coming under this sub-section are to be stated. The following steps may be taken by the tax auditor in this connection:

  1. Obtain full list of specified persons as contemplated in this
  2. Obtain details of expenditure/payments made to the specified persons.
  3. Scrutinize all items of expenditure/payments to the above
  4. It may be difficult to locate all such payments and it may also involve a time consuming effort. It is, however, possible to localize the area of enquiry by ascertaining the following:
  1. Call for all contracts or agreements entered into by the assessee and list out the contracts or agreements entered into with the specified persons and segregate the items of payments made to them under these
  2. In case of payments for purchases and expenses on credit basis, the appropriate ledger accounts can be scrutinized to identify the dealings with the specified persons.
  3. In case of cash purchases and expenses, the purchase or expense account should be scrutinized. It may be difficult to identify such payments in each and every case where the volume of transactions is rather huge and voluminous.
  4. Therefore, it may be necessary to restrict the scrutiny only to such payments in excess of certain monetary limits depending upon the size of the concern and the volume of business of the assessee.

Chart of persons specified in Section 40A(2)(b)- (Refer Paragraph 40.1)

Part-I

 

IndividualFirmAssociation of personsHUFCompany
1.His relatives1.Its partners 2.Their relatives1.Its members 2.Their relatives1.Its members 2.Their relatives1.Its directors 2.Their relatives

 

Part-II

 

Where person having substantial interest in the business or profession of the assessee is
IndividualAssociation of personsHUFCompany
1. His relatives1.Its members 2.Their relatives1. Its members 2.Their relatives1.Its Directors 2.Their relatives

3.Any other company carrying on business or profession in which the first mentioned company has substantial interest.

 

Note: Where one or more of the persons falling in any of the above categories (i.e. individual and his relatives, firm, its partners and their relatives, etc.) have substantial interest in the business or profession carried on by any person – that person is also covered under section 40A(2)(b).

Part-III

 

DirectorPartnerMember of AOPMember of HUF
Companies in which he is a DirectorFirms in which he is a partnerAOP of which he is a member
All other Directors of such CompaniesAll other partners of such firmsAll other members of such AOPAll other members of such HUF
Their relativesTheir relativesTheir relativesTheir relatives

Notes:

  1. Relative is defined in section 2(41) as in relation to an individual including husband, wife, brother, sister or any lineal ascendant or descendent of that
  2. “Person having a substantial interest” is explained in section 40A as under:
  1. In the case of company – the person concerned is, at any time, during the previous year the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) carrying not less than 20% of the voting
  2. In other cases – such person is at any time during the previous year, beneficially entitled to not less than 20% of the profits of such business or

Expenses or payments not deductible in certain circumstances.

40A. (1) The provisions of this section shall have effect notwithstanding anything to the contrary contained in any other provision of this Act relating to the computation of income under the head “Profits and gains of business or profession”.

(2)(a) Where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in clause (b) of this sub-section, and the Assessing Officer is of opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as a deduction :

[Provided that [for an assessment year commencing on or before the 1st day of April, 2016] no disallowance, on account of any expenditure being excessive or unreasonable having regard to the fair market value, shall be made in respect of a specified domestic transaction referred to in section 92BA, if such transaction is at arm’s length price as defined in clause (ii) of section 92F.]

(b) The persons referred to in clause (a) are the following, namely:—

  1. where the assessee is an individual, any relative of the assessee;
  2. where the assessee is a company, firm, association of persons or Hindu undivided family, any director of the company, partner of the firm, or member of the association or family, or any relative of such director, partner or member;
  3. any individual who has a substantial interest in the business or profession of the assessee, or any relative of such individual;
  4. a company, firm, association of persons or Hindu undivided family having a substantial interest in the business or profession of the assessee or any director, partner or member of such company, firm, association or family, or any relative of such director, partner or member [or any other company carrying on business or profession in which the first mentioned company has substantial interest];
  5. a company, firm, association of persons or Hindu undivided family of which a director, partner or member, as the case may be, has a substantial interest in the business or profession of the assessee; or any director, partner or member of such company, firm, association or family or any relative of such director, partner or member;
  6. any person who carries on a business or profession,—
  1. where the assessee being an individual, or any relative of such assessee, has a substantial interest in the business or profession of that person; or
  2. where the assessee being a company, firm, association of persons or Hindu undivided family, or any director of such company, partner of such firm or member of the association or family, or any relative of such director, partner or member, has a substantial interest in the business or profession of that

Explanation.—For the purposes of this sub-section, a person shall be deemed to have a substantial interest in a business or profession, if,—

  1. in a case where the business or profession is carried on by a company, such person is, at any time during the previous year, the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) carrying not less than twenty per cent of the voting power; and
  2. in any other case, such person is, at any time during the previous year, beneficially entitled to not less than twenty per cent of the profits of such business or profession.

3. Where the assessee incurs any expenditure in respect of which a payment or aggregate of payments made to a person in a day, otherwise than by an account payee cheque drawn on a bank or account payee bank draft, [or use of electronic clearing system through a bank account [or through such other electronic mode as may be prescribed], exceeds ten thousand rupees, no deduction shall be allowed in respect of such expenditure.

(3A) Where an allowance has been made in the assessment for any year in respect of any liability incurred by the assessee for any expenditure and subsequently during any previous year (hereinafter referred to as subsequent year) the assessee makes payment in respect thereof, otherwise than by an account payee cheque drawn on a bank or account payee bank draft,[or use of electronic clearing system through a bank account [or through such other electronic mode as may be prescribed]], the payment so made shall be deemed to be the profits and gains of business or profession and accordingly chargeable to income-tax as income of the subsequent year if the payment or aggregate of payments made to a person in a day, exceeds ten thousand rupees:

Provided that no disallowance shall be made and no payment shall be deemed to be the profits and gains of business or profession under sub-section (3) and this sub-section where a payment or aggregate of payments made to a person in a day, otherwise than by an account payee cheque drawn on a bank or account payee bank draft, [or use of electronic clearing system through a bank account [or through such other electronic mode as may be prescribed], exceeds ten thousand rupees,] in such cases and under such circumstances as may be prescribed, having regard to the nature and extent of banking facilities available, considerations of business expediency and other relevant factors :]

[Provided further that in the case of payment made for plying, hiring or leasing goods carriages, the provisions of sub-sections (3) and (3A) shall have effect as if for the words “[ten] thousand rupees”, the words “thirty-five thousand rupees” had been substituted.]

4. Notwithstanding anything contained in any other law for the time being in force or in any contract, where any payment in respect of any expenditure has to be made by [an account payee cheque drawn on a bank or account payee bank draft [or use of electronic clearing system through a bank account [or through such other electronic mode as may be prescribed]] in order that such expenditure may not be disallowed as a deduction under sub-section (3), then the payment may be made by such cheque or draft [or electronic clearing system] [or such other electronic mode as may be prescribed]; and where the payment is so made or tendered, no person shall be allowed to raise, in any suit or other proceeding, a plea based on the ground that the payment was not made or tendered in cash or in any other ]

5. Omitted by the Direct Tax Laws (Amendment) Act, 1987, w. e. 1- 4- 1989. 

6. Omitted by the Direct Tax Laws (Amendment) Act, 1987, w. f. 1- 4- 1989.

7(a) Subject to the provisions of clause (b), no deduction shall be allowed in respect of any provision (whether called as such or by any other name) made by the assessee for the payment of gratuity to his employees on their retirement or on termination of their employment for any

(b) Nothing in clause (a) shall apply in relation to any provision made by the assessee for the purpose of payment of a sum by way of any contribution towards an approved gratuity fund, or for the purpose of payment of any gratuity, that has become payable during the previous year.

Explanation.—For the removal of doubts, it is hereby declared that where any provision made by the assessee for the payment of gratuity to his employees on their retirement or termination of their employment for any reason has been allowed as a deduction in computing the income of the assessee for any assessment year, any sum paid out of such provision by way of contribution towards an approved gratuity fund or by way of gratuity to any employee shall not be allowed as a deduction in computing the income of the assessee of the previous year in which the sum is so paid.]

8. Omitted by the Finance Act, 1985 w. e. f 1- 4-

9.  No deduction shall be allowed in respect of any sum paid by the assessee as an employer towards the setting up or formation of, or as contribution to, any fund, trust, company, association of persons, body of individuals, society registered under the Societies Registration Act, 1860 (21 of 1860), or other institution for any purpose, except where such sum is so paid, for the purposes and to the extent provided by or under clause (iv) [or clause (iva)] or clause (v) of sub-section (1) of section 36, or as required by or under any other law for the time being in force.

10.  Notwithstanding anything contained in sub-section (9), where the Assessing Officer is satisfied that the fund, trust, company, association of persons, body of individuals, society or other institution referred to in that sub-section has, before the 1st day of March, 1984, bona fide laid out or expended any expenditure (not being in the nature of capital expenditure) wholly and exclusively for the welfare of the employees of the assessee referred to in sub-section (9) out of the sum referred to in that sub-section, the amount of such expenditure shall, in case no deduction has been allowed to the assessee in respect of such sum and subject to the other provisions of this Act, be deducted in computing the income referred to in section 28 of the assessee of the previous year in which such expenditure is so laid out or expended, as if such expenditure had been laid out or expended by the

11. Where the assessee has, before the 1st day of March, 1984, paid any sum to any fund, trust, company, association of persons, body of individuals, society or other institution referred to in sub-section (9), then, notwithstanding anything contained in any other law or in any instrument, he shall be entitled—

  1. to claim that so much of the amount paid by him as has not been laid out or expended by such fund, trust, company, association of persons, body of individuals, society or other institution (such amount being hereinafter referred to as the unutilised amount) be repaid to him, and where any claim is so made, the unutilised amount shall be repaid, as soon as may be, to him;
  2. to claim that any asset, being land, building, machinery, plant or furniture acquired or constructed by the fund, trust, company, association of persons, body of individuals, society or other institution out of the sum paid by the assessee, be transferred to him, and where any claim is so made, such asset shall be transferred, as soon as may be, to him.]

No deduction or allowance shall be allowed in respect of any marked to market loss or other expected loss, except as allowable under clause (xviii) of sub-section (1) of section 36.]

Legislative History:

This section was inserted by the Finance Act, 1968 (19 of 1968), with effect from 1 April, 1968, with a view to taking measures for countering tax evasion.

Object of the section:

In the course of business or profession, the assessee has to incur expenditure involving payments made from time to time to different persons under various circumstances. The legislature found from experience that the existing provisions of the Act were inadequate to deal with the evasion of tax under the cloak or guise of permissible deductions.

Section 40A was added by the Finance Act of 1968 and it came into force with effect from 1 April 1968. While introducing the Bill in the Lok sabha for its consideration, the Finance Minister made a speech on 29 April, 1968, in which he pointed out that the provision in question was intended to serve the objective of checking tax evasion.

Applicability of the Section:

The following are broadly the types or classes of payments in respect of the deductibility of which this section imposes restrictions and limitations:

  1. Payments to Relatives, associates and associated concerns [sub-section (2)]
Sub-section (1): General

An overriding provision:

As pointed out in Shree Sajjan Mills v CIT [(1985) 156 ITR 585 (SC)] section 40A, which contains a non- obstante clause in sub-section (1), is an overriding provision which operates in spite of anything to the contrary contained in any other provision of the Act relating to the computation of income under the head ‘Profits and gains of business or profession’. In other words, the legislature has made it clear that the provisions of section 40A will apply in supersession of other contrary provisions of the Act relating to the computation of income under the aforesaid head [Hasanand Pinjomal v CIT (1978) 112 ITR 134 (Guj).

Sub-section (2): Payments to relatives and associates

Legislative History (1968):

This sub-section continues unamended except that a proviso to clause (a), which was there originally was omitted subsequently. The proviso read as under:

“Provided that the provisions of this sub-section shall not apply in the case of an assessee being a company in respect of any expenditure to which sub-clause (i) of clause (c) of section 40 applies.”

The object, scope and effect of the introduction of this sub-section was explained by the Board in a circular (Circular No. 6P, dated 6 July, 1968) in the following terms:

Expenditure incurred in business and profession involving payment to relatives and associate concerns”-

  1. The Finance Act, 1968 has introduced new section 40A with effect from 1 April, 1968. Under sub- section (2) of new section 40A, expenditure incurred in a business or profession for which payment has been or is to be made to the taxpayer’s relatives or associates concerns is liable to be disallowed in computing the profits of the business or profession to the extent the expenditure is considered to be excessive or unreasonable. The unreasonableness of any expenditure is to be judged having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession or the benefit derived by, or accruing to, the taxpayer from the expenditure. Such portion of the expenditure which in the opinion of the Income-tax Officer (now Assessing Officer), is excessive or reasonable according to these criteria is to be disallowed in computing the profits of the business or profession.
  2. The categories of persons, payments to whom fall within the purview of this provision comprise, inter alia,-
  1. any relative of the taxpayer, or where the taxpayer is a company, firm, association of persons or Hindu undivided family, any director of the company, partner of the firm or member of the association or family and also relatives of such director, partner or member;
  1. persons who have a substantial interest in the business or profession of the taxpayer, and relatives of such persons; where such person is a company, firm, association of persons or Hindu undivided family, the directors, partners and members and their relatives;
  2. persons in whose business or profession the taxpayer has a substantial interest directly or
  3. The term “relative”, as defined in section 2(41) means, in relation to an individual, the husband, wife, brother or sister or any lineal ascendant or descendant of that individual. A person will be deemed to have a substantial interest in a business or profession if, in a case where the business or profession is carried on by a company the person beneficially owns shares in the company (other than preference shares), carrying not less than 20 per cent of the voting power and in any other case, where the person is beneficially entitled to not less than 20 per cent of the profits of business or profession.
  1. It may be noted that the provision is applicable to all categories of expenditure incurred in business and professions, including expenditure on purchase of raw materials, sores or goods, salaries to employees and also any other expenditure on professional services, or by way of brokerage, commission, interest, etc. Where payment for any expenditure is found to have been made to a relative or associate concern falling within the specified categories, it will be necessary for the Income-tax Officer (now Assessing Officer) to scrutinize the reasonableness of the expenditure with reference to the criteria mentioned in the The Income-tax Officer is expected to exercise his judgment in a reasonable and fair manner. It should be borne in mind that the provision is meant to check evasion of tax through excessive or unreasonable payments to relatives and associate concerns and should not be applied in a manner which will cause hardship in bona fide cases.
Curb on payments to connected persons:

One of the serious concerns of the revenue in the matter of computation of the business income was the avoidance or evasion of tax by claiming deduction of liberal payments made or benefits granted by an assese to closely connected persons ostensibly for services rendered by them. To curb the practice, the legislature initially introduced a restriction in the case of companies and gave the department a power to investigate into the reasonableness of the payments made to such persons in the light of the business needs of the company and the benefit obtained by making such payments (Section 10(4A) of the 1922 Act, re- enacted as section 40(c)(i) and (ii). The starting point of this development was Newton Studios v CIT (1955) 28 ITR 378 (Mad). A ceiling was introduced later). This power extended to remuneration, benefit or amenity provided to a director or a person having a substantial interest in the company (The 1961 Act added also the benefits given to a “relative of such director or other person”) either directly or in the form of enjoyment of assets belonging to the company. In 1963, the legislature conceived of the idea of a ceiling on the remuneration allowable to an employee of a company but modified it in 1964 by imposing a ceiling on the perquisites (which is so widely prevalent that it has come to be known, affectionately by the recipients as ‘perks’) allowed to its employees (later restricted to those drawing Rs. 7,500 or more per month as salary). The present section, inserted in 1968, has extended the curb, with modifications, to the case of all assessees

An analysis of this section discloses the following constituent elements in the scheme of disallowance:

  1. The assessee may be an individual, firm, company, association of persons (A ‘body of individuals’ is left out here) or Hindu undivided family [Ved Prakash M Patel v CIT (1988) 169 ITR 591 (MP)].
  2. The expenditure in question is one which involves a payment to a close associate. [The statute does not use this word; it is used here only to facilitate convenient reference] of the
  3. The persons treated as associates of the assessee are elaborately defined in clause (b). The determination includes the concepts of ‘relative’
    and a person having a substantial interest in the business or profession of the assessee or the One important aspect of the application of the provision will be to establish this associateship between the payer and the payee.
  4. The expenditure incurred is considered by the officer to be excessive or unreasonable, having regard to-
    1. The fair market value of the goods, services or facilities for which the payment is made; or
    2. The legitimate business needs of the assessee’s business or profession; or
    3. The benefit derived by or accruing to the assessee from the payment.

If the above conditions are fulfilled, the officer can disallow the expenditure to the extent he considers it excessive or unreasonable by the above objective standards or otherwise [For the three considerations mentioned are not exhaustive. See- Synpro Industries v CIT (1984) 146 ITR 176 (MP); Ganesh Soap Works v CIT (1986) 161 ITR 876 (MP); Anandji Shah v CIT (1990) 181 ITR 171 (Ker)].

Section 40A(2)(b):

The opening words of section 40 indicate that the amounts enumerated therein shall not be deducted in computing the income chargeable under the head “profits and gains of business or profession”, notwithstanding anything to the contrary in sections 30 to 38.

Expenditures must have been made:

Clause (a) contemplates an assessee incurring any expenditure in respect of which a payment has been or is made to any person referred to in clause (b). Where no such expenditure is incurred, obviously, the provisions of this sub-section cannot be invoked. In the case [CIT v Subbaraya Chetty & Sons (AK) (1980) 123 ITR 592 (Mad); CIT v Udhoji Shri Krishnadas (1983) 139 ITR 827 (MP)], the assessee sold goods to another with whom it had a close connection, i.e., it charged a lower sale rate in effect. The bona fide nature of the transaction was not in dispute. It was held that all that had happened was that a certain portion of the normal sale price was given up. As there was nothing which was paid out or away by the assessee from the sale price or the income that had accrued to it, there was no expenditure which could be disallowed by reference to section 40A(2)(a).

Question of fact or law:

In Upper India Publishing House (P) Ltd v CIT [(1979) 117 ITR 569 (SC). Also CIT v Skyline Industries Pvt Ltd (1985) 154 ITR 373 (MP); CIT v Orissa Cement Ltd (1988) 171 ITR 72 (Del); CIT v Kumar Engineers (1989) 178 ITR 630 (P&H); CIT v Northern India Iron & Steel Co Ltd (1989) 179 ITR 599 (Del); Trinity Pharmaceuticals India Ltd v CIT (1994) 206 ITR 431 (Ker)], it has been held by the Supreme Court that whether a particular expenditure is excessive and reasonable or not is essentially a question of fact and does not involve any issue of law. It was pointed out that in order to invoke clause (a), it has first to be held that a particular expenditure is excessive or unreasonable.

COURT RULINGS:

  1. TRADE DISCOUNT : In the case of United Exports v. CIT [2009] 185 374/[2011] 330 ITR 549 (Delhi), it was held that Trade discount provided to a sister concern is not an expenditure and therefore, no disallowance u/s. 40A(2) of the Act can be made.11/26/2020 4/59
  2. LINK WITH PROFITS : Edwise Consultants (P.) v. Addl. CIT [2013] 35 149/143 ITD 307 (Mum.-Trib.) Payment of high incentives to directors was not justifiable, merely because assessee-company had earned high profits in current year.
  3. JUSTIFICATION : In the case of Upper India Publishing House (P.) v. CIT [1979] 117 ITR 569/1 365 (SC), it was held that – Section 40A(2)(a) cannot have any application, unless it is first held that the expenditure was excessive and unreasonable.
  4. LITERAL INTERPRETATION : In case of State of Tamil Nadu Kandaswamy AIR 1975 SC 1871, it was held that Being a provision specifically designed to counter evasion of tax, the principle of strict literal interpretation generally applicable to Taxing Statutes, shall not apply. Where specific provision has been made for stopping the tax evasion than liberty of literal interpretation doesn’t exist.
  5. REASONABLENESS : In the case of CIT Samsung India Electronics Ltd. [2011] 338 ITR 186/11 221/199 325 (Delhi) (Mag.), it was held that when assessee able to proves that prices of raw material purchased from holding company is reasonable, then there cannot be any addition u/s 40A(2)(b).
  6. APPLICABILITY ON PARTNERS :Section 40A(2) applies in the case of firms only to payments made in lieu of goods, services and facilities to partners which are not covered by Section 40(b), and to all payments made for the goods, services and facilities to members of the family of a partner, or any relative of a If has to be held that the overriding effect given to Section 40A(2) is only in respect of matters not covered by Section 40(b). N.M. Anniah & Co. v. CIT [1975] 101 ITR 348 (Kar.).
  7. MOTIVE OF TAX EVASION: In case of CIT Indo Saudi Services (Travel) (P.) Ltd. [2009] 310 ITR 306 (Bom.), Honb’le Bombay High Court held that Section 40A(2)(b) is not applicable when the recipient is subject to higher tax / where tax evasion motive doesn’t exist.
  8. FULFILMENT OF ONLY ONE CONDITION: The Assessing Officer is required to record a finding as to whether expenditure is excessive or unreasonable in relation to any one of three requirements prescribed in section which are independent and alternative to each other; for making disallowance, all three requirements need not exist simultaneously. Coronation Flour Mills v. Asstt. CIT [2009] 314 ITR 1/[2010] 188 257 (Guj.).
  9. BURDEN OF PROOF: In case of Nund & Samont (P.) Ltd. v. CIT [1970] 78 ITR 268 (SC), it was held that burden of proof of reasonableness on the assessee for no disallowance u/s 40A(2)(b).
  10. SAME TAX BRACKETS: In the case of CIT V. S. Dempo & Co. (P.) Ltd. [2011] 196 193/8 159 (Bom.) it was held that where assessee purchased from its subsidiary company, at prices higher than the market rate for assured supply, there was no question of diversion of funds since both the assessee and the subsidiary were subjected to the same rate of tax, hence there was no warrant for addition by invoking section 40A(2).
  11. Where the interest paid by assessee to close relative and associate concern is not more than the rate at which interest was paid to other creditors, the interest so paid cannot be disallowed by invoking the provisions of s. 40A(2). Refer to Amrit Soap Co. CIT 17 DTR 350.

REPORTING REQUIREMENTS

  1. TAX AUDIT REPORT: The Tax Auditor needs to certify in the Clause 23 of the Form 3CD (Tax Audit Report), that the payments made or to be made to the Related parties for the expenditures, which debited to the Profit & Loss Account, is at par or less than fair market value of the Tax Auditor is required to collect all the information related to the transactions with related parties like copies of agreements, invoices, detailed description of services / goods, ledger account of concern parties.

TRANSACTIONS NOT COVERED

  1. Capital Expenditure: In general, capital expenses are not covered because of not charging to Profit & Loss Account. Although Depreciation on such capital expenditure will be claimed in the future but Depreciation is an allowance not However, provisions of Section 40A(2)(b) are applicable to expenditures which are in capital nature but fully claimed as deduction under other provisions (e.g. U/s 35. Sec 35(2AB), 35 or 35AD).
  2. Bad debts
  3. Payment to Partners
  4. Section 40A(2)(b) only covers expenditure not income. There is no need to report any kind of transaction of the nature of income which credited to the Profit and Loss Account.

Allowability of payment made to related parties under the Income-tax Act

Income-tax Law is concerned only with reduction of tax liability by an assessee by diverting business profits to relatives and associate concerns in the form of excessive payments for goods, services, etc. In order to curb such evasion, section 40A(2) was inserted by the Finance Act, 1968, with effect from April 1, 1968 which empowers Income-tax Authorities to disallow an expenditure or payment to the extent it is considered excessive or unreasonable, for the purpose of computing profits and gains of a business or profession.

Conclusion:

The payment should be in the nature of expenditure to qualify for reporting in Section 40(A)(2)(b) of the Act. If there is no expenditure then the provisions of Section 40A(2)(b) of the Act cannot be invoked. The understanding based on facts, provisions of law quoted above is that even if there is expenditure which is capital in nature (not debitable to profit and loss account) shall not necessitate reporting in Clause 23 of Tax Audit report for Section 40(A)(2)(b) of the Act. Further the expenditure to be reported in Clause 23 of Tax Audit report for Section 40(A)(2)(b) of the Act should lead to tax evasion.

The transaction of loans, advances or similar nature which are not deductible from Income of the assessee are outside the purview of Section 40A(2)(b) of the Act. The intention of legislature is clear and unambiguous since separate sections i.e. Section 269SS & 269T read with Section 2(22)(e) of the Act are separately defined in the provisions of the Act along with its reporting requirements in Tax Audit Report.

Disclaimer:

Our conclusions are based on the completeness & accuracy of the facts stated therein & assumptions, which if not entirely complete or accurate, should be communicated to us, as the inaccuracy or incompleteness could have a material impact on our conclusions. The conclusions reached & views expressed in the note are based on our understanding of the law & regulations prevailing as of the date of this note as well as our past experience with the tax and / or regulatory authorities. However, there can be no assurance that the tax authorities or regulators will concur with our views.

Legislation, its judicial interpretation & the policies of the tax and / or regulatory authorities are subject to change from time to time & these may have a bearing on the advice that we have given. Accordingly, any change or amendment in the law or relevant regulations would necessitate a review of our comments & recommendations contained in this note. Unless specifically requested, we have no responsibility to carry out any review of our comments for changes in laws or regulations occurring after the date of this note.

 Without prior permission of DMCGLOBAL SERVICES LLP, the contents of this study / note may not be quoted in whole or in part or otherwise referred to in any documents. This document is for the specific purpose and we accept no responsibility or liability to any party.

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Applicability of GST on gifts, rewards and recognition by Employer to Employees

Applicability of GST on gifts, rewards and recognition by Employer to Employees

The taxability and availability of Input Tax Credit on Gifts has always been a matter of discussion and confusion. With the implementation of GST, the term gift has become a buzzword. The gifts are provided by the company for the purpose of advancement of business or for sales promotion or as a reward and recognition. Different types of gifts like unbranded gifts, branded/customized gifts, Diwali gifts or target based rewards in lieu of discounts, laptops, motor vehicles, mobile phones etc. may be given to employees without consideration/ at concessional rate. The Legislature has included some specific provisions related to gifts under the GST regime.

To determine the taxability of gift, it is important to understand the meaning of the term ‘gift’. The expression “gift” has not been defined under the CGST Act, 2017. Accordingly, the term gift is open for interpretation. Hence to understand it one needs to refer to different provisions of CGST Act, 2017 along with The Gift Tax Act, 1958 which is stated below in this study.

Query:

The subject matter under consideration is as per details mentioned below:

  • Whether GST is payable on gift /transfer of assets (like Laptops/ Mobile Phones/ Motor vehicles) to employees with consideration (at concessional rates) or without consideration.
  • Impact of Input tax credit on purchase of assets
  • GST applicability in case invoices are in the name of Employees and payment is being made directly by the Company.

Our advice has been sought keeping in view:

  • Provisions of CGST Act, 2017
  • Provisions of The Gift Tax Act, 1958
  • CGST circular no. 92/11/2019 dated. 07/03/2019.
  • Press release dated 11 July 2017 (Further, It is imperative to note that the press release does not have any legal binding before any courts, unless such clarification is supported by way of circular/notification. However, one may place reliance on the same to understand the intent of law).

Analysis and Facts:

In order to further analyze the query, it is imperative to quote the relevant provisions of law under CGST Act, 2017 and The Gift Tax Act, 1958 at this juncture

Supply of goods or services or both is taxable event in GST. GST is applicable only if there is supply of goods/services.

“As per Section 2(52) – Goods means every kind of moveble property other than money and securities but includes actionable claim, growing crops, grass and things attached to or forming part of the land which are agreed to be severed before supply or under a contract.”

“As per Section 2(102) – Service Means anything other than goods, money and securities but includes activities relating to the use of money or its conversion by cash or by any other mode, from one form, currency or denomination, to another form, currency or denomination for which a separate consideration is charged.”

As per Section 7, of CGST Act, 2017, (Scope of supply)

  1. For the purposes of this Act, the expression supply includes –
  1. all forms of supply of goods or services or both such as sale, transfer, barter, exchange, license, rental, lease or disposal made or agreed to be made for a consideration by a person in the course or furtherance of business;
  2. import of services for a consideration whether or not in the course or furtherance of business;
  3. the activities specified in Schedule I, made or agreed to be made without a consideration.

Schedule I of Section 7 of CGST Act, 2017

Activities to be treated as supply even if made without consideration:

2. Supply of goods or services or both between related persons or between distinct persons as specified in section 25, when made in the course or furtherance of business:

Provided that gifts not exceeding fifty thousand rupees in value in a financial year by an employer to an employee shall not be treated as supply of goods or services or both.

As per the Explanation to section 15 of the CGST Act, 2017-

  1. person shall be deemed to be related persons if

(iii) such persons are employer and employee;

Section 2 (xii) of The Gift Tax Act:

“Gift means the transfer by one person to another of any existing movable or immovable property made voluntarily and without consideration in money or money’s worth.” and includes the transfer or conversion of any property referred to in section 4, deemed to be a gift under that section; [Explanation.   A transfer of any building or part thereof referred to in clause (iii), clause (iiia) or clause (iiib) of section 27 of the Income-tax Act, by the person who is deemed under the said clause to be the owner thereof made voluntarily and without consideration in money or money;s worth. Shall be deemed to be a gift made by such person.

As per Section 16, of CGST Act, 2017 (Eligibility and conditions for taking input tax credit)

  1. Every registered person shall, subject to such conditions and restrictions as may be prescribed and in the manner specified in section 49, be entitled to take credit of input tax charged on any supply of goods or services or both to him which are used or intended to be used in the course or furtherance of his business and the said amount shall be credited to the electronic credit ledger of such
  2. Notwithstanding anything contained in this section, no registered person shall be entitled to the credit of any input tax in respect of any supply of goods or services or both to him unless,
  1. he is in possession of a tax invoice or debit note issued by a supplier registered under this Act, or such other tax paying documents as may be prescribed;
  2. he has received the goods or services or both
  3. subject to the provisions of section 41, the tax charged in respect of such supply has been actually paid to the Government, either in cash or through utilization of input tax credit admissible in respect of the said supply; and
  4. he has furnished the return under section 39.
  1. As per Section 17, of CGST Act, 2017 (Apportionment of credit and blocked credits)

    5. Notwithstanding anything contained in sub-section (1) of section 16 and sub- section (1) of section 18, input tax credit shall not be available in respect of the following, namely:

  2. motor vehicles for transportation of persons having approved seating capacity of not more than thirteen persons (including the driver), except when they are used for making the following taxable supplies, namely:

(A)   further supply of such motor vehicles; or

(h) goods lost, stolen, destroyed, written off or disposed of by way of gift or free samples; and

As per Section 15 of CGST Act: – (1) The value of a supply of goods or services or both shall be the transaction value, which is the price actually paid or payable for the said supply of goods or services or both where the supplier and the recipient of the supply are not related and the price is the sole consideration for the supply.

While plain reading of section 15 of CGST Act it says that valuation of goods and service are to me made as per transaction value which is the price actually paid or payable for the said supply of goods or services or both”. So in free sample, free service and Gifts no price is payable, hence there in no value as per GST law also so no GST to be collected. But section 15 is applicable only when both the parties are unrelated. CGST rule 28 deals with valuation of goods and services between related or distinct person.

CGST Rule 28: – Value of supply of goods or services or both between distinct or related persons, other than through an agent.-The value of the supply of goods or services or both between distinct persons as specified in sub-section (4) and (5) of section 25 or where the supplier and recipient are related, other than where the supply is made through an agent, shall-

  1. Be the open market value of such supply;
  2. If the open market value is not available, be the value of supply of goods or services of like kind and quality;
  3. if the value is not determinable under clause (a) or (b), be the value as determined by the application of rule 30 or rule 31, in that order:

Provided that where the goods are intended for further supply as such by the recipient, the value shall, at the option of the supplier, be an amount equivalent to ninety percent of the price charged for the supply of goods of like kind and quality by the recipient to his customer not being a related person:

Provided further that where the recipient is eligible for full input tax credit, the value declared in the invoice shall be deemed to be the open market value of the goods or services.

Section 2(76)of CSGT Act, 2017  motor vehicle shall have the same meaning as assigned to it in clause (28) of section 2 of the Motor Vehicles Act, 1988;

Section 2(28) in The Motor Vehicles Act, 1988

“Motor vehicle” or “vehicle” mechanically propelled vehicle adapted for use upon roads whether the power of propulsion is transmitted thereto from an external or internal source and includes a chassis to which a body has not been attached and a trailer; but does not include a vehicle running upon fixed rails or a vehicle of a special type adapted for use only in a factory or in any other enclosed premises or a vehicle having less than four wheels fitted with engine capacity of not exceeding 4[twenty-five cubic centimeters]; 1[twenty-five cubic centimeters];”

Press Release dated 11 July 2017 by the government:

It is being reported that gifts and perquisites supplied by companies to their employees will be taxed in GST. Gifts upto a value of Rs 50,000/- per year by an employer to his employee are outside the ambit of GST. However, gifts of value more than Rs 50,000/- made without consideration are subject to GST, when made in the course or furtherance of business.

Another issue is the taxation of perquisites. It is pertinent to point out here that the services by an employee to the employer in the course of or in relation to his employment are outside the scope of GST (neither supply of goods nor supply of services). It follows therefrom that supply by the employer to the employee in terms of contractual agreement entered into between the employer and the employee, will not be subjected to GST. Further, the input tax credit (ITC) scheme under GST does not allow ITC of membership of a club, health and fitness centre

. It follows, therefore, that if such services are provided free of charge to all the employees by the employer then the same will not be subjected to GST, provided appropriate GST was paid when procured by the employer. The same would hold true for free housing to the employees, when the same is provided in terms of the contract between the employer and employee and is part and parcel of the cost-to-company (CTC).

Extract of CGST circular 92/11/2019 Dtd. 07/03/2019 on Free samples and gifts:

In the case of Federal Commissioner of Taxation v. McPhail [1968] 117 CLR 111 26 MARCH 1968 wherein the hon’ble court has observed that to constitute a ‘gift’, the property should be transferred voluntarily and not as a result of a contractual obligation and no advantage of material character was received by transferor. Relevant text of the judgement is reproduced as under.

‘But it is, I think, clear that to constitute a ‘gift’, it must appear that the property transferred was transferred voluntarily and not as the result of a contractual obligation to transfer it and that no advantage of a material character was received by the transferor by way of return’.

The Hon’ble Supreme Court cited the definition of ‘gift’ from Corpus Juris Secundum, Volume 38 in the case of Sonia Bhatia v. State of UP[1981] 2 SCC 585 as follows: A ‘Gift’ is commonly defined as a voluntary transfer of property by one to another, without any consideration or compensation therefore and does not require a consideration, but there can be none; if there is a consideration for the transaction it is not a gift.

Relevant Case:

In the case of Federal Commissioner of Taxation v. McPhail [1968] 117 CLR 111 26 MARCH 1968 wherein the hon’ble court has observed that to constitute a ‘gift’, the property should be transferred voluntarily and not as a result of a contractual obligation and no advantage of material character was received by transferor. Relevant text of the judgement is reproduced as under.

‘But it is, I think, clear that to constitute a ‘gift’, it must appear that the property transferred was transferred voluntarily and not as the result of a contractual obligation to transfer it and that no advantage of a material character was received by the transferor by way of return’.

The Hon’ble Supreme Court cited the definition of ‘gift’ from Corpus Juris Secundum, Volume 38 in the case of Sonia Bhatia v. State of UP[1981] 2 SCC 585 as follows: A ‘Gift’ is commonly defined as a voluntary transfer of property by one to another, without any consideration or compensation therefore and does not require a consideration, but there can be none; if there is a consideration for the transaction it is not a gift.

Extract of CGST circular 92/11/2019 Dtd. 07/03/2019 on Free samples and gifts:

  1. It is a common practice among certain sections of trade and industry, such as, pharmaceutical companies which often provide drug samples to their stockiest, dealers, medical practitioners, etc. without charging any consideration. As per sub- clause (a) of sub-section (1) of section 7 of the said Act, the expression “supply” includes all forms of supply of goods or services or both such as sale, transfer, barter, exchange, license, rental, lease or disposal made or agreed to be made for a consideration by a person in the course or furtherance of business. Therefore, the goods or services or both which are supplied free of cost (without any consideration) shall not be treated as ..supply” under GST (except in case of activities mentioned in Schedule I of the said Act). Accordingly, it is clarified that samples which are supplied free of cost, without any consideration, do not classify as “supply” under GST, except where the activity falls within the ambit of Schedule I of the said
  2. Further, clause (h) of sub-section (5) of section 17 of the said Act provides that ITC shall not be available in respect of goods lost, stolen, destroyed, written off or disposed of by way of gift or free samples. Thus, it is clarified that input tax credit shall not be available to the supplier on the inputs, input services and capital goods to the extent they are used in relation to the gifts or free samples distributed without any consideration. However, where the activity of distribution of gifts or free samples falls within the scope of “supply” on account of the provisions contained in Schedule I of the said Act, the supplier would be eligible to avail of the ITC.

Our Opinion & Comments:

1.   Whether GST is payable on gift /transfer of assets (like Laptops/ Mobile Phones/ Motor vehicles) to employees with consideration (at concessional rates) or without consideration.

The matter under consideration is that whether the goods transferred to employees with or without consideration are supply under CGST Act, 2017. The Concept of supply is defined under section 7 Scope of supply of the CGST Act, 2017. As per Section 7 (1) (a) of CGST Act, 2017, it is understood that to constitute a “supply” following elements are required to be satisfied:

  • Supply should be made in the course or furtherance of business, and
  • There should be some consideration

Now in case of gift/transfer to employees is concerned no consideration is charged hence it does not fall under the definition of supply as defined under Section 7 of the CGST Act 2017.

However if we refer to Entry Number 2 of Schedule I, gift/transfer between related persons may be treated as supply even if made without consideration. The relationship of employer & employee’s falls under the category of related parties as per CGST Act, 2017. As per the Explanation to section 15 of the CGST Act, 2017). It is important over here to refer to the Proviso of Entry No 2 of Schedule 1 which provides exemption to transfer below the value of Rs. 50,000 to an employee by an employer –

Provided that transfer of assets not exceeding fifty thousand rupees in value in a financial year by an employer to an employee shall not be treated as supply of goods or services or both.”

It is pertinent to note here that the services by an employee to an employer in the course of or in relation to his employment are outside the ambit of GST (neither supply of goods nor supply of services). It follows therefrom that supply by the employer to the employee in terms of contractual agreement entered into between the employer and the employee, will not be subjected to GST. Further, we need to analyze the gifts provided by the employer to the employee which does not form part of the employment agreement.

With regard to above complexities, the Government has come up with the press release dated 11 July 2017, wherein it has been specifically highlighted that any perquisites forming part of the

employment agreement, i.e., included in the employee’s cost-to-company (CTC) shall not be considered as supply.

In case of transfer of goods from employer to employee against consideration/ concessional consideration it is imperative to refer the definition of gift as stated under Section 2 (xii) of The Gift Tax Act and Hon’ble Supreme Court In the case of Federal Commissioner of Taxation v. McPhail [1968] 117 CLR 111 26 MARCH 1968 that a ‘gift’, it must appear that the property transferred was transferred voluntarily and not as the result of a contractual obligation to transfer it and that no advantage of a material character was received by the transferor by way of return’. Thus, it is clear that to fall in the definition of gift it is essential that no consideration is received by the transferor. From the harmonious reading of definition of gift, definition of supply as per Section 7 of CGST Act, 2017 and based on aforesaid analysis it can be inferred that transfer of goods to employees for a consideration, concessional or otherwise shall be out of the definition of gift and assuming that there is no contractual obligation then in that case such transfer shall be classified as supply. It is naturally inferred that such transfer falls in the definition of supply and hence output GST has to be charged at applicable rate.

Now once it is a supply the question is what should be the value of output supply. Since it is a supply between related parties hence reference has to be made to valuation Rule 28 of the CGST Act, 2017 i.e the open market value of such supply. It means whatever be the value at which goods are transferred is not relevant for the purpose of valuation, for charge of GST open market value is the value of taxable supply.

Now in case there is no consideration and the gift/transfer of goods is below Rs.50,000 then it shall not fall in the definition of supply as enumerated in Entry No 2 of Schedule I of CGST Act,2017 read with its proviso. Thus a gift/ transfer of goods to fall in the definition of supply between an employer and employee, it is mandatory that the value of goods which are subject matter of gifts/ transfer shall exceed Rs 50,000/- as valued according to Rule 28 of CGST Rules, 2017 and as envisaged under Entry No 2 of Schedule I of CGST Act, 2017 provided that this gift/transfer is not forming part in terms of the contract/employment agreement/ contractual obligation between the employer and employee and is not part and parcel of the cost-to-company (CTC).

In other words the gift/ transfer of goods shall not be considered as supply and no GST Output Tax is applicable, in case the gift/transfer is out of a contractual obligation of employment and is forming part of CTC.

2.   Impact of Input tax credit on purchase of assets.

The provision related to availability of ITC on gifts has been explained under section 17(5) (h) of the CGST Act, 2017.

As per first provision of section 17(5) (h) of the CGST Act, 2017, Input Tax Credit shall not be available is respect of goods lost, stolen, destroyed, written off or disposed of by way of Gift or free samples.

On Goods distributed as free sample or gifts by employer to employee not exceeding Rs 50,000/- per employee per financial year then Input Tax Credit is ineligible as per section 17(5)(h) of CGST Act. This is also clarified by CGST circular no. 92/11/2019 Dtd. 07/03/2019 clause (h) of sub-section (5) of section 17 of the said Act provides that ITC shall not be available in respect of goods lost, stolen, destroyed, written off or disposed of by way of gift or free samples. Thus, it is clarified that input tax credit shall not be available to the supplier on the inputs, input services and capital goods to the extent they are used in relation to the gifts or free samples distributed without any consideration.

Where the activity of distribution of gifts or free samples falls within the scope of “supply” on account of the provisions contained in Schedule I of the said Act, the supplier would be eligible to avail of the ITC. Further this is also clarified by CGST circular no. 92/11/2019 Dtd. 07/03/2019 where the activity of distribution of gifts or free samples falls within the scope of “supply” on account of the provisions contained in Schedule I of the said Act, the supplier would be eligible to avail of the ITC.

Now the question is if the transfer made by the employer to employees is a two-wheeler which falls under the definition of Motor vehicles as per Section 2(28) in The Motor Vehicles Act, 1988 then whether Input Tax Credit is available on its further supply. We need to refer to section 17(5)(a), of CGST Act, 2017, input tax credit shall not be available in respect of the motor vehicles for transportation of persons having approved seating capacity of not more than thirteen persons (including the driver), except when they are used for making taxable supplies, namely further supply of such motor vehicles. Thus, it is clarified that input tax credit shall be available to the employer if it supplies Motor vehicle to its employee. Again the valuation of supply has to be in terms of Rule 28 of CGST Rules 2017 that is Open Market value of such good provided that the value of transfer is in excess of Rs. 50,000 and this transfer is not forming part of the contract/employment agreement/ contractual obligation between the employer and employee and is not part and parcel of the cost-to-company (CTC).

3. GST applicability in case invoices are in the name of Employees and payment is being made directly by the Company.

In this case to determine the taxability of goods or services transferred, it is important to understand the meaning of the term ‘Goods’ & ‘Services’. The expression ‘Goods’ & ‘Services’ has been defined under the CGST Act, hence, one needs to refer to section 2 (52) & section 2(102) of The CGST Act, 2017 respectively.

“As per Section 2(52) – goods means every kind of movable property other than money and securities but includes actionable claim, growing crops, grass and things attached to or forming part of the land which are greed to be served before supply or under a contract”

“As per Section 2(102) – services means anything other than goods, money and securities but includes activities relating to the use of money or its conversion by cash or by any other mode, from one form, currency or denomination, to another form, currency or denomination for which a separate consideration is charged

From the above, it is clear that monetary payment doesn’t fall under the ambit of CGST Act, 2017 neither as goods nor as service. Further since the title of goods never came in the employer name so the question of supply and applicability of GST output tax thereon does not arise. However this issue is a matter of interpretation like in case of glass which could be defined as half empty or half full. Another interpretation of this could make this transaction fall in the definition of supply and liable for GST output tax as the real essence of this payment is Gift to employee free of cost exceeding the value of Rs. 50,000. In this scenario GST output tax shall be leviable on open market value as per Rule 28 of CGST Rules 2017. Also since the conditions of ITC claim also do not get fulfilled hence the GST ITC would not be available to be set off against Output GST liability against this supply.

For claim of ITC following conditions are required to be satisfied:

As per Section 16, of CGST Act, 2017

(2.) Notwithstanding anything contained in this section, no registered person shall be entitled to the credit of any input tax in respect of any supply of goods or services or both to him unless,

  1. he is in possession of a tax invoice or debit note issued by a supplier registered under this Act,
  2. he has received the goods or services or
  3. subject to the provisions of section 41, the tax charged in respect of such supply has been actually paid to the Government, either in cash or through utilisation of input tax credit admissible in respect of the said supply; and
  4. he has furnished the return under section

To avoid such a scenario wherein it is advisable that such payment be given to employee as Ex- Gratia/ Bonus and booked under the head salary in the books of accounts liable for TDS under Section 192 of the Act. Also such Ex-Gratia/ Bonus be made part of contractual agreement between employer and employee. In this way it cannot be defined as supply as per Section 7 of CGST Act, 2017 and thus not liable for GST output tax.

Disclaimer:

Our conclusions are based on the completeness & accuracy of the facts stated therein & assumptions, which if not entirely complete or accurate, should be communicated to us, as the inaccuracy or incompleteness could have a material impact on our conclusions. The conclusions reached & views expressed in the note are based on our understanding of the law & regulations prevailing as of the date of this note as well as our past experience with the tax and / or regulatory authorities. However, there can be no assurance that the tax authorities or regulators will concur with our views.

Legislation, its judicial interpretation & the policies of the tax and / or regulatory authorities are subject to change from time to time & these may have a bearing on the advice that we have given. Accordingly, any change or amendment in the law or relevant regulations would necessitate a review of our comments & recommendations contained in this note. Unless specifically requested, we have no responsibility to carry out any review of our comments for changes in laws or regulations occurring after the date of this note.

Without prior permission of DMCGLOBAL SERVICES LLP, the contents of this study / note may not be quoted in whole or in part or otherwise referred to in any documents. This document is for the specific purpose and we accept no responsibility or liability to any party.

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