Monday, November 21, 2016

Demonetization and the Income Tax Act

[The following guest post is contributed by Kailash Nath P S S, who is a lawyer and a chartered accountant, and is currently associated with Wadia Ghandy & Co., Mumbai. Views expressed here are personal and do not reflect the firm’s views.]


The recent move of the Central Government exercising its powers u/s 26(2) of the Reserve Bank of India Act, 1934 (“RBI Act”), to withdraw the legal tender character of existing bank notes in denominations of Rs. 500 and Rs. 1000 (“Specified Notes”) issued by the Reserve bank of India is unprecedented. As the Specified Notes cease to be legal tender, a scheme has been formulated under which the Specified Notes can be deposited or exchanged across bank branches and other places designated by the Reserve Bank of India (“RBI”) up to 30 December 2016 (and in exceptional cases, 31 March 2016). While there has been a lot of hue and cry over the many aspects related to this move, the most baffling aspect has been the nature of treatment of such deposit under the Income Tax Act, 1961 (“Act”).

As announced by the Revenue Secretary, Rules 114B and 114E (corresponding to Section 285BA of the Act relating to Annual Information Reports) were amended to enable banks to report cash deposits of over Rs. 250,000 (previously Rs. 10,00,000) to the Central Board of Direct Taxes (“CBDT”). It is further announced that any cash deposits made from undisclosed sources would attract penalty of 200% of tax payable, even if they are subject to tax at the maximum marginal rate of 30%. While there have been varied interpretations regarding imposing the penalty, the legal position and the procedure that should be adopted under the Act to impose any penalty under the Act has been discussed below.

Assessment Procedure under the Act

Under section 139 of the Act, every person with taxable income is statutorily required to file a return of income on or before the due date. Such a return of income would either be summarily processed under section 143(1) to compute the total income or to check for any arithmetical adjustments, disallowances, or inclusion of any additional income not included in computing the total income. The same may also be selected for scrutiny (under the computer assisted scrutiny selection (“CASS”) system) under section 143(2) of the Act by the Assessing Officer (“AO”) by calling for information (asking the assessee to produce books of accounts, bank statements, statements of assets and liabilities, sources of funds, etc.). Also, if the AO has circumstances to believe that any income chargeable to tax has escaped assessment, a notice can be issued under section 147 to re-assess such income under section 148. The AO can re-open assessments by issuing notices up to 6 years from the end of the assessment year in which the income was first assessable.

Introduction of Section 270A with effect from 1 April 2017

Presently, section 271(1)(c) provides for levy of penalty for concealment of income or for furnishing inaccurate particulars of income. The initiation of penalty proceedings under section 271(1)(c) is subject to controversy, as AOs regularly initiate penalty proceedings as soon as assessment under Section 143(3) is complete. The Supreme Court in CIT, Ahmedabad v. Reliance Petroproducts Pvt. Ltd.[1] stated: “If we accept the contention of the revenue then in case of every return where the claim made is not accepted by the Assessing Officer for any reason, the assessee will invite penalty under Section 271(1)(c). That is clearly not the intendment of the legislature”. Moreover, the Income Tax Simplification Committee headed by Justice R.V. Easwar has recommended that no penalty should be levied for concealment if assessee has taken a bona fide view of a provision enabling a claim etc. or on the basis of any judicial ruling and if any addition or disallowance is made ad hoc on assumptions or without evidence.

Disregarding the above, the Parliament by way of the Finance Act, 2016 introduced section 270A under the Act and repealed section 271, both with effect from 1 April 2017. The section deals with penalty for underreporting and misreporting of income. The penalty in the event income is ‘underreported’ is 50% of the tax payable on such underreported income, and in case of misreporting, the penalty is 200% of the tax on such amount. Hence, penalty for ‘concealment of income’ is effectively replaced by penalty for ‘underreporting’ and ‘misreporting’ of income.

The Act does not define ‘underreporting’ and ‘misreporting’, but sets out the instances where the income will be treated as such. An assessee shall be considered to have underreported its income if, among others, the income assessed (under section 143(3) or any other provision) is greater than the income determined in the return processed under section 143(1), and the underreported income will be the difference between the amount of income assessed and the amount of income determined under section 143(1)(a). However, subsection (6) states that under reported income shall not include, among others, (a) income in respect of which the assessee offers an explanation, or (b) the accounts are correct and complete to the satisfaction of the AO (if an estimate of income is drawn from them). In both the cases, the AO should be satisfied that the explanation is bona fide and the assessee has disclosed all the material facts to substantiate the explanation offered.

Subsection (9) sets out the instances where the under reporting of income would be treated as ‘misreporting’. Misrepresentation or suppression of facts, failure to record investments in the books of account, claiming expenditure not substantiated by any evidence, recording of any false entry in the books of account, and failure to record any receipt in books of account are instances of underreporting which would be treated as ‘misreporting’.

Burden of Proof

The Supreme Court had held previously in many cases that the burden of proof is on the Department to prove that the assessee had a guilty mind to establish that it concealed income or furnished inaccurate particulars. To overcome this interpretation, an Explanation was introduced in section 271(1)(c) where the burden of proof was imposed on the assessee to establish bona fides and innocence. However, under section 270A, the operative portion of the section (assessed income being more than declared income) is sufficient to levy penalty. However, to establish ‘misreporting’, the burden is cast on the Department to prove the same, as there is no provision similar to Explanation under section 271(1)(c). However, it may be noted that the Supreme Court of India in Union of India v. Dharamendra Textile Processors[2] after considering section 271(1)(c) came to the conclusion that the Explanations added to section 271(1)(c) indicate the element of strict liability on the assessee for concealment or for giving inaccurate particulars while filing returns and that the object behind enactment of section 271(1)(c) read with the Explanations indicates that the section has been enacted to provide for a remedy for loss of revenue.

Going by the above, though mens rea may not be required to be established under law, if the material and evidence with the AO sufficiently points to misreporting on the part of the asseessee that falls within the confines of subsection (9), penalty may be imposed under the Act.

Application of Section 270A to Deposit of Specified Notes

In instances where Specified Notes are deposited by the assessee, the liability to establish that it has been generated from an established and bona fide sources depends on facts of the case. Any liability to offer explanation only arises after a return has been filed for the current period (i.e. before 31 July 2017 or 30 September 2017), and if the return is taken up for scrutiny. Any cash deposited in the bank accounts may even form a part of the income which was subject to tax previously or may form part of the funds in the ordinary course of business and which has been deposited in the account, and subsequently offered to tax in the return of income. Hence, the question that arises is under what circumstances can the penalty be levied on these deposits, besides levy of tax.

For the purpose of illustration, let’s assume a trader who, for exchanging his Specified Notes, deposits the same in his bank account, representing sales in the ordinary course of business. At the end of the financial year, he offers the excess of income over expenditure to tax. During the course of the assessment proceedings it is for the AO to establish that the said deposits represents income from undisclosed sources. If the assessee is unable to offer satisfactory explanation regarding the source of the income, the AO may attempt to treat the same as ‘unexplained investment’ (from undisclosed sources) under section 69 of the Act, and impose tax under section 115BBE at maximum marginal rate of 30%. Besides imposing tax, the AO may attempt to invoke penalty proceedings under section 270A as ‘misreporting’ of income. However, no deduction in respect of any expenditure or allowance or set off of any loss shall be allowed to the assessee in computing his income. In addition, penalty will be imposed treated it the same as ‘misreporting’.

The judgments of the Supreme Court on the subject matter during previous demonetization drives can be referred to. A three-judge bench of the Supreme Court in Srilekha Banerjee and Ors. v.  Commissioner of Income Tax, Bihar and Orissa,[3] following the earlier judgment in Mehta Parikh & Co. v. Commissioner of Income Tax, Bombay,[4] held that if there is an entry in the account books of the assessee which shows the receipt of a sum, it is necessary for the assessee to establish, if asked, what the source of that money is. It stated that the Department cannot act unreasonably and reject that explanation of the assessee to hold it otherwise. It stated that if, however, the explanation is unconvincing and one which deserves to be rejected, the Department can reject it and draw the inference that the amount represents income either from the sources already disclosed by the assessee or from some undisclosed source. It stated that before the Department rejects any evidence, it must either show an inherent weakness in the explanation or rebut it by putting to the assessee some information or evidence which it has in its possession, and the Department cannot by merely rejecting unreasonably a good explanation, convert good proof into no proof.

Waiver of Penalty

Section 273A(1) empowers the Principal Commissioner or Commissioner to grant waiver or reduction from penalty imposed or imposable under section 270A. The waiver or reduction under section 273A(1) can be granted by the Principal Commissioner or Commissioner either on his own motion or otherwise, i.e., on an application made by the taxpayer. The assessee should have, prior to the detection by the AO of the concealment of particulars of income, voluntarily and in good faith, made full and true disclosure of such particulars. He should have also co-operated in any enquiry relating to the assessment of his income and has either paid or made satisfactory arrangements for the payment of any tax or interest payable in consequence of an order passed under the Act. An order accepting or rejecting the application shall be passed within a period of twelve months from the receipt of the application after giving the assessee an opportunity of being heard.

Other Issues

In addition to discharging liability under the Act, the assessee has to duly consider obligations under indirect tax legislations, given the information exchange channels between various arms of the Revenue. Depending on the nature of business, the assessee may be called upon to correlate the deposits under State VAT laws, excise laws or under the Finance Act, 1994, towards service tax also. Further, assessee should be cautious while making claims of sources as loans or advances towards property transactions as sections 269SS and 269T prohibits cash transactions in excess of Rs. 20,000 for accepting or advancing loans and deposits or in relation to transfer of an immovable property, whether or not the transfer takes place. Provisions with regard to collection of tax at source under section 206C and quoting of PAN of the buyers have to be borne in mind by bullion traders who make cash sales above specified limits (bullion exceeding Rs. 2,00,000 and jewellery exceeding Rs. 5,00,000) and by sellers who receive sale consideration in cash exceeding Rs. 2,00,000 for sale of any goods.

More importantly, attention maybe drawn to section 276C which contains provisions for launching prosecution for wilful attempt to evade tax. The section has been further amended to provide for rigorous imprisonment (between six months to seven years) where the amount sought to be evaded, or tax on under-reported income exceeds Rs. 25,00,000.


The primary point to be noted here is that all cash that is deposited is not definitely income, or for that matter, undisclosed income. However, the onus is largely on the assessee to prove that he has not misreported or suppressed any facts while making deposits of the Specified Notes. At the same time, the Department cannot summarily, and without any cogent reasons, reject the explanations offered by the assessees. It is not an exaggeration to say that this drive is likely to result in prolonged litigation and some degree of inconvenience to the assessees. With reports coming in that notices are already being issued seeking explanation for the sources of cash deposits, we can only hope that the ‘ease of doing business principles’ are emulated even with the Indian residents and assessees. It may however be borne in mind that this window may not be taken as an opportunity to deposit any cash and pay tax at regular rates on undisclosed income, as there is likely to be detailed scrutiny after the Income Declaration Scheme, 2016, having ended quite recently.

- Kailash Nath P S S

[1] MANU/SC/0182/2010.

[2] (2008) 306 ITR 277.

[3] MANU/SC/0101/1963.

[4] MANU/SC/0053/1957.

1 comment:

vswami said...


Some of, if not all, the observations, in the write-up are seen to be in agreement with the viewpoints largely shared by/ exchanged in well informed circles, of tax pundits and others.
One may wish to add: By and large, there has been a temptation, unwittingly or otherwise, to equate, and use , the terms ‘cash deposits’ and ‘income’ interchangeably; that is, the impression given is that those represent one and the same thing, in quantum. What needs to be realised is that , in any view, the cash deposits could at best be ‘gross receipts’ ; and not the ‘income’ or ‘profits and gains’ on which alone levy of tax , plus penalty if so attracted, could normally be made.
It is in this context / with focus on, that the implications and consequence of application of sec 68 and its allied sections likely to be invoked call for consideration. This is the very same angle which has been highlighted and examined in the published Articles , - (2006)156 TAXMAN 121; (2006) 160 TAXMAN 145. As set out/discussed therein, without satisfying the Revenue on the exact ‘source’ of monies or things of value such as bullion, etc., levy of tax and penalty might be reckoned on the amount of ‘gross receipts’ equal to ‘cash deposits’.