What are direct taxes?
Direct taxes are taxes where the incidence and impact of taxation falls on the same entity. For instance, income tax, corporation tax, wealth tax and gift tax are direct taxes. Conversely, an indirect tax is not directly levied on the taxpayers. This tax is levied on goods/services and the person on which the burden falls and the person who pays the tax are different. For instance, you may have paid sgst/cgst as a consumer for food purchased at a restaurant. This is paid by you to the restaurant owner, who has passed on the burden of the taxes on you, even though the actual tax was levied on the restaurant. A few examples of indirect taxes in India include service tax, central excise, customs duty, GST, entertainment tax etc.
Relevant constitutional provisions
The preamble of the constitution mentions India as a ‘Socialist’ country, which secures for its citizen’s ‘equality of opportunity and status’. Similarly, the directive principles of state policy reiterates that the state shall endeavor to minimize inequalities in income and prevent concentration of wealth and means to production in its Article 37 and Article 38 respectively. One way of achieving this is through direct taxes which are progressive in nature i.e. richer are taxed at a higher rate as compared to the poor. For instance, income tax rate on a person earning Rs.3,00,000 p.a is 5% while a person earning Rs.10,00,000 is required to pay tax at 30%. Any person earning income of more than Rs.50,00,000 is required to pay an additional surcharge of 25% of the tax!
Article 265 of the Constitution of India provides that “no tax shall be levied or collected except by the authority of law”. Therefore, no direct taxes can be levied or collected in India, unless it is explicitly and clearly authorized by way of legislation. The Income-tax Act, 1961 (ITA) was enacted to provide for levy and collection of tax on income earned by a person. The government at different points of time had also passed other direct tax legislations (now abolished) like Gift Tax Act and the Wealth Tax Act.
Moreover, the Constitution of India provides for certain limitations on the powers of the parliament to enact legislations in relation to direct taxes, which have been discussed below.
First, the parliament should have legislative competence to enact the law to impose tax. Only those taxes, specifically mentioned in List I of Schedule 7 can be imposed by the union government. For instance, vide Entry 82 of List I, the parliament has the exclusive right to frame legislations to tax income (other than agricultural income which may be taxed only by state legislatures). Similarly, Entry 85 and Entry 86 of List I gives the parliament the right to impose corporation tax and wealth tax respectively. Any tax not specifically mentioned in List II and List III of the Schedule 7, is also taxable by the parliament under Article 248 of the Constitution read with Entry 97 of Union List. Gift tax and expenditure taxes are examples of taxes which have been taxed under these residuary provisions.
Second, the taxing statutes should not be in contravention of the fundamental rights enumerated in Part III of the constitution i.e. the taxing statutes should not be arbitrary, discriminatory or in violation of Articles 21, 14 and 19(1) (g) of the Constitution of India.
The constitutional provisions mentioned above have been discussed by way of few case studies which have been in the news in the past year.
Vodafone case
This case has been in the news again in the past year as the government has withdrawn the retrospective application of the amendment to section 9 and 195 of the Income Tax Act lately.
Facts: Vodafone wanted to take over the business of Hutchison in India. However, as a tax planning strategy, instead of direct share transfer or asset transfer between the Indian subsidiaries, Hutchison-Hong Kong sold 100% of its shares in its downstream subsidiary CGP Investments Holdings to Vodafone International Holdings-Netherlands. There were no direct transfers between the Indian entities running telecom business in India, however there was a change in the ownership of business. (It may be noted that Hutchinson Hong Kong held 100 % shares in their downstream company CGP Investments Holding in the Cayman Islands, which in turn held shares in a Mauritius subsidiary. The Mauritius subsidiary controlled the business of Hutchinson in India, and held 67% of shares in the Indian subsidiary Hutchison Essar Limited)
Position of Revenue: The Indian tax authorities scrutinized this transaction and by lifting the corporate veil, found it to be an impermissible tax avoidance transaction or a colorable transaction. By using the concept of ‘Look Through’, they found that the ultimate beneficiary to the transaction was Vodafone India, whose business and market dominance increased. They found that the jurisdiction where the ultimate assets (from which the value of the shares was derived in the upstream holding companies) are located is India. Hence, by liberally interpreting section 9(1)(i) of the Income Tax Act, 1960, it was held that a non resident is liable to pay tax on income deemed to accrue or arise in India by indirect transfer of a capital asset situated in India.
As Hutchinson no longer had any presence in India, the revenue authorities took a stand that Vodafone India should have deducted tax at source before transfer of shares between the two non-resident companies u/s 195 of the Indian Income Tax Act.
Decision of the Supreme Court: The honorable Supreme Court of India, in this case ruled against the revenue. They held that Article 265 of the Constitution of India states that no tax shall be levied except by authority of law. Consequently, no tax can be levied without clear words incorporated in the legislation and no equitable construction of the words is permissible. Neither Section 9 nor Section 195 allows for levy of tax on non residents for such a transaction. Section 9 does not cover indirect transfer of capital assets in India between non residents. Also, Section 195 covers only tax deducted at source by a resident entity while transacting with a non resident. It does not cover transaction between two non-resident entities.
The court also refused to hold that there had been any attempt at impermissible tax avoidance, finding that the creation of the structure which was in place had been driven by commercial considerations and could not be condemned as a tax avoidance device. While discussing the westminster principle it was observed that, “given that a document or transaction is genuine, the court cannot go behind it to some supposed underlying substance”. The Court discussed the ratio of McDowell & Company Limited v. The Commercial Tax Officer (1986 AIR 649) case and the Union of India v. Azadi Bachao Andolan ((2003) 263 ITR 706) case and held that “tax planning may be legitimate provided it is within the framework of law” and that “Every tax planning is not illegitimate….Only colourable device cannot be a part of tax planning and it is wrong to encourage the belief that it is honourable to avoid payment of tax by resorting to dubious methods.” In the present case no colourable device was made out, hence no question of piercing the corporate veil arose.
Analysis: The Vodafone case was largely decided against the revenue because tax statutes are strictly interpreted and there was a lacuna in the law itself which did not explicitly cover such transactions. Taxation statute being a fiscal statute imposes pecuniary burden on the taxpayer, and so such statutes are construed strictly. Unless the black letter of the law permits, no tax can be levied merely by doing purposive interpretation. This is in accordance to Article 265 of the constitution, which only allows tax to be imposed by ‘authority of law’. Separately, another law of interpretation applicable to tax statutes are that wherever there are two possible outcomes, then that interpretation is given which is in favour of assessee. This was another reason for the revenue losing its case in Supreme Court.
Also, even though rigorous tax planning strategies bordering on tax evasion have been discussed by the Supreme Court in many cases, there were no clear tax rules disallowing such transactions for being impermissible tax avoidance transactions at that time. Later, GAAR or general anti-avoidance rules were introduced and were incorporated in the Income Tax Act. (However, GAAR is still to be successfully applied to any case and no recorded case exists after 2017, when these clauses became applicable.)
Aftermath: A clarificatory retrospective amendment to section 9 and 195 of Income Tax Act was made to provide certainty in law and to remove ambiguity vide Finance Act 2012. The new law was applicable to transfer of share by a non-resident in a company incorporated abroad if the share derived (directly or indirectly) its value substantially from assets located in India. This struck at the root of the entire case on which Vodafone’s claims were based before the proceedings in the Supreme Court.
Having exhausted all their recourse under Indian law, Vodafone now initiated arbitration before the Permanent Court of Arbitration, Hague, on the ground that the retrospective amendment was in violation of the fair and equitable treatment promised under the India-Netherlands bilateral investment treaty.
The fair and equitable treatment (FET) clause is itself a vague and broad clause, having varied interpretations. One school of thought lays down that such clauses obligates the host government to treat the investing country with “minimum standard” as required under customary international law. However, actual practice seems to indicate that it demands, from the host government, something beyond the required minimum standards. It has been an evolving concept and some tribunals have held it to include a host state having a transparent, stable regime with consistency of law and protection from arbitrary and discriminatory treatment. Further, even the interpretation of FET by arbitral tribunals is not consistent. In some other instances, tribunals have sought to apply a high threshold; that is, the conduct of the host state must ‘shock or surprise the tribunal’s sense of judicial propriety’. In Vodafone case, retrospective application of tax statutes was considered to be against FET clause. The Indian government challenged the arbitration award in Singapore Court on the ground that taxation is not covered under the treaty and is a sovereign right of the country.
Based on the retrospective amendment, the tax authorities also levied tax on Cairn UK Holding Limited by way of reassessment u/s 147 of Income Tax Act, which opened further Pandora’s box. In this case, Cairn UK Holding Limited (Cairn UK) transferred shares of its Indian subsidiaries to Cairn India Holding Limited (incorporated in Jersey, which was another subsidiary of Cairn UK Holding Limited). Thereafter, the shares of Cairn India Holding Limited (Cairn Jersey) were sold by Cairn UK to Cairn India Limited (Indian subsidiary of Cairn UK). This holding company was incorporated in June 2006, in the United Kingdom. Thereafter, Cairn India Limited had its IPO wherein 30.5% stake was divested. This sale of shares by Cairn UK was sought to be taxed retrospectively by the authorities. Cairn UK filed an appeal in India and simultaneously started arbitration proceedings like in case of Vodafone. Again the decision was delivered in favour of Cairn. Cairn sought to enforce the award against India in various jurisdictions, including enforcing the same against its foreign public sector units. Indian government appealed against this arbitral award passed on the basis of India –UK bilateral investment treaty.
In the interest of equity and to settle the matter, the Indian government has now made application of the amendments proposed to section 9 and 195 of Income Tax Act, retrospective only.
Faceless Assessments and appeals
Basics of the scheme: India is one of the first countries to have faceless assessments. Under these faceless assessments, the cases selected for scrutiny are randomly allocated to officers anywhere in the country. The identity of the officer dealing with the case is kept secret and all correspondences take place through a National Faceless Assessment Center (NEFAC). All correspondence between the officer and the tax payer is done online and no physical contact is established between the two at any stage. Furthermore, instead of the decision being made by one assessing officer, all decisions of assessing officer are firstly required to be approved by an officer of the level of Joint Commissioner or Additional Commissioner. Secondly, based on certain risk parameters, some cases are selected by National Faceless Assessment Center to be sent to a Review Unit. A review unit again has a reviewing officer and a joint commissioner/Additional Commissioner level officer who approves all review reports prepared by the reviewing officer.
The aim is to improve tax administration by making it more objective, transparent and corruption-free. A similar structure has been proposed for the first appeal before CIT (Appeals) for which notifications have been issued by CBDT and second appeal before ITAT which is still to be notified.
High Courts on Faceless Assessments: In its first year, the faceless scheme has come upon certain hurdles, which can be taken as teething trouble. The first batch of assessment orders have been challenged in various high courts through writ petitions. Some of the common issues are not giving adequate opportunities to represent their case and lack of accountability. For instance, the Delhi High Court, in the case of RKKR Foundation v. NEFAC has held that the time given to the petitioner to show cause being three days, is not reasonable time to respond and has lead to the assessee being denied natural justice. Similarly, any order passed before the time prescribed in the show cause notice and without taking under consideration the submissions of the assessee have been declared non-est (please see Madras High Court decision in Antony Alphonse Kevin Alphonse v. ITO and Ekambaran Sukambaran v. ITO). Moreover, in somecases, the assessee has received the show cause notice beyond the last date for response provided in such notices. This is because the service of notice was delayed due to delay in digital signing of the notice by NEFAC or due to other technical reasons.
Rightly, the high courts have quashed such orders, based on the reading of section 144B (9) of the Income Tax Act, which states that the assessment shall be non est if not made in accordance with the procedure laid down under this section. Hence, if no show cause notice is issued or is issued without the draft order or any other procedural lapses are present, it shall lead to the assessment being declared infructuous. It is interesting to note that the government has proposed to remove this provision section 144B (9) from the Income Tax Act, vide the Finance Bill, 2022.
Reopening/Reassessment
Initially, as per section 147 of the Income Tax, the income tax department could reopen a case upto 4 years, 6 years for income which has escaped assessment of more than Rs. 1,00,000 and 16 years for foreign assets respectively. Such cases could be reopened if the assessing officer has ‘reason to believe’ that income has escaped assessment and the assessee has not truly and fully disclosed all material facts on record. However, the government vide Finance Act 2021 has reduced the number of years till when a case can be reopened to 3 years and 10 years if more than Rs.50,00,000 has escaped assessment. The term ‘reason to believe’, which was vague, has been substituted with ‘the assessing officer should have ‘information’ as defined by notification, which should be the basis for issuing notice u/s 148 of IT Act. Furthermore, prior to issuance to such a notice, the assessing officer is required to conduct an enquiry, give proper opportunity to the assessee to respond and only if it is found to be a fit case for reopening, a notice under section 148 shall be issued to the assessee.
However, due to advent of corona, the last date for issuing reassessment notices under the old regime was extended by the Central Board of Direct Taxes (CBDT) vide powers given to it by under Taxation and Other Laws (Relaxation and Amendment of Certain Provisions) Act, 2020 (TOLA).
The assessees have challenged the notices issued to them (vide the writ jurisdiction of the high court) after April 1, 2021, which have not followed the new procedure laid down by Finance Act, 2021, notwithstanding the extension provided by the above notifications. While some high courts have upheld such notices, others have found them to be ultra vires due to excessive delegation. For instance, the Chhattisgarh High Court is of the opinion that Section 3(1) of Relaxation Act (TOLA) empowers the Government to extend only the time limits and it does not delegate the power to legislate on provisions to be followed for initiation of reassessment proceedings. Further, Revenue cannot rely on Covid-19 for contending that the new provisions Sections 147 to 151 of the Income Tax Act, 1961 should not operate during the period 1st April, 2021 to 30th June, 2021 as Parliament was fully aware of Covid-19 Pandemic when it passed the Finance Act, 2021.
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