AI Income Taxation in India Remains Unclear Due to Section 28 vs Section 56 Conflict

Taxation of AI-Generated Income in India: Navigating the Ambiguity Between Section 28 and Section 56 of the Income Tax Act, 1961

The rapid proliferation of artificial intelligence tools has created a new income-generating category that does not fit neatly within the Income Tax Act, 1961. Whether AI-generated income falls under Section 28 (business income) or Section 56 (income from other sources) remains unresolved, with significant consequences for deductibility and set-off. The deductibility of AI subscription costs under Section 37(1) and the Equalisation Levy exposure for non-resident platforms adds further complexity. Drawing on judicial precedents including

Barendra Prasad Ray v. ITO and Sassoon J. David & Co. v. CIT, this article analyses the legislative gap and calls for urgent CBDT guidance.

Introduction

The use of Artificial Intelligence (AI) tools in commercial and professional activity has grown at an unprecedented pace in India since 2022. Chartered Accountants draft tax opinions using large language models, software developers use AI coding assistants to produce billable deliverables, and content creators publish AI-generated articles, music, and visuals for revenue. In each of these scenarios, the human contribution is directional and supervisory rather than creative or technical — the substantial ‘work’ is performed by the AI system.

The Income Tax Act, 1961 (‘the Act’), however, was designed for an era of purely human effort. The concepts of ‘business’ under Section 2(13), ‘profession’ under Section 2(36), and ‘work’ under Section 194J were never intended to accommodate a non-human agent as the primary income-generating entity. This structural mismatch creates three urgent legal questions — (i) how is AI-generated income classified, (ii) can the cost of AI tools be deducted, and (iii) what are the TDS obligations? In the absence of any CBDT circular or legislative amendment addressing these questions, taxpayers and practitioners are navigating a legal vacuum.

Analysis

2.1 Classification: Section 28 vs. Section 56

The central classification question is whether AI-generated income constitutes ‘profits and gains of business or profession’ under Section 28(1), or ‘income from other sources’ under Section 56(2). The distinction is not merely academic — it determines whether business expenses are deductible, whether losses can be set off, and what effective tax rate applies.

The Supreme Court, in Barendra Prasad Ray v. ITO [1981] 129 ITR 295 (SC), held that ‘business’ requires a course of dealings with a profit motive, continuity of activity, and systemic organisation. When an individual or entity uses an AI tool systematically to generate income — consistently and with commercial intent — the profit motive and continuity tests are satisfied, making the income taxable as business income under Section 28(1).

However, where AI use is incidental and sporadic — for instance, a lawyer who occasionally uses an AI tool to assist in drafting — the income retains its professional character under Section 28(1) based on the taxpayer’s primary occupation. The risk arises at the margins: a freelancer who generates all his revenue through AI prompts and sells AI-designed graphics to clients sits in definitional grey territory. If such activity is treated as ‘casual and non-recurring,’ Section 56(2)(ix) applies — with no expense deduction (except Section 57) and no loss set-off benefits.

The critical test, drawn from the Supreme Court’s ratio in Barendra Prasad Ray (supra), is whether the AI-usage activity constitutes a ‘course of dealings.’ A one-time AI-generated output sold for profit would likely fall under Section 56. A structured freelance operation using AI tools would fall under Section 28. The taxpayer’s own conduct, intent, and regularity determine classification — but without CBDT guidance, this remains a matter of subjective assessment open to dispute with the assessing officer.

2.2  Deductibility of AI Subscription Costs Under Section 37(1)

Section 37(1) permits deduction of any expenditure (not being capital or personal expenditure) incurred wholly and exclusively for business purposes. The Supreme Court in Sassoon J. David & Co. Pvt. Ltd. v. CIT [1979] 118 ITR 261 (SC) affirmed the three-pronged test: (i) business purpose, (ii) non-capital, and (iii) non-personal nature.

AI tool subscriptions — recurring SaaS-model payments for platform access — satisfy all three tests when used for business purposes. They are not capital expenditure because the taxpayer acquires no ownership in the AI model; the subscription lapses upon non-renewal. They are wholly business in nature when segregated from personal use. Deductibility under Section 37(1) should, in principle, be available.

However, a critical trap exists: AI platforms such as OpenAI, Midjourney, and Adobe Firefly are non-resident entities providing digital services to Indian users. Such services may attract Equalisation Levy under the Finance Act, 2016 (as amended by Finance Act, 2020). Section 40(a)(ib) of the Act disallows deduction of expenditure on which Equalisation Levy is payable but has not been paid. Most Indian taxpayers are unaware of this exposure — creating a latent deductibility risk for AI subscription costs paid to foreign platforms.

2.3  TDS Implications Under Section 194J

Section 194J of the Act requires TDS at 10% on fees for professional services and at 2% on fees for technical services (post Finance Act, 2020 amendment). When a client pays for AI-generated deliverables — content, software code, or designs — the TDS characterisation depends on whether a human professional is the contracting party or merely a facilitator.

The Bombay High Court in Kotak Securities Ltd. v. DCIT [2016] 383 ITR 1 (Bom) held that the nature of the service rendered — not the medium through which it is delivered — determines TDS applicability under Section 194J. Applying this principle: if the contracted party (individual/firm) is a professional who uses AI as a tool, Section 194J at 10% applies. If the service is purely automated without human professional involvement, the 2% ‘technical service’ rate may apply.

For non-resident AI platforms, Section 195 (TDS on payments to non-residents) or the Equalisation Levy framework under the Finance Act, 2016 applies depending on whether the payment qualifies as royalty under Section 9(1)(vi), fees for technical services under Section 9(1)(vii), or falls within the equalisation levy net.

Has This Issue Been Settled by Any Existing Judicial or Legislative Precedent?

No court or tribunal in India has directly ruled on the classification of AI-generated income or the deductibility of AI subscription costs. The CBDT has not issued any circular, instruction, or clarification on any of the three issues analysed above. The Finance Act, 2022’s introduction of Section 115BBH for Virtual Digital Assets — which imposes a flat 30% rate with no deductions — represents the closest legislative analogy to a novel technology-income provision, but its specific drafting excludes AI-generated income (which does not arise from a ‘cryptographically generated’ asset under Section 2(47A)).

The question of income attribution — whether AI-generated income belongs to the user, the platform, or the AI itself — similarly remains entirely unsettled. The judicial framework for attribution of income under Section 4, read with Section 5, has only ever contemplated human agents. The absence of any ruling or circular leaves taxpayers exposed to varying and unpredictable assessments by different Assessing Officers across jurisdictions.

Relevant Cases on Analogous Issues

While no case directly addresses AI-generated income, the following judicial precedents govern the legal principles applicable to this analysis:

• Barendra Prasad Ray v. ITO [1981] 129 ITR 295 (SC)

Established the ‘continuity and profit motive’ test for determining whether an activity constitutes ‘business’ under Section 2(13). Directly applicable to determining whether systematic AI usage qualifies as business under Section 28.

• Sassoon J. David & Co. Pvt. Ltd. v. CIT [1979] 118 ITR 261 (SC)

Laid down the three-test framework for deductibility under Section 37(1) — business purpose, non-capital, non-personal. Applicable to AI subscription cost deductibility analysis.

• Kotak Securities Ltd. v. DCIT [2016] 383 ITR 1 (Bom)

Held that nature of service (not delivery medium) determines TDS applicability under Section 194J. Directly applicable to TDS treatment of AI-generated deliverables.

• CIT v. Paushak Ltd. [1993] 198 ITR 168 (Guj)

The Gujarat High Court held that income from a novel commercial activity must be characterised by reference to the taxpayer’s dominant intention and business purpose — not by the novelty of the activity itself. This supports classification of systematic AI income as business income under Section 28.

• CIT v. Dr. P.C. Rege [1972] 83 ITR 178 (Bom)

Held that professional income retains its character under Section 28 even when generated through technological assistance. Supports the position that a professional using AI tools generates professional income — not casual income under Section 56.

Cases That Would Have Altered the Analysis if Available

Had India’s courts had occasion to rule on the following analogous global developments, the legal landscape would have been significantly clearer:

• The US IRS’s position on ‘self-employment income’ from AI-assisted freelancing — which treats the human operator as the taxpayer regardless of AI contribution — would have provided a persuasive precedent for Section 28 classification in India.
• The OECD’s ongoing deliberations on ‘nexus’ and ‘value creation’ under Pillar One, which address the question of where value is created in automated digital services, could have informed the income attribution analysis under Sections 4 and 5.
• Any AAR (Authority for Advance Ruling) ruling on the Equalisation Levy applicability to AI platform subscriptions would have settled the Section 40(a)(ib) deductibility trap identified in this article.

The absence of these precedents — domestic or otherwise — underscores the urgency of CBDT action rather than leaving taxpayers to await inevitable litigation.

Summary of Present Legal Position

Key Takeaways for Practitioners

First, the classification of AI-generated income as business income under Section 28 or casual income under Section 56 is determined by the taxpayer’s conduct, regularity, and commercial intent — not by the nature of the AI tool or output. Systematic, profit-motivated use favours Section 28; sporadic, non-recurring use risks falling under Section 56(2)(ix) without any expense deduction benefit.

Second, the Equalisation Levy trap under Section 40(a)(ib) is a latent and widely overlooked compliance risk. Indian businesses paying subscription fees to non-resident AI platforms (OpenAI, Midjourney, Adobe Firefly etc.) must evaluate Equalisation Levy applicability before claiming Section 37(1) deductions — failure to pay the levy results in full disallowance of the subscription cost.

Third, TDS characterisation of AI-generated deliverables requires case-by-case analysis. Where a professional uses AI as an assistive tool, Section 194J at 10% applies. Where the service is entirely automated, the 2% technical service rate may apply. Payers should document the nature of the engagement to support whichever rate is adopted.

Fourth, Section 115BBH (VDA flat tax at 30%) does not apply to AI-generated income. AI income does not arise from a cryptographically generated asset under Section 2(47A) — but the absence of CBDT clarity means practitioners should proactively document the non-VDA character of AI income to avoid disputes at the assessment stage.

Conclusion

The taxation of AI-generated income in India is a frontier legal issue with immediate practical relevance for lakhs of professionals, freelancers, and businesses. The existing judicial framework — built on pre-AI concepts of business, profession, and work — provides partial but incomplete guidance. The classification of AI income as business income (Section 28) or casual income (Section 56), the deductibility of AI subscription costs under Section 37(1) subject to the Equalisation Levy trap, and the TDS characterisation of AI-generated deliverables under Section 194J are all matters on which CBDT must provide authoritative guidance.

So, IN my opinion CBDT SHOULD issue a comprehensive Circular addressing:

(i) The classification framework for AI-generated income based on regularity and intent;

(ii) The deductibility of AI platform costs, including Equalisation Levy compliance for non-resident platforms;

(iii) TDS rates applicable to AI-generated deliverables; and

(iv) Explicit exclusion of AI-generated income from the VDA regime under Section 115BBH. Until such guidance is issued, taxpayers should adopt conservative positions — classifying systematic AI income as business income under Section 28, claiming Section 37(1) deductions with documented Equalisation Levy compliance, and applying Section 194J TDS at the 2% technical service rate for automated deliverables.