02 « May « 2018

Introduction

1. An assessee may withdraw/convert/treat his stock in trade and hold it as a capital asset if there are changes in facts and circumstances necessitating such conversion.

2. Conversion of stock-in-trade to capital asset may also result into advantage of lower taxes since capital gains are taxed at a lower rate compared to business income and there is also an advantage of indexation. Therefore, many a times we see builders convert their stock-in-trade i.e. land into a capital asset or a share trader converts his stock-in-trade of shares into investment. Such conversion was
usually not treated as taxable by the
taxpayer and consequently on sale of such investment, taxes as applicable to capital gains were paid.

3. However, the Income tax department disputed the veracity of such conversion in the year of sale and taxed the income arising on sale of investment as a business income. For example, in many cases it was seen that a share trader converted his stock of shares as on 31-3-2004 into investment as from AY 05-06, LTCG was tax free and STCG was taxed at a lower rate. Thus when the shares were sold after one year of conversion, assessee would claim income on sale as income arising on sale of investment and consequently claim LTCG as exempt. However, the A.O. would treat such gains as business income.

4. Thus, when an inventory is converted into a capital asset, several issues regarding taxability of said transaction arise. Some of the issues are as under:

(i) Whether conversion of inventory into a capital asset is permitted by law?

(ii) Whether AO can dispute such conversion?

(iii) Whether such conversion gives rise to a taxable event?

(iv) If there is a taxable event upon conversion, then what is the sale consideration and when is the tax to be paid i.e., in the year in which there is sale of capital asset or in the year of conversion itself?

(v) What should be taken as the cost of acquisition of the capital asset post conversion and what will be the period of holding of the capital asset?

5. The above issues on conversion have arisen from a very long time and different assessees have given different treatments upon such conversion. However, unlike Section 45(2) which provides for taxability in the case of conversion of a capital asset into stock-in-trade, there were no specific provisions dealing with a reverse situation i.e taxability arising on conversion of Inventory into Capital Assets.

Proposed Amendment

6. The Finance Bill, 2018 proposes to make amendments to following provisions:

(i) Section 28, by inserting clause (via) so as to provide that the fair market value of inventory as on the date on which it is converted into, or treated as a capital asset determined in the prescribed manner shall be charged to tax as business income.

(ii) Section 2(24), by inserting clause (xiia) so as to include such fair market value in the definition of income;

(iii) Section 49, by inserting Sub-Section (9) so as to provide that for the purposes of computation of capital gains arising on transfer of such capital assets, the fair market value on the date of conversion shall be the cost of acquisition;

(iv) Clause (42A) of section 2, by inserting clause (ba) in Explanation 1 clause(i), so as to provide that the period of holding of such capital asset shall be reckoned from the date of conversion or treatment.

Reason for proposed amendments

7. As per the Memorandum explaining the provisions, the reason for proposed amendment are two fold as under :

(i) To provide symmetrical treatment like treatment provided for conversion of capital asset into stock-in-trade u/s. 45(2).

(ii) To discourage the practice of deferring the tax payment by converting the inventory into capital asset.

Effective date of proposed amendments

8. These amendments will take effect from 1st April, 2019 and will, accordingly, apply in relation to the assessment year 2019-20 and subsequent assessment years.

Analysis

9. It is important to analyse the pre-amended law to know the difference between the pre-amended law and post-amended law. Further, the conversions which have taken place prior to the proposed amendments would be governed by the pre-amended law.

10. The pre-amended law is essentially derived from judicial precedents. Some of the important decisions and the legal principles laid down by them are as under:

A. NO TAXABLE EVENT ON CONVERSION OF INVENTORY INTO CAPITAL ASSET

Sir Kikabhai Premchand v CIT (1953) 24 ITR 506 (SC).

This a landmark decision which forms the fulcrum of various subsequent decisions on the issue of conversion of stock-in-trade into capital asset. This was a Judgment rendered by a Full Bench (5 Judges) and the verdict was a split in the ratio of 4:1. The judgment deals with the tax treatment in the year of conversion. In this case, assessee a trader in silver bars and shares was valuing the stock at cost. During the relevant previous year the assessee withdrew from the business certain shares and silver bars and settled then or certain trusts at cost. The AO assessed the profit at the difference between the cost price of the said shares and silver bars and the market value thereof at the date of their withdrawal from the business. The High Court confirmed the action of the AO. Reversing the decision of the High Court, the Supreme court held, speaking through Bose, J. for the majority view :

(i) A man cannot be compelled to make a profit out of any particular transaction.

(ii) It is wholly unreal and artificial to separate the business from its owner and treat them as if they were separate entities trading with each other and then by means of a fictional sale introduce a fictional profit which in truth and in fact is non-existent.

(iii) The position that the man is supposed to be selling to himself and thereby making a profit out of himself which on the face of it is not only absurd but against all canons of mercantile and income-tax law.

(iv) Under the Income-tax Act the State has no power to tax a potential future advantage. All it can tax is income, profits and gains made in the relevant accounting year.

Thus, as per this decision there is no taxable event arising on conversion of inventory into Capital Asset.

At this juncture, it will be very important to consider the dissenting view of Bhagwati, J who held as under :

(i) So far as the business is concerned the asset ceases to be a part of the stock-in-trade whether it is realised or is withdrawn from the stock-in-trade. It makes not the slightest difference whether an asset is realised in the course of the business or is withdrawn from the stock-in-trade of the business.

(ii) So far as the business is concerned it is entitled to credit in its goods account the price of that asset as has been realised by the sale thereof or the market value of that asset as at the date of its withdrawal.

Thus, as per the dissenting view there is a taxable event arising on conversion of inventory into capital asset and market value of the stock-in-trade shall be the sale consideration.

Interestingly one can see that the minority view is now the proposed amended law and the majority view is set at naught by the Parliament.

In CIT v. Dhanuka & Sons [1980] 124 ITR 24 (Cal.)(HC) while dealing with the assessment in the year of conversion, on considering Sir Kikabhai Premchand’s case (supra) and several other judgments had expressed as under:–

“14. Further, in our view, there cannot be any actual profit or loss in such transfers where no third party is involved and the items are kept in a different account of the assessee himself. The question of gain or loss would arise in the facts of the instant case only in future when the stocks transferred to the investment account might be dealt with by the assessee. If such shares be disposed of at a value other than the value at which it was transferred from the business stock, the question of capital loss or capital gain would arise.”

Thus, conversion did not result into any taxable event and taxable event takes place only upon subsequent sale of capital asset giving rise to capital gains tax only.

In ACIT v. Bright Star Investment (P.) Ltd. [2009] 120 TTJ 498 (Mum)(Trib) assessee had converted some shares from stock-in-trade to investment as on 1-4-1998 at its book value. Thereafter, the assessee sold some of the shares out of the above shares and offered profit earned as long-term capital gain. The Assessing Officer opined that in view of the provisions laid down under section 45(2) the income of the assessee would be computed separately as business income till the date of conversion of the shares from the stock to investment and thereafter as long-term capital gain. The Assessing Officer, therefore, took the highest market rate of the said shares on date of conversion and computed the business income, being the difference in the value at which the said shares were converted into investment and the market value of the said shares on the date of conversion, i.e., 1-4-1998 and, further computed the long-term capital gain at ₹ 4,57,62,262 being the difference between the market value and the actual sale value of the shares. The Hon’ble ITAT held as under :

(i) While incorporating sub-section (2) to section 45, the Legislature has not visualised the situation in other way round, where the stock-in-trade is to be converted into the investment and later on the investment is sold on profit. In the absence of a specific provision to deal with this type of situation, a rational formula should be worked out to determine the profits and gains on transfer of the asset.

(ii) The formula which was adopted by the assessees i.e., the difference between the sale price of the shares and the cost of acquisition of share, which is the book value on the date of conversion with indexation from the date of conversion, should be computed as a capital gain was to be accepted.

It is to be noted that no appeal against the above decision was filed by the Department. However the Income Tax Department filed an appeal before the Bombay High Court in the case of
Synchem Chemicals (I) Ltd. reported in CIT-10 v. Synchem Chemicals (I) Ltd. [2016] 384 ITR 498 (Bom.)(HC) wherein the ITAT had followed the decision of
ACIT v. Bright Star Investment (P.) Ltd. (supra). The Department appeal was dismissed by the High Court.

B. COST OF ACQUISITION AND INDEXATION

In the case of Kalyani Exports & Investment (P.) Ltd./Jannhavi Investment (P.) Ltd./Rajgad Trading (P.) Ltd. v. Dy. CIT [2001] 78 ITD 95 (Pune) (TM) assessee acquired certain shares in the year 1977. On the original holding they received bonus shares in the financial year 1981-82 and additional bonus shares in the financial year 1989-90. All the shares were held as stock-in-trade till 6-11-1987. On the sale of the shares, while working out capital gain, assessee computed fair market price as on
1-4-1981. Indexation was also claimed by taking base year as AY 1981-82. The Assessing Officer held that since the assessee was holding the shares as stock-in-trade up to 2-11-1987 and as the said shares were not capital assets as on 1-4-1981, the option adopted as fair market price as on 1-4-1981 was not available to the assessee and indexation should be allowed from the year of conversion. The Tribunal held as under :

(i) There can be only one acquisition of an asset and that when the assessee acquires it for the first time, irrespective of its character at that point of time. It was therefore, held that what is relevant for the purpose of capital gains is the cost of acquisition and not the date at which the asset became a capital asset. Thus, FMV as on 1-4-1981 was to be taken as cost as acquisition.

(ii) Indexation has to be taken from the Base Year 1981-82.

The above decision of the ITAT has been confirmed by the Bombay High Court in CIT v. Jannhavi Investment Pvt. Ltd. [2008] 304 ITR 276 (Bom)(HC) The High Court held as under :

“In our view, there is no substance in the contention of the Revenue. The amendment of 1993 referred to hereinabove does not in any way nullify or dilute the ratio as laid down in the case of
Keshavji Karsondas v. CIT reported in [1994] 207 ITR 737 (Bom.) The cost of acquisition can only be the cost on the date of the actual acquisition. In the present case, there was no acquisition of the shares on November 6, 1987, when the same were converted from stock-in-trade to a capital asset.”

C. PERIOD OF HOLDING

In Splendor Constructions (P.) Ltd. v. ITO [2009] 27 SOT 39 (Del.)(Trib.) and Deensons Trading Pvt. Co. Ltd. v. ITO [2017] 81 taxmann.com 71 (Chennai – Trib.) it was held that holding period was to be counted from the date of conversion and not from the date of acquisition. The decisions also held that the Third Member decision of ITAT in the case of Jahannvi Investment Pvt. Ltd. (supra) related to cost of acquisition and not period of holding.

D. DISPUTING THE VERACITY OF CONVERSION

In CIT-Delhi v. Abhinandan Investment Ltd. [2016] 282 CTR 466 (Delhi) the year of conversion of stock-in-trade into investment and the year of sale of investment was the same. The conversion was not accepted by the Court. It was held as under :

(i) The exercise of conversion was seen as sham to reduce tax incidence and consequently the conversion was not recognised.

(ii) The period of holding is to be computed from date of conversion

(iii) The Court gave a prima facie view that on sale of investment/converted stock-in-trade, cost of acquisition could be the market value as on the date of conversion. Further, in the year of sale of investment, difference between market value and book value as on date of conversion should be assessed as business income and balance as capital gains. However, it is to be noted that the Court did not finally decide the issue and left the question open to be decided in an appropriate case.

Similarly the Mumbai ITAT in Mr Kenneth D’Souza v. Addl. CIT ITA No 865/M/2012 A.Y. 2008-09 dtd. 6-2-2015 (Mum)(Trib.)
also did not uphold the validity of conversion of stock-in-trade of shares into investments on the ground that Assessee had not shown any material change in facts justifying such conversion. The decision of ITAT was confirmed by the Bombay High Court in Kenneth D’Souza v. Addln CIT ITA No 770/M/15 dtd 24-1-2018(Bom.)(HC).

However, in Deeplok Financial Services Ltd. v. CIT [2017] 393 ITR 395 (Cal)(HC) the claim of assessee regarding conversion of stock in trade into investment in earlier year and return of capital gains in year of sale of converted stock-in-trade was accepted. It was held as under :

(i) Section 45(2) of the Act provides for conversion by the owner of a capital asset into or its treatment by him as stock-in-trade of a business carried on by him as chargeable to income-tax . The Act however does not provide for the conversion of stock-in-trade into capital asset.

(ii) Conversion of stock-in-trade into Investment is permissible even though the Income-tax Act does not provide for the same.

It appears that the above decision has acted as a trigger for the proposed amendment.

11. Thus the pre-amended position can be summed up as under:

a) Though conversion is permissible in law, veracity of such conversion can be disputed by the AO.

b) Conversion does not give rise to any taxable event.

c) Taxable event arises only upon subsequent sale of capital asset and the gains will be taxable as capital gains. It is to be noted that the observation of
Delhi HC in CIT-Delhi v. Abhinandan Investment Ltd. (supra) was only a prima facie view and not a conclusive decision.

d) The cost of acquisition shall be the actual cost of acquiring the asset. However, in
ACIT v. Bright Star Investment (P.) Ltd. (supra) the ITAT accepted the Book Value of stock- in-trade as on the date of conversion as cost of acquisition.

e) For classifying gains as short term capital gains or Long Term capital gains, period of holding is to be computed from date of conversion.

12. Having analysed the pre-amended law, I will now proceed to analyse the post-amended law as under :

A. CONVERSION OF INVENTORY INTO STOCK IN TRADE RESULTS IN A TAXABLE EVENT

By virtue of amending Section 28 by inserting clause (via) it is provided that the fair market value of inventory as on the date on which it is converted into, or treated as a capital asset shall be charged to tax as business income. Consequently Section 2(24) is amended by inserting clause (xiia) so as to include such fair market value in the definition of income. Thus, FMV as on the date of conversion will be taken as income u/s. 28.

B. YEAR OF TAXABILITY SHALL BE THE YEAR OF CONVERSION

The year of taxability shall be the year of conversion itself. The reason for same is as under :

(i) The amendment is in accordance with the principle laid down by the minority view in Sir Kikabhai Premchand v. CIT (Supra) according to which there is a taxable event upon conversion. The minority view did not consider the principle of trading with oneself as applicable to the situation of conversion of stock-in-trade into capital asset. Hence, there is no merit in the argument that the business income arising on conversion is to taxed in the year of sale of capital asset.

(ii) Section 45(2) specifically provides that gain on conversion is to be taxed the year of sale of stock-in-trade. No such provision is incorporated w.r.t. conversion of stock-in- trade into investment.

(iii) The memorandum explaining the provisions clearly state the one of the objectives of the proposed amendments is to discourage the practice of deferring the tax payment
by converting the inventory into capital asset.

(iv) The FMV as on date of conversion is itself income as per Section 2(24). Hence, there is no reason for deferring the incidence of tax to the year of sale of Capital Asset.

C. FAIR MARKET VALUE

The FMV as on the date of conversion/treatment as capital asset shall be taken into consideration. Definition of FMV in relation to ‘capital asset’ has been provided in clause (22B) of Section 2 to be a value which it can fetch in the open market. However the same will not apply in this case as this clause requires FMV in relation to ‘Inventory’ and further in this clause it is provided that FMV of inventory shall be determined in the prescribed manner. It is to be noted that under the Income- tax Act FMV is not always the value which an asset can fetch in the open market. For instance under Rules 11U and UA, FMV is not always the value which can be fetched in the open market. Thus, one will have to wait for the CBDT to prescribe the valuation rules.

D. INCOME

The amount to be taken as income is the entire FMV. This is because the difference between the FMV and the Book Value of opening stock will be adjusted in the trading account itself. For example, In AY 19-20 stock in trade being one share is purchased for ₹ 100. The closing stock is valued at ₹ 90. Hence, a loss of ₹ 10 will be booked in AY 2019-20. The share is converted to investment in the middle of AY 20-21. The FMV as on date of conversion was ₹ 200. For computation of income under Section 28(via) ₹ 200 will have to be taken and not ₹ 200-90. This is because the difference of ₹ 110 will be adjusted in the trading and P/L A/C itself.

E. COST OF ACQUISITION ON SUBSEQUENT SALE OF CAPITAL ASSET

Section 49(9) provides that for the purposes of computation of capital gains arising on transfer of such capital assets, the fair market value on the date of conversion shall be the cost of acquisition.

F. PERIOD OF HOLDING

Clause (42A) of section 2, by inserting clause (ba) in Explanation 1 clause (i), provides that the period of holding of such capital asset shall be reckoned from the date of conversion or treatment.

G. CERTAIN ISSUES

(i) The conversion of stock-in-trade into investment has now been given a statutory mandate. Suppose, there is a claim of loss on account of conversion of certain stock- in-trade which is adjusted against business profits and according to AO the conversion is done for the purpose of reducing profits. Though ultimately the amount of profit which will be brought to tax may not change but there is a deference. Can the AO dispute the conversion? According to me, AO can no longer dispute the conversions which take place after the proposed amendments are brought into effect as conversion of stock-in-trade into investment is statutorily recognised and there is no provision putting any pre-conditions for conversion.

(ii) A situation may arise where no tax is paid upon conversion. The converted stock-in-trade is sold after 10 years. There is no way the gain of conversion can be taxed after 10 years. The issue will arise regarding adoption of cost of acquisition i.e., whether FMV as on date of conversion can be adopted. The proposed provision of Section 49(9) states that FMV as on the date of conversion will be the cost of acquisition. It does not state that FMV will be cost of acquisition only if gains on conversion are offered to tax.

Conclusion

13 As pointed out above, the proposed amendments completely disregard the fundamental principles of Income Tax Act such as “no man can trade with himself” or that “no one can profit from oneself” . It was on these principles that the Supreme Court in
Sir Kikabhai Premchand v CIT (Supra) held that there is no taxable event upon conversion. It further held that State has no power to tax potential profits. This amendment is a part and parcel of the recent trend to tax
deemed/ notional income instead of taxing real income.

14 From the analysis of the pre-amended law, it can be seen that almost all issues arising on conversion were no longer res-integra and were perhaps settled after years of litigation. The situation is similar to introducing penalty provisions u/s. 270A though the law on penalty u/s. 271(1)(c) was almost settled after several years of litigation.

15 The Supreme Court in Sir Kikabhai’s case also highlighted the freedom of businessman to deal with his business in the manner he likes by way of an illustration. It appears that such freedom now stands impinged. I would conclude by reproducing the said illustration which would aptly manifest the contrast between the pre-amended law and post-amended law :

“A man trades in rice and also uses rice for his family consumption. The bags are all stored in one godown and he draws upon his stock as and when he finds it necessary to do so, now for his business, now for his own use. What he keeps for his own personal use cannot be taxed however much the market rises; nor can he be taxed on what he gives away from his own personal stock, nor, so far as his shop is concerned, can he be compelled to sell at a profit. If he keeps two sets of books and enters in one all the bags which go into his personal godown and in the other the rice which is withdrawn from the godown into his shop, rice just sufficient to meet the day-to-day demands of his customers so that only a negligible quantity is left over in the shop after each day’s sales, his private and personal dealings with the bags in his personal godown could not be taxed unless he sells them at profit. What he chooses to do with the rice in his godown is no concern of the Income-tax department provided always that he does not sell it or otherwise make a profit out of it. He can consume it, or give it away, or just let it rot. Why should it make a difference if instead of keeping two sets of books he keeps only one? How can he be said to have made an income personally or his business a profit, because he uses ten bags out of his godown for a feast for the marriage of his daughter? How can it make any difference whether the bags are shifted directly from the godown to the kitchen or from the godown to the shop and from the shop to the kitchen, or from the shop back to the godown and from there to the kitchen? And yet, when the reasoning of the learned Attorney-General is pushed to its logical conclusion, the form of the transaction is of its essence and it is taxable or not according to the route the rice takes from the godown to the wedding feast. In our opinion, it would make no difference if the man instead of giving the feast himself hands over the rice to his daughter as a gift for the marriage festivities of her son.”

I. Introduction

1) Since the Union Budget for the fiscal year 2012-13 presented on 16th March 2012, and all budgets thereafter, we have seen the direct tax proposals being assiduously organised into various heads. While some of these heads represent the disposition of Government’s policies such as
Ease of doing business, Make in India and Swachchh Bharat, some other heads denote the transient and ad hoc nature of yearly budgetary exercise such as
Rationalisation measures and Tax incentives and reliefs. But there is one head – Widening of tax base – which has figured in some form or the other in direct tax proposals for most budgets during the years 2012 till 2018.

2) The focus of the Government in the recent years has been to boost socio-economic growth, improve investment climate, promote affordable housing and provide fillip to digital economy. All these laudable objectives require funds and one way to generate funds is through tax revenues. To fund them, the Government has been broadening the tax base by bringing in more and more types of transactions within the tax net and also mobilising additional resources to generate higher tax revenues. As a result, the growth rate of direct taxes in the financial years 2016-17 and 2017-18 has been significant at 12.6% and 18.7% (till 15th January 2018) respectively. The number of effective taxpayer base has increased from ₹ 6.47 crores at the beginning of financial year 2014-15 to ₹ 8.27 crores at the end of financial year 16-171.

3) One such measure aimed at widening the tax base proposed in the Budget for the year 2018-19 is amendment to provisions relating to dividends under Section 2(22) of the Income-tax Act, 1961 (the “Act”) and to Dividend Distribution Tax (“DDT”) under Sections 115-O and 115R.

II. Taxation of dividends – Existing scheme

4) As per Section 8 of the Act, any dividend declared by a company or distributed/ paid by it within the meaning of sub-clauses (a) to (e) of Section 2(22) is includible in assessee’s total income. As per Section 2(22), dividend includes:

i. distribution by a company of accumulated profits if such distribution entails the release of company’s assets [Clause (a)];

ii. distribution by a company to shareholders of debentures, debenture-stock, or deposit certificates and any distribution to its preference shareholders of shares by way of bonus, to the extent to which the company possesses accumulated profits [Clause (b)];

iii. distribution to shareholders on liquidation of company [Clause (c)];

iv. distribution to shareholders on reduction of share capital [Clause (d)];

v. advance or loan to a 10% or higher shareholder or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest or payment for such shareholder’s individual benefit [Clause (e)].

5) Except for dividends referred to in sub-clause (e) of Section 2(22), DDT is payable by the company @ 15% on the amount of dividends declared/distributed. Consequently, dividend is exempt in the hands of the recipient by virtue of Section 10(34) of the Act, subject to provisions of Section 115BBDA as per which the amount of dividend in excess of ₹ 10 lakhs in a year received by a resident individual, Hindu undivided family or a firm is taxable @ 10%.

6) Under the existing scheme, deemed dividend referred to in sub-clause (e) of Section 2(22) is taxable in the hands of the shareholder/recipient and DDT is not payable thereon by the payer-company.

III. Proposed amendments and analysis

A. Expansion of scope of “accumulated profits”

III(A)(i) Amendment in brief

7) The dividend referred to in the clauses of Section 2(22) intends to cover distribution/payment to the extent of accumulated profits of the company, whether capitalized or not. The scope of “accumulated profits” is set out in Explanation 1 and Explanation 2 below Section 2(22). As per Explanation 2, the expression “accumulated profits” in sub-clauses (a), (b), (d) and (e), shall include all profits of the company up to the date of distribution or payment referred to in those sub-clauses, and in sub-clause (c) shall include all profits of the company up to the date of liquidation, but shall not, where the liquidation is consequent on the compulsory acquisition of its undertaking by the Government or a corporation owned or controlled by the Government under any law for the time being in force, include any profits of the company prior to three successive previous years immediately preceding the previous year in which such acquisition took place.

8) Explanation 2A is proposed to be added after Explanation 2 to expand the scope of “accumulated profits” to provide that in case of an amalgamated company, the accumulated profits, whether capitalised or not, or loss, as the case may be, shall be increased by the accumulated profits, whether capitalised or not, of the amalgamating company on the date of amalgamation.

9) The expanded scope will apply to distributions/ payments made on or after 1st April, 2018.

III(A)(ii) Analysis of amendment

10) The expansive scope of the term “accumulated profits” would mean that not only the profits of the company in question are to be considered for determining accumulated profits but even profits of a company which gets amalgamated into the company in question should be considered. E.g. X Limited merges into Y Limited. The accumulated profits of X Limited as on date of amalgamation is ₹ 100 and that of Y Limited as on date of distribution is ₹ 500. Y Limited distributes dividend of nature referable to any of the clauses in Section 2(22) to its shareholders. The accumulated profits of Y Limited for the purpose of computing the amount of “dividend” shall be ₹ 600.

11) The reason for expanding the scope of “accumulated profits”, as stated in the Memorandum explaining provisions of Finance Bill, 2018 (the “Memorandum”), is to get over abusive arrangements whereby a company with large accumulated profits amalgamate into a company with less accumulated profits and the amalgamated company would distribute/ pay dividend out of the accumulated profits of the amalgamating company. In this fashion, the amalgamated company would circumvent the provisions as the accumulated profits would be less. In the case of ACIT v. Gautam Sarabhai Trust No. 23 reported in [2002] 81 ITD 677 (Ahd.), the Ahmedabad Bench of the Income-tax Appellate Tribunal (the “Tribunal”) had the occasion to deal with one such case. In this case, the Tribunal held that profits in balance sheet of amalgamating company could not be treated as accumulated profits of amalgamated company and surplus realised by amalgamating company and capitalised by issue of paid-up capital would not be covered under the expression “accumulated profits”.

12) Though the Memorandum does not make reference to this judgment of the Tribunal, the amendment intends to get over arrangements such as the one in that case i.e., of reverse mergers (where large/ profit making company gets amalgamated into a smaller/ loss making company).

13) The intention behind the amendment is to prevent abusive arrangements and not to extend any benefit in the form of reduction of losses of the amalgamating company from profits of amalgamated company. Therefore, the language of Explanation 2A has been carefully worded and refers to “accumulated profits, whether capitalised or not, or loss” of the amalgamated company but refers only to “accumulated profits, whether capitalised or not” of the amalgamating company. The absence of the words “or loss” when referring to amalgamating company makes the intention of the legislature clear that no benefit of losses of amalgamating company would be available to the amalgamated company for reduction from the latter’s accumulated profits for computing the amount of dividend. Though for income-tax purposes, it is settled that “profits” would include “loss”2, such a contention may not be possible to reduce losses of amalgamating company from accumulated profits of the amalgamated company for the purpose of Section 2(22) due to the conspicuous absence of the words “or loss” in one place and their mention in another as stated above.

III(A)(iii) Whether the amendment was necessary and its consequences?

14) The General Anti-Avoidance Rule (“GAAR”) contained in Chapter X-A of the Act is in force. These provisions are intended to tackle abusive arrangements. Therefore, one may say that adequate safeguards already exist to tackle abusive arrangements such as the ones intended to be prevented by this amendment. While giving its views on applicability and implementation of GAAR, the Central Board of Direct Taxes, in Circular No. 7 of 2017, justified the need for GAAR by stating that specific anti-avoidance provisions (commonly known as SAAR) may not address all situations of abuse, and there was need for GAAR. Now even with GAAR, the legislature has come up with a specific amendment to tackle abusive arrangements. Of course, GAAR is applicable only where the tax benefit from an impermissible avoidance arrangement is exceeds ₹ 3 crores3; the effect of this amendment would be that even amalgamations which are not intended to misuse or abuse the provisions of the Act but are driven by expediency and commercial considerations would get covered.

15) By bringing in SAAR to prevent abuse through amalgamations, the legislature has done away with the need to take approvals necessary for invoking GAAR and possibly the consequent litigation arising therefrom.

16) This will lead to significant tax impact on schemes of restructuring, rearrangements and takeovers and may become a disincentive to genuine schemes of restructuring, rearrangements and takeovers where any tax benefit is only incidental. Thus, this measure to widen the tax base is likely to impede the Ease of Doing Business.

B. DDT on dividend under sub-clause (e) of Section 2(22)

III(B)(i) Amendment in brief

17) The Explanation to Chapter XII-D of the Act pertaining to DDT provisions which provides that DDT is not payable by the company on dividend under sub-clause (e) of Section 2(22) is proposed to be deleted. As a consequence of this deletion, companies shall become liable to pay DDT on the advance or loan to a 10% or higher shareholder or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest or payment for such shareholder’s individual benefit.

18) Furthermore, the rate of DDT in such cases is sought to be fixed at 30% as against the usual rate of 15% by inserting a proviso in sub-section (1) of Section 115-O and making sub-section (1B) inapplicable. The Memorandum states that DDT will be chargeable in such cases @ 30% without grossing up and consequently, the grossing-up provision in Section 115-O(1B) is made inapplicable.

19) The amendment will apply to transactions undertaken i.e., payments made on or after 1st April, 2018.

III(B)(ii) Analysis of amendment

20) Explanation below Chapter XII-D provided that for the purpose of DDT provisions, “dividend” would not include advance or loan to a 10% or higher shareholder or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest or payment for such shareholder’s individual benefit [i.e. Section 2(22)(e)].

21) With the deletion of this Explanation, DDT provisions would become applicable to such transactions also and the company would have to pay DDT when it gives loan to a 10% or higher shareholder or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest or pays any amount for such shareholder’s individual benefit. The rate of DDT would be flat 30% by virtue of insertion of proviso to Section 115-O(1) and no benefit of slab rate etc., would be available. As a consequence of this amendment, the amount which was earlier includible in the hands of the shareholders would become exempt by virtue of Section 10(34) of the Act. The effect of this amendment is shifting of incidence of tax from the shareholder/ recipient to the payer-company and denial of slab rates (if applicable) to the recipient.

22) For instance, in the existing scheme, when a closely held company, Z Private Limited, would lend a sum of ₹ 100 to its shareholder (holding more than 10% shares), the shareholder would have to pay tax on ₹ 100 received by him at the marginal rates applicable to him. The benefit of slab rates and minimum exemption limit would be available to the shareholder. After the proposed amendment is incorporated, if Z Private Limited has ₹ 100 for being loaned to the shareholder and discharge tax liability thereon from such ₹ 100, it would have to set aside an amount @ 30% (plus surcharge and cess) from the amount to be actually loaned to discharge DDT liability. In such case, Z Private Limited would be able to lend only ₹ 76.92 and the balance ₹ 23.08 (i.e., 30% of the amount loaned, excluding surcharge and cess) would have to be paid as DDT by it.

III(B)(iii) Whether the amendment serves Government’s intention?

23) The rationale of this amendment, as stated in the Memorandum, is to bring clarity and certainty in the taxation of deemed dividends and prevent camouflaging dividend in the form of loans and advances. It is important to note that the charging provision for taxing loans and advances to a shareholder or to its concern or for its benefit is sub-clause (e) of Section 2(22). There is no amendment in this sub-clause or its exceptions in sub-clauses (ii). Litigation on applicability of this provision majorly revolves around the following points:

i. Whether the giving of the loan or advance constitutes ordinary course of its business for the company;

ii. Whether money lending is a substantial part of the company’s business;

iii. Interpretation of beneficial owner vis-Ã -vis registered owner;

iv. Whether benefit of loan/ advance has been derived or not;

v. Whether recipient is shareholder in the payer company or not;

vi. Whether the advance was in the course of a commercial transaction;

vii. Material time when shareholding must be seen i.e., at the time of giving of loan/ advance or as at the year end;

viii. Applicability to inter-corporate deposits;

ix. Applicability to loan or advance due to business expediency;

x. Applicability to advances made to director to make purchases on behalf of the company;

xi. Applicability to shareholder’s running account in company’s books and credit balances therein;

xii. Applicability when amounts paid under family arrangements;

xiii. Controversies regarding computation of accumulated profits; etc.

24) None of the abovementioned issues would get resolved by the present amendment. Therefore, it is unlikely that the proposed amendment would help to bring in “clarity” in taxation of deemed dividends as sought to be achieved by the present amendment. The Memorandum also states that the provision of Section 2(22)(e) has been subject matter of extensive litigation. However, without any change in the substantive law, litigation also may not reduce.

25) The amendment may bring in “certainty” in collection of tax and may overcome the problem of the collection of the tax. However, it needs to be considered that the amendment only seeks to shift the point of taxation from the shareholder/ recipient to the company. This, per se, may not overcome the problem in collecting taxes. This is because a closely held company may contest action of the Assessing Officers in imposing DDT. A company which can give a loan or an advance to a shareholder or to its concern or for its benefit would even contest imposition of DDT which would ultimately benefit such shareholder. On the whole, the amendment does not seem to be well-thought through and is unlikely to serve the purposes for which it is intended.

C. DDT on dividend payouts to unit holders in an equity oriented fund

III(C)(i) Amendment in brief

26) One more proposal to widen the tax base made by the Government is introduction of DDT on income distributed to a unit holder of equity oriented funds. An amendment has been proposed in Section 115R(2) of the Act to provide that DDT shall be charged @ 10% of the amount of income distributed by a mutual fund. The DDT is liable to be paid by the mutual fund effectively reducing the income in the hands of the unit holder.

27) Clause (b) in second proviso in Section 115R(2) which guards income distributed by equity oriented funds from levy of DDT is proposed to be deleted.

28) The above amendment will apply from 1st April 2018 and would apply from distributions made on or after this date.

III(C)(ii) Analysis of amendment

29) The rationale behind the proposed amendment is to provide a level playing field between growth-oriented funds and dividend distributing funds. The Budget 2018 also proposes to introduce capital gains tax on transfer of long term equity-oriented mutual fund units which have been exempt since the year 2004 upon introduction of Securities Transaction Tax. With introduction of capital gains tax on transfer of long term equity-oriented mutual fund units @ 10%, the Government has proposed to introduce DDT @ 10% on dividend paid by equity oriented fund in order to obviate disadvantage to unit holders of growth schemes vis-Ã -vis unit holders of dividend schemes of equity oriented funds.

30) The DDT to be payable on dividends distributed must be done on gross basis as per Section 115R(2) of the Act and as a result of this amendment, the amount of dividends actually received by unit holders of mutual funds would be lesser. The amount received by the unit holders as dividend would continue to remain exempt under Section 10(35) of the Act.

IV. To sum-up

31) One of the expectations of the Industry from Budget 2018 was abolition of DDT as its abolition was thought to be an aid in
Ease of doing business. Contrary to expectations, the Government has sought to widen its ambit. The above amendments to DDT provisions only suggest that DDT is here to stay as DDT is perceived to facilitate easy collection of taxes. Ease of collecting taxes, though not a separate head for organizing tax proposals in a Budget, after all, is one of the inherent policies in tax collecting exercise for any Government.

1. Paras 144 and 145 of 2018-19 Budget Speech.

2. CIT v. Harprasad & Co. (P.) Limited [1975] 99 ITR 118 (SC)

3. Rule 10U(1)(a) of Income-tax Rules, 1962.

Vide Finance Bill, 2018 the Finance Minister has proposed certain amendments in regard to scheme of taxation of long term capital gains arising on transfer of equity shares and units of mutual funds. Proposed amendments and their implications are being discussed hereunder with reference to present provisions of the Act.

Present provision

As per section 10(38) of the Income-tax Act any income arising from transfer of long term capital asset being an equity share in a company or a unit of Equity Oriented Fund or a unit of Business Trust is exempt from tax provided Security Transaction Tax (STT) has been paid on transfer of the shares or units.

By way of insertion of a proviso vide Finance Act, 2017 w.e.f. 1-4-2018 i.e. A.Y. 2018-19 it was provided that exemption in respect of income arising on transfer of equity shares in a company will not be available in case STT was not paid in respect of transaction for acquisition of shares except in the cases of acquisition as may be notified by the Central Government. The Central Government
vide Notification No. SO 1789(E) dated 5-6-2017 has notified certain cases of acquisition of shares pursuant to aforesaid proviso wherein exemption will be available for income on transfer of shares even if STT at the time of acquisition has not been paid. Such transfers are generally those transactions which represent allotment of shares on preferential basis or shares allotted as per the scheme approved by the Government etc.

Further, proviso to Section 10(38) of the Income-tax Act provides that such capital gain, notwithstanding it will be exempt, will be considered for the purpose of book profit for the purpose of payment of tax under Section 115 JB of the Act. It has also been provided that income arising on transactions undertaken on a recognised stock exchange located in any International Financial Services Centre and where the consideration is paid or payable in foreign currency will also be exempt notwithstanding that STT in respect thereof has not been paid.

In conclusion, it is stated that in terms of Section 10(38) of the Income-tax Act capital gains arising on transfer of shares or units of mutual funds held for a period of 12 months will be exempt from tax.

In respect of transfer of shares or units held for long term, other than referred to in Section 10(38) of the Act, tax is payable in terms of provisions of Section 112 of the Income-tax Act. In respect of such transfers, tax is payable @ 20% after taking indexation as per the second proviso to Section 48 of the Income-tax Act. The aforesaid Section also provides an option to an assessee that tax can be paid by him on capital gains @ 10% without taking indexation.

Amendments proposed

Provisions of Section 10(38) are proposed to be made inapplicable in respect of transfer of shares or units after 1-4-2018. Accordingly, no exemption from capital gains arising on transfer of shares or units even held for long term will be available in accordance with present provisions of Section 10(38) of the Income-tax Act.

A new Section 112A is proposed to be inserted in the Act. The aforesaid section provides that notwithstanding provisions of Section 112, tax will be payable by an assessee in respect of capital gains arising from transfer of long term asset being equity shares in a company or units of an equity oriented fund or units of business trust on the amount exceeding ₹ one lakh @ 10%. Further, it has been provided that in respect of equity shares STT has been paid on acquisition as well as on transfer of shares. It has, however, been provided in sub-section (4) that Central Government may by notification specify nature of acquisition in respect of which condition of payment of STT will not be applicable. In regard to capital gains arising on transfer of units of oriented fund or units of business trust condition of payment of STT is applicable only at the time of transfer of such units.

Tax liability payable by an assessee in terms of sub-section (2) is to be determined on the basis that tax will be payable @ 10% of amount of capital gain exceeding ₹ one lakh and tax will be payable on remaining income considering the same to be the total income. By way of proviso it has further been provided that in case of an individual or Hindu Undivided Family total income other than the capital gains is less than the maximum amount not chargeable to tax, amount of capital gains to the extent of such amount will be reduced and accordingly tax on long term capital gain @ 10% is to be calculated on the remaining amount of long term capital gains.

Sub-section (3) exempts the transactions from taxability of transfer undertaken on a recognised stock exchange located in any International Financial Services Centre as at present.

Sub-section (5) provides that benefit of indexation will not be available to the assessees.

Sub-section (6) provides that for the purpose of determination of long term capital gains which will be chargeable as per Section 112A of the Income-tax Act fair market as on 1-2-2018 will be cost of acquisition in case same is higher. Provisions of Sub-Sections (7) & (8) provide that no deduction in any of the Sections under Chapter VIA will be available and no tax rebate available under Section 87A will also be allowable to the assesses from amount of long term capital gain and tax payable thereon.

Comments

In regard to proposed provisions of Section 112A of the Income Tax Act following comments are being made:-

1. The proposed amendments are against the concept introduced in the Income Tax Act for granting exemption from long term capital gain along with levy of STT w.e.f 1-4-2004. The Finance Minister in his speech at that time had stated that it will be win-win situation. The assessee will be able to get exemption in respect of long term capital gain arising on transactions on which STT has been paid and the Government will also be able to get its due tax by way of STT. The amendment in the Scheme is contrary to the purpose and intention with which exemption was introduced in Section 10(38) of the Income Tax Act.

2. It may be stated that provisions of Section 112A, like other sections in Chapter XII provides for ‘Determination of Tax in Certain Special Cases’. These sections are not the charging sections but same provides for special rates in respect of particular nature of the income. Charging sections of the Income Tax Act in relation to capital gain are Sections 45 to 55. Section 48, which provides for indexation is part of the charging sections. Accordingly, an issue arises whether an assessee is required to compute the income under the head “Capital Gain” as per above referred charging sections or total income under the head “Capital Gain” needs to be calculated taking into consideration provisions of Section 112A of the Income Tax Act. In case we refer to provisions of Section 112 of the Act same provides for payment of tax @ 20% on long term capital gain, which is determined as per the charging sections including the provision for indexation. Thereafter a Proviso has been provided therein to the effect that in case tax payable @ 20% exceeds the tax payable @ 10% of the amount of capital gain without taking indexation then such excess amount of tax is to be ignored. Accordingly, the aforesaid Proviso in Section 112 do not modify the computation of taxable income but only grant a relief in the computation of tax payable. Section 112A, however, provides that long term capital gain shall be determined without taking indexation. Hence, an issue arises that how an assessee has to compute his income under the head “Capital Gain”. This may lead to litigation unless clarified by way of suitable amendment in the charging sections.

3. As per the present provisions of Section 112 of the Act an assessee has an option to pay tax @ 20% after availing benefits of indexation or @ 10% without availing benefits of indexation. In the proposed provisions of section 112A of the Act tax is payable in all cases @ 10% without taking benefit of indexation. It is incongruous with provisions of taxation of long term capital gain. An assessee may be in a disadvantageous position while making payment of tax @ 10% without availing benefit of indexation. An option should be available to an assessee to pay tax after indexation @ 20% or without indexation @ 10% as is available in section 112 of the Act.

4. It is stated that in the cases of individuals having total income other than capital gain of less than the maximum limit of income not chargeable to tax and an amount of capital gain along with other income is less than Rs. Five Lacs, tax liability in terms of provisions of Section 112A of the Income Tax Act will works out to be more than the tax liability which otherwise would be in such cases. This position is being shown by way of following example:-

Amount (Rs.)

Income other than long term capital gain 2,00,000/-

Long term capital gain on transfer of shares 3,00,000/-

Total Income 5,00,000/-

A. Tax payable considering long term capital gain as part of normal taxable income.

– Tax payable on Rs. 2,50,000/- Nil

– Tax payable on balance of Rs. 2,50,000/- @ 5% 12,500/-

Total Tax payable 12,500/-

Less rebate available u/s. 87A of the Act 5,000/-

Net amount of tax payable. 7,500/-

B. Tax payable by the assessee in terms of Section 112A of the Act

Long term capital gain 3,00,000/-

Less :Amount representing difference between other income and exempt Income not chargeable to tax. 50,000/-

Balance long term capital gain 2,50,000/-

Less : Exemption available u/s. 112A 1,00,000/-

Balance long term capital gain chargeable to tax 1,50,000/-

Tax payable on above @ 10% 15,000/-

Tax payable on other income Nil
_________________________
Total Tax Payable. 15,000/-
_________________________

It is suggested that an option should be provided to an assessee to calculate the tax considering the long term capital gain as part of its income and pay the tax thereon accordingly or avail the concession provides for of specified rate in Section 112A of the Act.

5. There was also a doubt in regard to the position whether loss can be set off against any other long term capital gain and wether same can be carried over to subsequent year for the purpose of set off against long term capital gain. This position has been clarified by CBDT vide Notification dated 4-2-2018 wherein it has been stated that long term capital loss can be set off and carried forward in accordance with existing provisions of the Act and, therefore, it can be set off against any other long term capital gains and unabsorbed loss can be carried forward to subsequent 8 years for set off against long term capital gains.

6. There appears to be anomaly while reading Sub-section (4) of Section 112A of the Income Tax Act with reference to provisions of Sub-section (1) of Section 112A of the Act. Sub-Section (1)(iii)(a) provides for a condition for payment of STT on acquisition as well as on transfer of equity shares. Sub-section (4) provides that Central Government may by notification specify the nature of acquisition in respect of which provisions of Sub-clause (a) of Clause (iii) of Sub-section (1) shall not apply. The reading of above Sub-section gives an interpretation that in respect of cases specified by the Central Government with reference to condition of STT on acquisition above clause will not be applicable at all and resulting thereby condition for payment of STT will not apply. This appears to be an unintended position.

Suggestion

It is suggested that provisions should provide for computation of long term capital gain in respect of equity shares and units referred to in section 112A of the Act in the normal course as per provisions of sections 45 – 55 of the Act including indexation in terms of proviso to section 48 of the Act. As regards cost of acquisition to be taken at fair market value as on 31-1-2018 necessary amendment should be made in section 49 of the Act. Provisions of section 112 should be applicable to these shares and units also and an option should be available to an assessee to pay the tax at 20% after taking indexation or @ 10% after determining the long term capital gain without indexation. In case of individual assesses an option should be provided to determine the tax liability considering the income in the normal course or availing benefit of concessional rate of tax as provided in this regard. These amendments are necessary since provisions as proposed will be disadvantageous to certain assesses and may also lead to litigation.

Character is repeated habits, and repeated habits alone can reform character.

– Swami Vivekananda

Vide the Finance Bill, 2018, India has yet again introduced anti-Base Erosion and Profit Shifting measures in its domestic law in line with the Action Plans formulated by the Organisation of Economic Cooperation and Development (‘OECD’). The international tax amendments brought out
vide this Finance Bill seek to expand the scope of the term ‘business connection’ contained in Section 9 of the Income-tax Act, 1961 (‘the Act’) by way of

I) Substitution of clause a) to Explanation 2 of Section 9(1)(i) of the Act and

II) Introduction of Explanation 2A to Section 9(1)(i) of the Act.

I. Widening of the scope of business connection arising out of Dependent Agents by way of substitution of clause a) to Explanation 2 of Section 9(1)(i) of the Act

A. Current Provision prior to proposed amendment

Section 9 (1) – “The following incomes shall be deemed to accrue or arise in India :–

(i) All income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India….

Explanation 2.– For the removal of doubts, it is hereby declared that “business connection” shall include any business activity carried out through a person who, acting on behalf of the non-resident,–

(a) has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident, unless his activities are limited to the purchase of goods or merchandise for the non-resident; or…

(b) ..

(c) ….

Provided that such business connection shall not include any business activity carried out through a broker, general commission agent or any other agent having an independent status, if such broker, general commission agent or any other agent having an independent status is acting in the ordinary course of his business…”

As per Section 9(1)(i) read with Explanation 2, any person acting on behalf of a non-resident in the capacity of an agent/broker etc. would constitute a business connection of the non-resident provided that i) such agent has an authority to conclude contracts on behalf of the non-resident which it habitually exercises in India and ii) the agent is not of independent status and iii) the activities carried on by the agent are not merely restricted to the purchase of goods for the non-resident.

The definition of business connection to include Dependent Agents as contained in the Act is also very similar to the provisions contained in Article 5(5) of the OECD Model Tax Convention which is adopted in almost all Double Tax Avoidance Agreements entered into by India with other countries, wherein if any person acting on behalf of the non-resident is habitually authorised to conclude contracts for the non-resident, then such agent would constitute a PE in the source country.

B. Need / Reason for the amendment

As provided in the Memorandum to the Finance Bill, 2018, (‘Memorandum’) it has been noted that
“in many cases, with a view to avoid establishing a permanent establishment under Article 5(5) of the DTAA, the person acting on behalf of the non-resident negotiates the contract but does not conclude the contract”.

BEPS Action Plan 7 – Preventing the Artificial Avoidance of Permanent Establishment Status has examined the issue in detail. The Action Plan noting that the prerequisite for the application of Article 5(5) of the OECD is the formal conclusion of contracts in the name of the non-resident, has observed that the said prerequisite is often circumvented in cases where non-residents replace subsidiaries which traditionally act as distributors by commissionaire arrangements. The Action Plan defines commissionaire arrangements to mean arrangements through which a person sells products in a State in its own name but on behalf of a foreign enterprise that is the owner of these products. Under these sort of agreements, the foreign enterprise would be able to sell products in a State without having a PE to which such sales may be attributed and without therefore being taxed in that State on profits derived from such sales. The agent also would not be taxed as it would not own the products that it sells. It has further noted that the application of the Rule in Article 5(5) has been artificially avoided by the non-residents by formally concluding contracts outside India even though the contracts are substantially negotiated by the agent in India.

The Memorandum referring to the BEPS Action Plan 7 has stated that “the OECD under BEPS Action Plan 7 reviewed the definition of PE with a view to preventing avoidance of payment of tax by circumventing the existing PE definition by way of commissionaire arrangements or fragmentation of business activities. In order to tackle such tax avoidance scheme, the BEPS Action Plan 7 recommended modifications to paragraph (5) of Article 5 to provide that an agent would include not only a person who habitually concludes contracts on behalf of the non-resident, but also a person who habitually plays a principal role leading to the conclusion of contracts”.

In fact, the recommendations made in the said BEPS Action Plan 7 have been implemented by way of inclusion in Article 12 of the Multilateral Convention to Implement Tax Treaty Related Measures (‘MLI’) to which India is also a signatory. This would imply that the recommendations proposed would automatically apply to India’s treaties with other countries if the said treaty partner has also opted for Article 12 of the MLI. Therefore, the provisions of Article 5(5) as modified by the MLI would be significantly wider in scope as compared to the current provisions of the Act (enumerated in Para A above). Since the provisions of Section 90 of the Act provide assessees an option to opt for either taxability under the Act or the DTAA, whichever is more beneficial to them, it was noted that the current provisions in the Act being narrower in scope would be more beneficial to the assessee rendering the provisions of the DTAA as amended by the MLI ineffective.

Therefore, to maintain congruency with the BEPS initiative and to ensure the effectiveness of the DTAA, the Finance Bill, 2018 has laid down the following proposed amendment:

C. Proposed Amendment

Explanation 2 to Section 9(1) post the proposed amendment/substitution of clause (a) would read as under:

Explanation 2.– For the removal of doubts, it is hereby declared that “business connection” shall include any business activity carried out
through a person who, acting on behalf of the non-resident, –

“(a) has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident or habitually concludes contracts or habitually plays the principal role leading to conclusion of contracts by that non-resident and the contracts are –

i) in the name of the non-resident; or

ii) for the transfer of the ownership of, or for the granting of the right to use, property owned by that non-resident or that non-resident has the right to use; or

iii) for the provision of services by the non-resident; or…

(b) ..

(c) ….

The amended provision requires that the person acting on behalf of the non-resident habitually plays a principal role in conclusion of the contracts and also requires that at least one of the 3 conditions contained in sub-clauses (i), (ii) or (iii) above are also satisfied.

However, it must be pointed out that as evident from the proviso where an agent is carrying any of the aforesaid activities during the course of his business in his independent capacity, the said provision would not apply as per the First Proviso to Section 9(1)(i) of the Act.

D. Interpretation

It is abundantly clear that the proposed amendment is wider than the existing provision as it seeks to encompass not only the agents who habitually concluded contracts but also agents who play a principal role in the conclusion of the contract. However, there are certain terms / phrases contained in the proposed amendment that would require proper interpretation so as to ensure that the amended provisions are not arbitrarily applied by the Income-tax Authorities.

1. The word “habitually” contained in proposed amendment refers to a systematic course of conduct on the part of the agent and would mean regularly, repeatedly or continuously and would not apply to isolated cases
[DDIT v. B4U International Holdings Ltd. (2012) 137 ITD 436) which has been subsequently affirmed by the Hon’ble Bombay High Court in (2015) 374 ITR 453 (Bom)]. Further, Para 33.1 of Action Plan 7 also states that to satisfy the condition of “habitually”, the presence maintained
“in a Contracting state should be more than merely transitory”. However, there is no pre-determined frequency that would constitute “habitually” and it would be logical to determine the habitual nature of the agent’s activities based on the nature of the business of the non-resident in India.

2. The next phrase that would be subject to interpretation would be “principal role leading to conclusion of contracts”. In my view, the phrase should be construed strictly to avoid unintended consequences and arbitrary taxation of all non-residents having any sort of presence in India. It would be essential to ensure that while seeking to widen the tax base to avoid BEPS, bona-fide assessees who are not contravening the provisions of the Act read with the DTAA are not roped in. The phrase “principal role leading to conclusion of contracts” would ideally cover situations where the conclusion of contract by the non-resident directly results from the actions carried out by its “agent” in India. The intention of the proposed amendment has to be kept in mind while interpreting the said phrase. As per Action Plan 7 at Para 32.5, the principal role leading to the conclusion of the contract
“will therefore typically be associated with the actions of the person who convinced the third party to enter into a contract with the enterprise” and therefore would apply
“where a person solicits and receives (but does not formally finalise) orders which are sent directly to a warehouse from which goods belonging to the enterprise are delivered and where the enterprise routinely approves these transactions”. It therefore implies that mere marketing activity which do not directly result in the conclusion of contracts should not be brought within the scope of the amendment.

3. Further, Para 33 of the Action Plan 7 also lays down that the contracts referred to in the recommended provisions which have been sought to be introduced vide the proposed amendment would only cover contracts relating to the activities which constitute the business of the non-resident. As an illustration, it has been laid down that if the person in India concludes employment contracts for the non-resident, the same would not be covered under the proposed amendment as it would not constitute the business of the non-resident.

4. Keeping in view the intention of the legislature and as per Para 32.9 of the Action Plan 7, it would be safe to say that the phrase
“in the name of the non-resident” would not restrict the application of the provision only to contracts that are literally in the name of the enterprise. For example, if the agent is responsible for negotiating contracts on behalf of an entire group of companies (e.g. ABC Group) and negotiates a contract of a specific company in the group (ABC Inc), merely because ABC Inc is not mentioned in the written contract, it would not be open for ABC Inc to contend that the contract was not negotiated in its name.

5. As per Para 32.11 of the Action Plan 7, the OECD has laid down that while interpreting the word
‘property’, whether or not that property existed/was owned by the non-resident at the time of conclusion of the contract would be an immaterial consideration and that it would cover future property as well as both tangible and intangible property. Therefore, the myopic interpretation of property might not hold good while determining the applicability of the provision.

E. Consequences/Controversies

1. The proposed amendment would definitely impact non-residents operating under the agency business model and would lead to an increase in the number of non-residents liable to file their returns in India as now income arising from agents playing a principal role in concluding contracts would also be taxable in India as against non-residents earning income only from agents who conclude contracts in India.

2. Further, it would also increase the administrative burden on the Department to track the nature of the activities of the agents in India and the ultimate contract finalised by the non-resident. Further, it would be interesting to note whether the authorities would resort to the Exchange of Information clause under the DTAAs to obtain such information or whether there would be any increase in reporting requirements by way of subsequent rules.

3. It would be interesting to note whether the onus to prove that the agent has had a principal role in concluding contracts would be on the Non-resident Assessee or the Department.

4. Further, the aforesaid amendment particularly the interpretation of the phrase
“principal role leading to conclusion of contracts” may lead to further litigation in India.

F. Suggestions

It may be advisable for the Government to include the phrase “that are routinely concluded without material modification by the enterprise” in the proposed clause (a) to keep the provision in further coherence with the provisions of Article 12 of the MLI and to further channelize the scope of the provision to meet the intention of the amendment to exclude cases where there has been material modification of the contract by the non-resident even where the agent has played a significant role in the conclusion of the contract.

II. Widening of the scope of business connection arising by way of insertion of Explanation 2A of Section 9(1)(i) of the Act – Business connection to include Significant Economic presence under the Digital economy

A. Current Provisions prior to proposed amendment

Section 9 (1) – “The following incomes shall be deemed to accrue or arise in India :–

(i) all income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India….

The Act does not contain any specific provisions on the constitution of a business connection on account of Significant Economic Presence and only includes physical presence within the meaning of business connection.

However, it is pertinent to point out that with the view of preventing BEPS arising out of the formulation of new business models under the digital economy, Chapter VIII of the Finance Act, 2016 had introduced an ‘Equalisation Levy’ at 6 % of the amount of consideration for specified services received or receivable by a non-resident not having permanent establishment (‘PE’) in India, from a resident in India who carries out business or profession, or from a non-resident having permanent establishment in India. Though Equalisation Levy does not widen the meaning of business connection in India and therefore is not pari materia with the amendment proposed in the Finance Bill. 2018, the intention behind both are similar i.e. to tax business income regularly earned by non-residents from India without having a physical presence therein.

B. Need / Reason for the amendment

It is a well-known principle that business profits of a non-resident are taxable in India only if the non-resident has a business connection or permanent establishment in India and only to the extent that the profits are attributable to the said business connection / permanent establishment. Broadly, a business connection / permanent establishment presupposes the existence of a physical nexus between the non-resident and the country in which it is said to have constituted a business connection / permanent establishment.

In this regard, the Memorandum, has noted that “For a long time, nexus based on physical presence was used as a proxy to regular economic allegiance of a non-resident. However, with the advancement in information and communication technology in the last few decades, new business models operating remotely through digital medium have emerged. Under these new business models, the non-resident enterprises interact with customers in another country without having any physical presence in that country resulting in avoidance of taxation in the source country. Therefore, the existing nexus rule based on physical presence do not hold good anymore for taxation of business profits in source country. As a result, the rights of the source country to tax business profits that are derived from its economy is unfairly and unreasonably eroded.”

The aforesaid erosion of the rights of the source country in the case of a digital economy was examined by the OECD in its BEPS Action Plan 1 – Addressing the Tax Challenges of the Digital Economy wherein it has discussed several options to tackle the direct tax challenges arising in digital businesses. One such option being a new nexus rule based on “significant economic presence”. The said recommendation proposed in the Action Plan forms the base of the proposed amendment as evident from the Memorandum which states that
“As per the Action Plan 1 Report, a non-resident enterprise would create a taxable presence in a country if it has a significant economic presence in that country on the basis of factors that have a purposeful and sustained interaction with the economy by the aid of technology and other automated tools. It further recommended that revenue factor may be used in combination with the aforesaid factors to determine ‘significant economic presence”.

Noting that the current provisions of the Act do not capture the existence of a business connection on account of significant economic presence, and that the definition of the term ‘business connection’ contained in the Act is also narrow in its scope as a result of which emerging business models such as digitized businesses, which do not require physical presence of itself or any agent in India, would not be covered within the scope of clause (i) of sub-section (1) of Section 9 of the Act, the Government of India, vide Finance Bill, 2018, has boldly proposed to introduce Explanation 2A in an attempt to maintain congruency with the BEPS initiative, which is provided below.

C. Proposed Amendment

After Explanation 2 to Section 9(1), the following Explanation is proposed to be inserted, namely:-

Explanation 2A – For the removal of doubts, it is hereby clarified that the significant economic presence of a non-resident shall constitute “business connection” in India and “significant economic presence” for this purpose, shall mean –

(a) transaction in respect of any goods, services or property carried out by a non-resident in India including provision of download of data or software in India, if the aggregate of payments arising from such transaction or transactions during the previous year exceeds such amount as may be prescribed; or

(b) systematic and continuous soliciting of business activities or engaging in interaction with such number of users as may be prescribed, in India through digital means:

Provided that the transactions or activities shall constitute significant economic presence in India, whether or not the non-resident has a residence or place of business in India or renders services in India:

Provided further that only so much of income as is attributable to the transactions or activities referred to in clause (a) or clause (b) shall be deemed to accrue or arise in India.”

D. Interpretation

1. Though the new explanation begins with the phrase ‘for the removal of doubts’, the Memorandum to the Finance Bill implicitly states that “This amendment will take effect from 1st April, 2019 and will, accordingly, apply in relation to assessment year 2019-20 and subsequent assessment years” and therefore the said proposed amendment cannot be given retrospective operation.

2. Further, it is also pertinent to note that the insertion of the said Explanation would not impact the taxability under the DTAAs entered into by India and would only come into force when corresponding modification to the rules governing constitution of a PE are made in the DTAAs as well. This is also implicitly stated in the Memorandum –
“The proposed amendment in the domestic law will enable India to negotiate for inclusion of the new nexus rule in the form of ‘significant economic presence’ in the Double Taxation Avoidance Agreements. It may be clarified that the aforesaid conditions stated above are mutually exclusive. The threshold of “revenue” and the “users” in India will be decided after consultation with the stakeholders. Further, it is also clarified that unless corresponding modifications to PE rules are made in the DTAAs, the cross-border business profits will continue to be taxed as per the existing treaty rules.”

3. The proposed Explanation 2A prescribes two limbs vide sub-clauses (a) and (b).

Sub-clause (a) includes within its purview any transactions of goods / services / property, including transactions by way of download of data / software, which are carried on by a non-resident in India, so long as the aggregate payments exceed such amounts as may be prescribed by the CBDT. Therefore, clause (a) is a revenue based factor and indicates that the Government is of the view that substantial revenue from India would constitute a potential indicator of the existence of a significant economic presence in India. It seeks to bring within the purview of tax, the sales income derived by a non-resident without having a physical presence in India. It is pertinent to note that while the intent of clause (a) is to bring digital economies within the purview of tax net, the language used therein seems to extend the tax net even to those regular transactions of goods / services which have not taken place via digitised means thus making the concept of business connection and permanent establishment redundant.

4. The First Proviso states that the said transaction or activities would create a significant economic presence irrespective of whether or not the non-resident has a residence or place of business in India or renders services in India. The inclusion of the first proviso seems to be confirming the principle applied in the decision of the Bangalore Tribunal in
ABB FZ LLC v. DCIT – (2017) 166 ITD 329 (Bang) wherein it was held that “49..In the present age of technology where the services, information, consultancy, management etc., can be provided with various virtual modes like e-mail, internet, video conference, remote monitoring, remote access to desk-top, etc., through various software, therefore, the argument of fixed place of business raised by the assessee that three employees rendered services only for 25 days cannot be sustained, as the services can be rendered without the physical presence of employees of the assessee.”

5. The interplay between Explanation 2A to Section 9(1) and Equalisation Levy introduced in Chapter VII of vide Finance Act, 2016 is also an interesting consideration. As per the Equalisation Levy provisions, there would be a levy of 6% on the amount of consideration for specified services (i.e. online advertisement, any provision for digital advertising space or any other facility or service for the purpose of online advertisement and includes any other service as may be notified by the Central Government in this behalf) received or receivable by a non-resident not having permanent establishment (‘PE’) in India, from a resident in India who carries out business or profession, or from a non-resident having permanent establishment in India. The services covered under the Equalisation Levy provisions could easily be covered under the wide sweeping sub-clauses of Explanation 2A.

Considering the fact that Section 10(50) of the Act exempts from taxation receipts which have suffered Equalisation Levy under Chapter VIII of the Finance Act, 2016, income from specified services would be taxed under the Equalisation Levy scheme and should not be subject to tax under either sub-clause of the proposed amendment.

E. Consequences / Controversies

1. As per the literal interpretation of sub-clause (a) to Explanation 2A, since the phrase ‘through digital means’ has not been introduced therein, it seems that the proposed amendment seeks to bring within its purview ‘transactions in respect to any goods, services, or property carried on in India’ by the non-resident and is not restricted to transactions of the non-resident carried out through digital means. This seems contrary to the intention specified in the Memorandum and would cause an unwarranted and probably unintended increase in the tax base. Further, the provision as is would render the concept of business connection and permanent establishment redundant.

2. The revenue based indicator contained in sub-clause (a) may not itself suffice to evidence a non-resident enterprise’s regular and sustained participation in a country and therefore sub-clause (b) which is a user based test acts as a further indicator of significant economic presence. The sub-clause (b) stipulates that systematic and continuous soliciting i.e. marketing of its business activities or engaging in interaction with such number of users would constitute a business connection, provided it is done via digital means. It is common for businesses in the digital economy to collect data about their customers, users suppliers and operations which would have value to the business as an input either in improving existing products / services or in providing products / services to another group of customers and therefore the sub-clause (b) assumes significance. The marketing and interaction by way digital technology has enabled businesses to leverage and monetise its activities. (Para 164 of the Action Plan 1). In fact Action Plan 1 at Para 253 has noted the benefit of digital economy vis-Ã -vis marketing and customer support in business –
“Businesses have always needed to carry out activities such as market research, marketing and advertising, and customer support. Digital technology has however had significant impact on how these activities are carried out, for example by enhancing the ability to carry out activities remotely, increasing the speed at which information can be processed, analysed and utilised, and, because distance forms less of a barrier to trade, expanding the number of potential customers that can be targeted and reached”. Further ongoing interactions with customers can increase the value of a particular business to other potential customers which has been illustrated in Para 257 of the Action Plan –
“For example, in the case of retail business operated via a website that provides a platform for customers to review and tag products, the interactions of those customers with the website can increase the value of the website to other customers, by enabling them to make more informed choices about products”. Further user contributions may be reflected in the value of the business itself, which is monetised via the sale price when the business is sold by its owners. (See Para 258). Therefore clause (b) seeks to bring within the tax net the contribution of users, which could be subsequently monetised and sold by the non-resident as i) data to third parties ii) selling targeted advertisements or iii) by selling the business itself and treating the user contribution as an asset. – Para 273. However, it may be difficult for clause (b) to apply on a standalone basis (as proposed under the amendment) as the activities covered therein may not directly result in instant revenue (though they may indirectly lead to potential revenue in the future) and therefore it may be more practical and feasible to apply a combination of clauses (a) and (b) as suggested in the Action Plan 1.

3. Attribution of Profits – The 2nd Proviso to Explanation 2A states that “only so much of income as is attributable to the transactions or activities referred to in clause (a) or clause (b) shall be deemed to accrue or arise in India. However, since the transactions referred to in sub-clauses (a) and (b) are of such wide import, the traditional rules of attribution would not suffice. In fact, the traditional rules of attribution are one of the reasons leading to the insertion of the amendment. Therefore, there would be a requirement for new rules of attribution specific to transactions provided for in Explanation 2A, in the absence of which the high probability of the amendment being misused by arbitrary attribution resulting in huge litigation cannot be ruled out.

4. Further, the implementation of the new Explanation 2A would also result in increase in the administrative burden on the Department who would have the near impossible task of tracking the download of data, soliciting of business and the number of users considering the same would be done via digital means. The Action Plan 1 at Para 270 also notes that i) the identification of overseas sellers ii) determining the extent of sales or activities without information from the offshore seller are close to impossible. Considering the fact that the amendment has been made only under the Act and not under the DTAA, it would be interesting to note whether the authorities would be able to resort to the Exchange of Information clause under the DTAAs to obtain such information or whether there would be any increase in reporting requirements of non-residents by way of subsequent rules.

5. Another controversy arising out of the amendment would be the treatment of income arising from download of data or provision of software where such download of data also leads to imparting of information or the provision of software which is also covered under the definition of royalty. Would the amount be taxed as business profits on a net basis or as royalty on gross basis? Normally, the principle of applying a specific provision over a more general provision should apply. However, in the instant case, the download of data / provision of software are specifically covered both under the proposed amendment as well as the definition of royalty and thus the answer is not clear.

F. Suggestions

1. Since the proposed amendment widens the definition of business connection, the words
“For the removal of doubts, it is hereby clarified” gives the said Explanation the flavour of retrospective amendment even though the Memorandum has clarified that the provisions would apply prospectively. The possibility of the said words being used by an officer to retrospectively apply the aforesaid amendment cannot be ruled out. Thus, it is humbly suggested that the aforesaid words may be deleted.

2. Considering the intent of the proposed amendment is to include digital economy within the ambit of ‘business connection’ and the fact that the literal interpretation of clause (a) expands the scope of “business connection” way beyond the intention, it is humbly suggested that it would be desirable if the words “through digital means” [as contained in clause (b)] are also inserted in Clause (a) to Explanation 2A consequent to which the same would read as under
“(a) transaction through digital means in respect of any goods, services or property carried out by a non-resident in India including provision of download of data or software in India, if the aggregate of payments arising from such transaction or transactions during the previous year exceeds such amount as may be prescribed”.

3. Currently, the proposed amendment seeks to implement the user-based indicator contained in clause (b) independently. Considering the difficulty in implementation of the said indicator on a standalone basis, it may be worthwhile to modify the applicability of clause (b) in line with the BEPS Action Plan 1 i.e. it may be worthwhile to follow the suggestion provided therein i.e. that the revenue-based indicator [as contained in clause (a)] be supplemented with a user-based indicator [as contained in clause (b)] i.e. both indicators should be cumulatively fulfilled.

4. In cases where an income (e.g. from software) gets covered under the scope of “royalty” as defined under the Act as well as under the scope of business connection under sub-clause (a) of the proposed amendment, it is humbly suggested that the Government should come up with a clarification as to which provision would be applicable.

This is my belief: that through difficulties and problems God gives us the opportunity to grow. So when your hopes and dreams and goals are dashed, search among the wreckage, you may find a golden opportunity hidden in the ruins

– Dr. A. P. J. Abdul Kalam

Bench	Institution	Disposal	Pendency	Smc Pendency
Mumbai	709	698	15765	251
Pune	314	174	7094	730
Nagpur	21	16	962	139
Raipur	26	0	1183	225
Panaji	65	43	332	39
Delhi	752	536	21414	864
Agra	36	46	999	134
Bilaspur	—	—	—	—
Lucknow	86	132	1082	194
Allahabad	77	135	756	59
Jabalpur	37	6	567	65
Kolkata	199	362	4885	271
Patna	23	0	506	64
Cuttack	63	55	858	46
Guwahati	44	20	402	49
Ranchi (Jharkhand) Circuit Bench	54	0	783	238
Chennai	339	225	3534	62
Bengaluru	395	288	4325	166
Kochi	37	64	878	25
Ahmedabad	371	336	8718	1560
Surat	108	12	3151	991
Indore	199	24	2107	268
Rajkot	93	45	1737	298
Hyderabad	315	116	3823	517
Visakhapatnam	29	74	916	239
Chandigarh	106	104	2109	270
Amritsar	73	9	1449	217
Jaipur	161	127	1070	371
Jodhpur	67	115	252	27
Total	4799	3762	91657	3879

Sr. No.	Amendment – Effective date of implementation 19th December, 2017	Earlier provision
1	The provisions of the Act shall be applicable on establishments employing 10 or more employees. Therefore the registration under the Act shall not be applicable for establishments having less than 10 employees (However the same shall not be applicable for the establishments already registered and having the valid S&E and till the expiry of the said registration.	Registration was applicable even for zero head count
2	The application for registration under the Act should be filed within 60 days from the commencement of operation.	Earlier it was within 30 days from the commencement of operation
3	The renewal of registration need to be applied online, not less than 30 days before the date of expiry of registration. In case in delay of submission of renewal, 50% of the renewal of registration fee to be paid as late payment.	Earlier it was 15 days prior to the expiry
4	No women shall be discriminated in the matter of recruitment, training, transfers, promotion or wages.	Earlier there was no such provisions
5	Women employees with their consent shall be allowed to work between 9.30 p.m. and 7 a.m., in any establishment in which adequate protection of their dignity, honour and safety, protection from sexual harassment and their transportation from the establishment to the doorstep of their residence as may be prescribed are provided by the employer or his authorised representative or manager or supervisor.	Earlier 8.30 PM to 7AM
6	The spread-over of an employee in establishment shall not exceed 10.5 hours in any day.	Earlier 11 hours in any day
7	The total number of overtime hours shall not exceed 125 hours in a period of 3 months.	Earlier 6 hours in a week
8	If an employee is denied weekly holiday, the compensatory leave in lieu thereof shall be given within two months of such weekly holiday.	Earlier there was no such provision
9	The employer of an establishment shall furnish to every worker an identity card. Such card shall contain the following and such other particulars as may be prescribed, namely :— the name of the employer; the name, if any, and the postal address, of the establishment; the name and age of the worker; date of joining, department, nature of work, designation; the signature (with date) of the employer or manager; Blood Group; Aadhaar Card Number.	Earlier there was No such provisions
10	Earned Leave – One day earned leave for every 20 days of work	Earlier 21 days in year
11	Casual Leave 8 days	Earlier there was no provision for casual leave
12	Maximum accumulation of EL shall not exceed 45 days. In case the employee applies for earned leave and not granted, the earned leave which exceeds 45 days to be encashed at the rate of actual wages. At the time of separation, the earned leave which is due to an employee should be encashed	Earlier 42 days of accumulation and there was no such provision for encashment incase the leaves exceeds the accumulation limit
13	National and festival holidays – employees shall be entitled for holidays on 26-Jan, 1-May, 15-Aug, & 2-Oct and 4 such other festival holidays, agreed by the employer and employees.	Earlier: 26-Jan, 1-May, 15-Aug, & 2-Oct No provision of Festival holidays
14	Establishment wherein fifty or more workers are employed, there shall be provided and maintained a suitable room or rooms as crèche for the use of children of such workers. Provided that, if a group of establishments, so decide to provide a common crèche within a radius of one kilometre, then, the same shall be permitted by the Chief Facilitator, subject to such conditions as may be specified in the order.	Earlier No such provision
15	There is a provision for annual return under the Act, which will be notified by the authority through a separate notification.	No such provision
16	The penalty for contravention of the New Act and the rules has been enhanced to INR 100,000 and in case of continuing contravention an additional fine which may extend to INR 2,000 for every day during which the contravention continues. Further, for repeated offenders the fine may extend to INR 2,00,000.	The Earlier Act provides for a minimum fine of INR 1,000 and a maximum fine of INR 5,000.

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