Friday, February 26, 2010

Taxation and the Budget: An Initial Assessment of the Finance Bill, 2010

From the perspective of taxation (particularly income tax and service tax), the budget proposes changes in several areas. Importantly, the Finance Minister has clarified that the Direct Taxes Code will be introduced from 1st April, 2011. The GST will also be sought to be implemented from that date. In this post, I shall look at a few issues in income tax and service tax that may arise out of the Finance Bill, 2010.

The definition of “Charitable purposes”:

A Proviso added to the explanation to Section 2(15) of the Income Tax Act by the Finance Act, 2008, had resulted in some confusion as to whether an institution which incidentally earned some fees in connection to its charitable activities would be entitled to take advantage of the benefits granted to charitable institutions. In Himachal Pradesh Environment Protection and Pollution Control Board v. CIT, the Income Tax Appellate Tribunal had held that the Proviso only excluded those institutions in which the charitable purpose was a “mask” or a device to hide the true purpose of trade and commerce. Thus, the test under the Proviso in determining whether an institution advanced an object of general public utility and was a charitable institution or not; was whether or not the charitable purpose was a mask to shield commercial activities or not.

The Finance Bill, 2010, adds a further Proviso that “the advancement of any other object of general public utility” shall continue to be a “charitable purpose” if the total receipts from any activity in the nature of trade, commerce or business, or any activity of rendering any service in relation to any trade, commerce or business do not exceed Rs.10 lakhs in the previous year. The interpretation of this may result in some ambiguity. The new Proviso is sought to be inserted with retrospective effect from 1st April, 2009.

The Revenue can perhaps argue that this further Proviso indicates that the test for whether the first Proviso applies or not; is not whether the charitable activity is a “mask” for commercial activities. Instead, the first Proviso would apply in every case where fees are earned by the institution, except (as per the second Proviso) where the fees do not exceed Rs. 10 lakh. It seems a possible construction that in every case where fees received exceed Rs. 10 lakh; the first Proviso would apply – even if the charitable purpose is not a mask for commercial activities. The newly inserted Proviso seems to indicate, in other words, that the test is not just of what the true nature of the activities of the institution is, but is instead a blanket test applicable to all institutions which earn fees from charitable purposes – whether the charitable purpose is a device or not, is immaterial. If the fees received are over Rs. 10 lakhs, the institution would not be carrying out a charitable purpose.

Assessees can, of course, argue that the second Proviso is an additional test to satisfy; over and above the test that the charitable purpose is a mask. That interpretation would mean, however, that those activities which are simply a mask or a device for commercial purposes, would still be entitled to take the benefit of “charitable purposes” if the fees they earn are less than Rs. 10 lakhs. The Memorandum accompanying the Finance Bill seems to indicate that the construction in favour of the Revenue is the true intent behind the Bill. It specifically refers to the “absolute restriction” imposed by the First Proviso. As a matter of policy, however, there may not be a strong reason to say that an organization which carries out genuine charitable activities is not established for a charitable purpose if incidental to its activities it earns some fees. What view the judiciary will take of the effect of the new Proviso is a matter which remains to be seen after the enactment into law of the Bill.

Section 9:

The controversy in the taxation of non-residents in interpreting Section 9 of the Income Tax Act has been discussed on several occasions earlier. Essentially, under the judgment of the Supreme Court in Ishikawajima, for Section 9(1)(vii) to be applied in order to say that fees for technical services are deemed to accrue or arise in India, it is essential that the service is both rendered and utilized in India. An Explanation was inserted in 2007 attempting to modify this rule. However, as was held by the Karnataka High Court in Jindal, on a plain reading, the Explanation did not do away with the principle of Ishikawajima. This Explanation is sought to be replaced by a new one, again with retrospective effect from 1976. The new Explanation specifically states that it is not necessary that the services should be rendered in India. On its text, it is now clear that the rule in Ishikawajima is not good law.

There may perhaps be a constitutional challenge open to the new Explanation, as being  in violation of territorial nexus requirements – it is debatable whether that challenge would succeed. It is unclear as to how strongly the nexus doctrine would apply to a Union law; and in any case, the mere existence of a nexus is sufficient (the strength of the nexus not being relevant). The Union can well contend that even now, services must be utilized in India even if not rendered in India, and that constitutes territorial nexus. If the Explanation stands as it presently is post-enactment, one thing would be clear: the income of a non-resident shall be deemed to accrue or arise in India under Sections 9(1) (v), (vi), and (vii) whether or not (i) the non-resident has a residence or place of business or business connection in India; or (ii) the non-resident has rendered services in India.


The Finance Bill proposes to clarify that the transfer of assets on a conversion of a company into a Limited Liability Partnership will not be regarded as a transfer of assets for the purpose of capital gains, if certain conditions are met. These conditions include that the company’s total sales, turnover or gross receipts in the three previous years should not exceed Rs. 60 lakh. Thus, for companies not within that limit, a conversion to a limited liability partnership will result in capital gains liability. Several other conditions are also mentioned. Furthermore, under Section 115JAA as it now stands, certain tax credits are allowed to companies which are covered under Section 115JA and 115JB for MAT purposes. This credit will not be allowed – under the proposed sub-section (7) to Section 115JAA – to successor LLP’s on a company’s conversion to an LLP.


There was a controversy between some High Courts about whether a High Court has the power to condone delays in filing appeals under Section 260A of the Income Tax Act. The weight of authority suggested that there was no such power to condone delays under Section 260A. The Bill gives High Courts the power to condone delays, with retrospective effect from 1st October, 1998. This is likely to lead to a huge flood – literally, thousands – of applications for restoration of appeals which were dismissed on account of delay.

Service tax:

The Delhi High Court had held in Home Retail that the renting of immovable property on its own would not constitute a service. The Finance Bill, 2010 indicates that renting of immovable property itself would be a taxable service under the Finance Act, 1994. This amendment is also retrospective, with effect from 1st June, 2007. Furthermore, as the accompanying Memorandum states, under the existing law in relation to service tax, IT software services are included as taxable services only in those cases where the service is used in furtherance of business or commerce. This limitation is sought to be dropped by amending Section 65(105)(zzzze) of the Finance Act, 1994 – information technology software service will be taxable services irrespective of the use to which the service is put to.


In sum, in both service tax and income tax, the Finance Bill, 2010 continues the trend of the legislature to upset judicial decisions by retrospective amendments. There are some changes sought to be introduced in terms of income tax slabs, higher TDS limits have been made available, and the rate of MAT has been increased. From a legal viewpoint, several proposals merit greater debate and scrutiny.

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