As per the recent Amendment introduced through Finance Act 2022, ‘Health and Education Cess’ is not allowed as business expenditure for the computation of business income. The ‘Health and Education Cess’ is imposed as an additional surcharge on the taxpayer for funding specific government welfare programs and is part of income tax.
However, there continue to be diverse opinions in the market in this relation. Some state that the amendment is a clarification and is retrospectively applicable. While others state that the amendment is spelling a new law and can be applied only prospectively. In the following paragraphs, the author shall discuss whether cess is allowable as a business expense prior to the amendment.
Please note that cess, surcharge, and surtax are of similar nature and have been used interchangeably in this note.
Legal Provisions
Section 37 of the Income Tax Act, 1961 (“Act”) provides for the allowability of revenue and non-personal expenditure (other than those failing under sections 30 to 36) laid out or expended wholly and exclusively for the purposes of business or profession.
As per Section 40, (a)(ii) of the Act, any sum paid on account of any rate or tax levied on the profits and gains of business is not deductible in computing the income chargeable under the head ‘Profits and gains of business or profession’.
Similarly, Section 2(43) of the Act, defines ‘tax’ to mean income-tax chargeable under the provisions of the Act at the rates specified in part I of the First Schedule. Such tax shall be increased by a surcharge, for the purposes of the Union, calculated in each case in the manner provided therein. Thus, a surcharge or a cess is nothing but a tax levied further on tax, for which a specific rate is provided in the Act. Furthermore, with reference to the definition of “tax” in section 2(43), the definition section commences with the phraseology “unless the context otherwise requires”. Thus, the term “tax” must be given a wide meaning and should not be restricted to mean only “income tax”.
“Section 4 of the Income Tax Act, of 1961 provides for the levy of tax:
“(1) Where any Central Act enacts that income tax shall be charged for any assessment year at any rate or rates, income tax at that rate those rates shall be charged for that year in accordance with, and subject to the provisions (including provisions for the levy of additional income-tax)of, this Act in respect of the total income of the previous year of every person; Chapter II of every Finance Act provides “Rates of income-tax” chargeable for the relevant assessment year.”
What is cess?
The abovementioned provisions were explained by the Hon’ble Supreme Court in CIT v. K. Srinivasan 83 ITR 346 (SC) asunder:
“the above legislative history of the Finance Acts, as also the practice, would appear to indicate that the term “income-tax” as employed in s. 2 includes surcharge as also the special and the additional surcharge whenever provided within the meaning of Art. 271 of the Constitution. The phraseology employed in the Finance Acts of 1940 and 1941showed that only the rates of income tax and super tax were to the increased by a surcharge for the purpose of the Central Government. In the Finance Act of 1958, the language used showed that the income tax that was to be charged was to be increased by a surcharge for the purposes of the Union. The word “surcharge” has thus been used to either increase the rates of income tax and super-tax or to increase these taxes. The scheme of the Finance Act of 1971 appears to leave no room for doubt that the term “income tax” as used in s. 2 includes a surcharge.”
The Education Cess which was introduced vide section 2 of the Finance Act 2004 and is an additional surcharge for the purposes of the Union to meet their financial priorities in the health and education sector. The base tax, surcharge, and additional surcharge also known as Education Cess, therefore, comprise the total income-tax payable on the income by an assessee. Both the surcharges are levied for the specific purposes of the Union and constitute the total income tax.
The above legal position has been affirmed in various decisions of the Hon’ble ITAT. For instance, the bench at Hyderabad in the case of Virtusa (India) Private Limited dated 04.03.2016 and Hon’ble Chandigarh ITAT in M/s Steel Strips Wheels Ltd. v. DCIT (CPC), Bangalore dated 18.03.2020 has reaffirmed this position.
Application of Section 37(1) of the Act
When one looks at the scheme of the Act and examines the interplay of the provisions of section 40(a)(ii) and section 37(1), it is clear that first, the expense must pass through the anvil of Section 37(1), only then an examination under section 40(a)(ii) of the Act is made. This is clearly evident from section 40(a)(ii) which starts with a non-obstante clause, which reads as follows:
“40. Notwithstanding anything to the contrary in sections 30 to 38, the following amounts shall not be deducted in computing the income chargeable under the head “Profits and gains of business or profession”,- 1. In the case of any assessee-(ii) any sum paid on account of any rate of tax levied on the profits or gains of any business or profession or assessed at a proportion of, or otherwise on the basis of, any such profits or gains.”
The effect of the non-obstante clause in section 40 is that the allowability of a deduction u/s 40(a)(ii) shall be barred if it is otherwise allowable under any of the provisions contained in sections 30 to 38. However, if it does not pass the criteria of allowability u/s 30 to 38 at the threshold, that is the end of the matter and there is no need to go back to section 40(a)(ii). In view of this, the allowability of education cess shall have to be examined first under the terms of section 37(1) i.e. whether the said expenditure has been ‘laid out or expended wholly and exclusively for the purposes of business or profession. The fundamental question, therefore, which arises for consideration is whether an education cess is an expenditure ‘laid out or expended wholly and exclusively for the purposes of business or profession. The answer to this question is clearly negative because ‘education cess’ is not expenditure at all. Rather, it is a charge upon the profits, similar to income tax. Any expenditure to earn a profit cannot be a part of the profit itself. It is an application of an income and not an expenditure ‘laid out or expended wholly and exclusively for the purposes of business or profession so as to pass the tests envisaged u/s 37(1).
In this relation, the Hon’ble Gujarat High Court in S.L.M. Maneklal Industries Ltd. v. CIT [1988] 39 Taxman 42(Gujarat), has held that surcharge was not an expenditure ‘‘laid out or expended wholly and exclusively for the purposes of business or profession u/s 37(1) of Act. The payment of surtax or surcharge has nothing to do with the conduct of the business of the assessee. It was not an expenditure incurred for the purpose of business or for the purpose of earning profit. It is only after the profit or income is earned that, as pointed out above, the question of payment of surtax would arise. It is an event that takes place after the income is earned not in the course of or in the process of earning income. It is out of the profits or income earned that surtax is to be paid.
In other words, payment of surtax is the application of the profits after they are earned. As discussed above, a surtax is levied on excess chargeable profits computed in the manner laid down in the Act. It is a levy on the total income computed under the Act after it is adjusted in accordance with the First Schedule to the Act. The computation of income for the purpose of the Act has to precede the assessment of surtax under the Act. Therefore, surtax stands on the same footing as income tax on the total income computed under the Act. Payment of both income tax and surtax is the application of income after it is earned and not expenditure incurred for the purpose of business. It is not a deduction before one arrives at the profits inasmuch as it is not payment for the purpose of earning profit. Since payment of surtax is not an allowable deduction under section 37, the question of whether it comes within the mischief of section 40(a)(ii) does not arise. In other words, it is not necessary to consider whether the prohibition contained in section 40(a)(ii) is applicable to the payment of surtax.
This view was also taken by the Calcutta High Court in CIT in Molins of India Ltd. V. CIT[1983] 144 ITR 317, the Karnataka High Court in CIT v. International Instruments (P) Ltd [1983] 144 ITR 936, Full bench of the Kerala High Court in A.V. Thomas & Co. CIT[1986] 159 ITR 431 and Madras High Court in Sundaram Industries Ltd. v. CIT[1986] 159 ITR 646. The ‘education cess’ fails the test of deductibility at the first stage itself under the terms of section 37(1) and, therefore there is no further need to examine embargo u/s 40(a)(ii).
Application of Section 40(a)(ii) of Act
A different approach was adopted by the Courts in the Sesa Goa v. JCIT case where the Bpmbay High Court simply assumed the allowability of ‘education cess’ as an expenditure ‘laid out or expended wholly and exclusively for the purpose of business or profession’ u/s37(1) and instead proceeded to examine the prohibition contained in section 40(a)(ii). This brings us to section 40(a)(ii) of the Act and even if one were to assume the deductibility of ‘education cess’ u/s 37(1) of the Act, the question arises whether the bar contained in section40(a)(ii) operates qua ‘education cess’. To put it simply, the real question would be to see whether ‘education cess’ is taxable so as to fall within the mischief of Section 40(a)(ii) of the Act.
It may be noticed at the outset that education cess was introduced as an additional surcharge as explained in the ‘Explanatory Memorandum to Finance Bill, 2012. The relevant excerpt from the said Memorandum reads as follows:
“(2) Education Cess- for the assessment year 2012-13, an additional surcharge called the “Education Cess on income tax and “Secondary and Higher Education Cess on income tax” shall continue to be levied at the rate of two percent and one percent, respectively, on the amount of tax computed, inclusive of surcharge, in all cases. No marginal relief shall be available in respect of such Cess.”
An ‘additional surcharge’ is, therefore, nothing but a tax’, as held by a three-judge Bench of the Hon’ble Supreme Court in CIT v K Srinivasan [1972] 83 ITR 346 (SC). The following words of Grover, J elucidate the law in unequivocal terms.
“In our judgment, it is unnecessary to express any opinion in the matter because the essential point for determination is whether a surcharge is an additional made or rate for charging income tax. If that meaning is applied to s 2 of the Finance Act 1963 it would lead to the result that income tax and super tax were to be charged in four different ways or at four different rates which may be described as (i) the basic charge or rate (in part I of the First Schedule); (ii) Sur-charge; (iii) special surcharge and (iv)additional surcharge calculated in the manner provided in the Schedule. Read in this way the additional charge forms a part of the income tax and super tax.”
This judgment in K Srinivasan cited above, however, was not considered by the Bombay High Court in Sesa Goa. While computing the taxable business income under the Act, various deductions are allowed for expenses that are incurred for the purpose of the business. Certain deductions are allowed on the satisfaction of certain conditions. Among these, expenses that are in the nature of ‘rate’ or ‘tax’ are specifically disallowed under section 40(a)(ii) of the Act while computing the business income. Therefore, a question arises as to whether ‘cess’ on income tax would be considered as a ‘tax’ so (1) as to qualify for an item of disallowance under section40(a)(ii) or it is separate from ‘tax’ and hence is an allowable expenditure from computing business income. This question arises in the context of provisions of section 40(a)(ii) which inter alia provides that notwithstanding anything to the contrary in sections 30 to 38 of the Income-tax Act, 1961, the following amounts shall not be deducted in computing the income chargeable under the head “Profits and gains of business or profession”. – (a) In the case of any assessee – (ia) ………………… (ib) …………….. (ic) …………….. (ii) Any sum paid on account of any rate or tax levied on the profits or gains of any business or profession or assessed at a proportion of, or otherwise on the basis of, any such profits or gains.
[Explanation 1– For the removal of doubts, it is hereby declared that for the purposes of this sub-clause, any sum paid on account of any rate or tax levied includes and shall be deemed always to have included any sum eligible for relief of tax under section 90 or, as the case may be, deduction from the Indian income-tax payable under section 91.] [Explanation 2- For the removal of doubts, it is hereby declared that for the purposes of this sub-clause, any sum paid on account of any rate or tax levied includes any sum eligible for relief of tax under section 90A;]
From the aforesaid provisions of section 40(a)(ii), it is quite clear that any sum paid on account of any rate or tax levied on the profits or gains of any business or profession or assessed as a proportion of, or otherwise on the basis of any such profits and gains, will not be allowable as a deduction in the computation of income chargeable under the head “Profits and gains of business or profession”. It may also be stated here that even rate or tax assessed as a proportion of or otherwise on the basis of any such profits and gains, also falls within the mischief of section 40(a)(ii) of the Act.
The judgment in the case of A. V. Thomas & Co. Ltd v. CIT [1986] 159 ITR 431 (Ker) relates to the issue of whether a surtax is a charge on income and a levy on the profits and gains of business and whether the same could be allowed as a deduction under section 37 of the Act, r.w.s.40(a)(ii) of the Act. It was held in this case that surtax is an application of profits and gains of business after they have been earned and it is not an expenditure laid out or expended for the purposes of business and therefore, not an allowable deduction. Therefore, whether or not the amount in question, comes within the express prohibition contained in section 40(a)(ii), the claim for deduction of surtax in computing the total income of an assessee, is not allowable. It may also be stated here that the aforesaid judgment of the Kerala High Court has been affirmed by the Supreme Court, in the case of Smith Kline and French (India) Ltd v. CIT [1996] 219 ITR 581 (SC).
It may also be stated here that in the aforesaid judgment of the Supreme Court, the case of Jaipuria Sarnia Amalgamated Collieries Ltd v. CIT [1971] 82 ITR 580 (SC), has also been considered. The aforesaid criteria applied by the Kerala High Court to the charge of the surtax is equally applicable to the charge of education cess, in view of the following reasons: 1. Both types of education cess are charged under section 2 of Chapter II of the Finance Act, as an additional surcharge and the same are calculated at the rate of 2% and 1% of income-tax plus surcharge, respectively, As per section 2(1) of Chapter II of the Finance Act, income-tax shall be charged at the rates specified in Part I of the First Schedule and such tax shall be increased by a surcharge for the purposes of Union, calculated in each case in the manner provided therein. Thus, the surcharge is nothing but a part of the tax. 2. Thus, the education cess is a levy on the total income, computed under the Income-Tax Act. It is an application of the profits and gains of the business, after they have been earned, 3. Therefore, any amount paid on account of the education cess is not an expenditure laid out or expended for the purposes of the business.
In the case SRD Nutrients Private Limited v. Commissioner of central excise reported in [TS-5207-SC-2017-0], the Hon’ble Supreme Court, while examining the issue of “whether the Education Cess and Higher Education Cess which were paid along with the excise duty were liable to be refunded along with the central excise duty in terms of the exemption notifications”, elucidated on the nature of Cess levied on Excise Duty or Service Tax under Central Excise Act or Finance Tax and held it to be in nature of excise duly approving the Hon’ble Rajasthan High Court judgment in the case Banswara Syntex Ltd v. Union of India reported in [TS-6662-HC-2016 (RAJASTHAN )-0], wherein it was held that
“15. The very fact that the surcharge is collected as part of a levy under three different enactments goes to show that the scheme of levy of Education Cess was by way of collecting special funds for the purpose of Government projects towards providing and financing universalized quality of basic education by enhancing the burden of Central Excise Duty, Customs Duty, and Service Tax by way of charging a surcharge to be collected for the purpose of Union. It was made clear that in respect of all three taxes, the surcharge collected along with the tax will bear the same character of respective taxes to which the surcharge was appended and was to be governed by the respective enactments under which Education Cess in the form of surcharge is levied & collected.”
In the case of CIT v. International Instruments P. Ltd. [1983] 144 ITR 936 (Kar) the Division Bench of the Karnataka High Court held that the surtax levied on the chargeable profits under the Companies (Profits) Surtax Act, 1964 (hereinafter referred to as the “Surtax Act”) was nothing but an additional tax on the profits and (1) gains of an assessee’s business and since surtax was a charge on the profits and gains of the business of companies, the company was not entitled to claim a deduction of surtax payable by it in computing its total income under the Income-tax Act. In the Molins of India Ltd v. CIT [1983] 144 ITR 317, the Calcutta High Court held that the tax imposed by the companies (Profits) Surtax Act,1964 was essential of the same character as income-tax or excess profits tax and liability – to pay this tax depends upon whether profits are made or not.
The Division Bench of the Calcutta High Court also held that surtax was not also allowable in view of the provisions of section 40(a)(ii) of the Income-tax Act, 1961, and the term “tax” in the said provision could not be understood to mean only income-tax. It was held that the tax sought to be imposed on a company by the Companies (Profits) Surtax Act comes within the mischief of section 40(a)(ii). The decision of the Madras High Court in the case of Sundaram Industries Ltd. v. CIT reported in (1986) 159 ITR 646 is noteworthy to consider. The relevant Para from the above judgment is reproduced below
“13. With regard to the construction of section 40(a)(ii), the Calcutta High Court pointed out that the preamble of the Surtax Act stated that the Act was to impose a special tax on the profits of certain companies. It was held that the surtax imposable has to be calculated on the basis of the total income of the assessee company after- making statutory adjustments and if the tax that is sought to be imposed is not on the profits or gains of the business of the assessee. it is certainly levied on the basis of the profits or gains made by the assessee company in its business and, therefore, it could not be said that the tax sought to be imposed by the Surtax Act will not come within the mischief of section 40(a)(ii)of the Income-tax Act.”
The Calcutta High Court also negated the argument that the definition of “tax” in section 2(43) must be read in section 40(a)(ii) of the Act. The relevant observations are as follows (p. 328 of 144 ITR)
“We are unable to accept the contention that ‘tax’ in s. 40(a)(ii) must be understood to mean only income-tax. The definition is given in s. 2(43) only will apply ‘unless the context otherwise requires. The expression ‘any rate or tax’ in s.40(a)(ii) means any rate or any tax and not income tax only. That section is not confined to income- tax only is made clear by the words ‘levied on the profits or gains of any business or profession or assessed at a proportion of or otherwise on the basis of any such profits or gains.”
In the light of the discussion in the preceding paragraphs, it is clearly established that: a. Education cess, as contemplated under the Chapter II of the Finance Act is nothing but an additional surcharge which, in turn, is nothing but tax chargeable under the Act. The education cess is nothing more than an apportionment of profits after they have arisen. In other words, it is not a charge on the profits, but an allocation or an apportionment that is made thereafter. Besides, the education cess is not relatable to the carrying on of the business of the assessee, because if the assessee suffers a loss or does not have any chargeable profits, then no education cess is payable but the assessee can carry on his business activity. In other words, the Education Cess is chargeable only in the event of chargeable profits being there and not otherwise. Hence, the Education Cess is a tax for the purpose of section 40(a)(ii) and hence is not allowable as a deduction from computing the profits or gains of any business or profession. Accordingly, the ‘education cess’ fails the fundamental tests of deductibility u/s 37 and is also hit by the mischief of section 40(a)(ii) of the Income-tax Act, 1961.
Hence, the amendment vide Finance Act, 2022 should be seen as a clarification that has retrospective applicability.
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