WEEK 2: CANONS OF TAXATION

Taxes are a compulsory contribution of wealth levied upon persons, natural or corporate,
to defray the expenses incurred in conferring a common benefit upon the residents of the
state.
Greater is the rate of tax, higher is the revenue of the government. But, higher tax rates may
impede investment; lead to tax evasion, etc. Hence, the search for the optimal rate of
taxation! Therefore, economists like Adam Smith and John S. Mill have identified some
canons or principles of taxation with an aim to design a good tax system. These are of
two types:
• Adam Smith’s canons of taxation
• Other canons of taxation
Adam Smith’s canon of taxation (progressive)
Adam Smith stated that tax rate and tax system are important for government when they
design tax. He proposed four canons of taxation to develop a good system of taxation.
1. The Ability to pay: Ability to pay states that “the higher you earn, the higher you
pay.” This is what equity is. It means that the citizens of every state should support
the government by paying as nearly as possible in proportion to their income.

2. Certainty: Smith suggested that tax law should be clear. There should be no
ambiguity and arbitrariness in the tax statute. ‘The tax which each individual has
to pay ought to be clear. The time of payment, the amount to be paid, ought to be
clear and plain to the contributor and to every other person’. There needs to be a strict
interpretation of tax statutes. Every tax needs to be backed by relevant statute. Every
tax needs to have legislation. There has to be some certainty i.e., whatever tax is being
imposed, should be backed by a statute or legislation.

3. Convenience: ‘Every tax ought to be levied at the time or in the manner in which it is
most convenient for the contributor to pay it’. Tax shall be levied when it is most
convenient for the taxpayer to pay it. It can be periodic whether annually, quarterly
etc
.
4. Canon of economy: ‘Every tax ought to be so contrived as both, to take out and keep
out of the pockets of the people as little as possible over and above what it brings into
the public treasury of the state’. In other words, the amount spent on administering
the tax should be minimum. In other words, the last canon implies that the
expenses of collection of taxes should not be excessive. They should be kept to the
minimum, consistent with the administrative efficiency.

Contrast Adam Smith with JS Mill (regressive)

John Mill stated that “The rule of equality and of fair proportion seems to me to be that
people should be taxed in an equal ratio on their superfluities, necessaries being untaxed,
and surplus paying in all cases an equal percentage.” Mill adds international considerations to
these concepts of what is a good tax. Globalisation makes it essential for tax systems to be
integrated to some extent.
Mill’s system of taxation
1. Super fluities to be taxed in equal ratio
2. Necessaries should be untaxed
SOURCES OF DOMESTIC TAX LAW:
Taxation Statutes, Constitution of India, Other Statutes, Judicial Decisions, Decisions by
Administrative Bodies and Circulars issued by CBDT (central board of direct taxes)

1. Primary legislation: It creates the chargeability of the tax, who is to pay it, when it
becomes payable, when and how it is to be collected.
2. Judicial and quasi-judicial decisions
3. Administrative decisions: Decisions of CBDT and Settlement Commission (which are
both administrative agencies) are facts specific and may not be relevant factually or legally to
decide other cases.
4. Statutory notifications
5. CBDT Circulars: (as opposed to statutory notifications) are explanatory only and have
no legal effect. However, both circulars and press notes are reliable, being indicative of
official policy.
6. Constitution of India: as some of the Articles have a direct bearing on the tax statute (Part
XIII and Schedule VII, for example)
7. Other legislations like Companies Act, Partnership Act, Hindu and other Personal Laws
etc. which affect the levy and incidence of tax.
Indian Income Tax: Timeline
o Aftermath of the 1857 Mutiny: financial crunch which led to introduction of the
first Income Tax Act in February, 1860 by James Wilson. The tax system was modelled
largely on the lines of the British system.
o The Act received the assent of the Governor General on July 24, 1860, and came
into effect immediately. It was divided into 21 parts consisting of no less than 259 sections.
o Income was classified under four schedules: i) income from landed property; ii)
income from professions and trade; iii) income from securities, annuities and dividends; and
iv) income from salaries and pensions.
o The legislation lapsed in 1865 and was re-introduced in 1867.
o Income Tax Act, 1886: Anglo-Russian War - Governer General Lord Dufferin. The
first comprehensive Act of its kind in modern India that was a combination of 'Licence Tax'
and 'Income Tax'.
o 1916 - graduated rates of taxation on income above Rs. 2,000 introduced
o 1917 - super tax introduced
o 1922 - Indian Income Tax Act passed
o 1939 - substantial amendments made
o 1961 - A new act was drafted which came into force from April 1, 1962 and is
currently in force.

Week 3
Constitutional Provisions related to Indian Taxation system

Fiscal Policy
Fiscal policy - dealing with the government’s taxation and expenditure decisions (Budget –
government)
• Monetary policy - policy dealing with the supply of money in the economy (central bank –
rates of interest)
• Receipts - revenue and capital
• Expenditure - revenue and capital
• Fiscal Deficit = Total Expenditure (that is, Revenue Expenditure + Capital Expenditure) –
(Revenue Receipts + Recoveries of Loans + Other Capital Receipts (that is all Revenue and
Capital Receipts other than loans taken))

Capital Expenditure and Revenue Expenditure

Expenditure incurred by an assesse may be of two types – Capital Expenditure and Revenue
Expenditure. The distinction between the two is vital because capital expenditure, even if
incurred for the purpose of earning income, is not deductible while computing taxable
income, unless the law expressly so provides.
Revenue expenditure, on the other hand, is deductible while computing taxable income unless
the law provides specific rules to disallow such expenditure wholly or partly.

Capital Expenditure is incurred in acquiring, extending or improving a fixed asset. Revenue

expenditures is incurred in the normal course of a business as a routine business expenditure.
Capital expenditure produces benefits for several previous years. Revenue expenditure is
consumed within a previous year.
Capital expenditures makes improvements in earning capacity of a business. Revenue
expenditure on the other hand, maintains the profit making capacity of a business.

Co-operative Federalism
 Art.265 – No tax shall be levied or collected except by authority of law
 There must be a law;
 The law must authorize the tax; and
 The tax must be levied and collected according to the law.
 Distribution of powers – legislative competence – doctrine of repugnancy (Art.246,
Seventh Schedule)
 Division of taxing powers – levy, collection and retention / distribution
 Union taxes can be classified into 4 categories
 Levied, collected and retained by the Union (corporation tax, customs duty,
etc.)
 Levied, collected by Union but revenues shared with the States (income tax
and excise duties - exceptions) – Art.270
 Levied and collected by Union but wholly assigned to the States (succession and
estate duties) – Art.269
 Levied by Union but collected by States (stamp duties and excise duties on medicinal
preparations) – Art.268
 State taxes – land revenue, agricultural income tax, excise duties on narcotics and
alcohol, sales taxes (Art.286, entry 92A)
 Consolidated Fund of India

 Stamp duty example (stamp duty on share certificates – paid to central government,
claim made by the concerned state government)
 Service Tax – consequent amendment made

Part XIII of Indian Constitution

 Art.301 - Subject to Part XIII, trade, commerce and intercourse throughout the
territory of India shall be free.
 Art.302 – Parliament is empowered to impose such restrictions on trade, commerce as
may be required in public interest.
  Art.303 – Neither Parliament nor any State legislature is empowered to make any law
giving preference to one State over another. Exception: if declared by law that it is
necessary to do so for dealing with a situation of scarcity.
 Art.304 - Notwithstanding 301 or 303, a State may impose a tax on imported goods,
but this should not amount to a discrimination between manufactured and imported
goods.
 Proviso: State legislature can impose reasonable restrictions on freedom of trade and
commerce with or within the state as may be required in public interest. However,
such bill cannot be introduced in the State Legislature without previous sanction of
the President.
 Entry taxes and the importance of Art.304(b)
 Difference between powers of Parliament (Art.302) and State legislature: (Art.304)
reasonableness and Presidential sanction

Is tax a restriction?

Stage One

 Language in Art.304(a)
 Atiabari – Art.301 grants protection from ‘direct and immediate’ restrictions on the
‘movement of trade’ (pith and substance + effect and operation). It also states that
Regulatory measures or measures imposing compensatory taxes for the use of trading
facilities does not violate Art301 and 304 (b). It is a measure which facilitaterade
though it appeared to harm it and compensatory tax is identical, as it a tax imposed on
traders facilitates trade by improving trade facilities is compensatory.
 Automobile
 Das J. propounded the theory of compensatory taxes as a clarification to the
Atiabari test
 Regulatory measures or compensatory taxes – outside Art.301 purview
 Example of a regulatory measure – one which actually facilitated trade, though
it appeared to harm it (eg. traffic rules)
 The Court stated that since Rajasthan Government raised aroung Rs 24 lakh
annually from motor vehicle tax under Rajasthan motor vehicle taxation act
and spent Rs. 60 lakh on unkeep of roads, the tax was compensatory. Stated
“this vehicle tax statue is compensatory”.
 Compensatory tax – toll or tax which charges for use of trading facilities and
is not a barrier, burden or deterrent for a trader
 Quantum of levy cannot be much more than the benefit to trade

Beyond Automobile

Stage Two
 Bolani Ores – subsequent dilution (Entry 57, List II) as changed the language from
“this vehicle tax statue is compensatory” to “vehicle tax is compensatory” and rewrote
Entry 57 List II from “tax on vehicle “to “compensatory tax on vehicle”.
 International Tourist Corporation
 dropped the requirement of proportionality
 If the tax were to be proportionate to the expenditure on regulation and service it
would not be a tax but a fee’
 Is a compensatory tax comparable with a fee?
Stage Two

 Bhagatram
 Concept of compensatory taxes has been widened
 Even some link between tax and facilities extended to such dealers, direct or
indirect, sufficient
 Bihar Chamber
 Some connection sufficient – judicial notice of the various facilities provided by
the State
 Hansa Corporation and Geo Miller
 talk about the validity of surcharge on sales tax
 Compensatory taxes were described as measures compensating the
 municipalities for loss of revenue (as it promote commerce)
 Who is to be compensated – trader or the State?

Stage Three

• Jindal Stainless
The Haryana Local Area Development tax act sought to tax the transport of raw materials
required by the Haryana industries. Court concluded that compensatory tax is the service
rendered or facility provided should be more or less equal with the tax levied.
2. Fall out of Automobile : Compensatory tax as a sub-class of fee
3. Distinction between a tax and fee
 Underlying principle of equivalence: Tax - burden (ability to pay, as part of common
burden and any benefit is incidental and not capable of direct measurement) vs. Fee:
equivalence (quantifiable or measurable benefit). Fee is levied on individual but
Compensatory tax is levied on Individual as a member of class. Equivalence is
necessary but not sufficient for a levy to be considered as fee. A tax is not
compensatory in general which doesn’t mean tax which is compensatory becomes fee
A fee will not be compensatory unless it improves trade.
4. Distinction between fee and compensatory tax – capacity of bearer (individual vs.
individual as a member of a class)
The case also talks about the features of a compensatory tax:

‘In the context of Article 301, therefore, compensatory tax is a compulsory contribution
levied broadly in proportion to the special benefits derived to defray the costs of regulation or
to meet the outlay incurred for some special advantage to trade, commerce and intercourse. It
may incidentally bring in net-revenue to the government but that circumstance is not an
essential ingredient of compensatory tax.’ (para 37)

6. How does one determine the compensatory nature?

 Act must facially indicate the quantifiable benefit
 If provisions are ambiguous / do not spell out the benefit, burden upon State

7. Ultimate ruling: Atiabari and Automobile restored; Bhagatram and Bihar Chamber bad law

Fee
• Ram Chandra v State of UP – fee must be earmarked for rendering some special (not
indirect or remote) benefit /services to licensees in the notified market – substantial portion
must be shown to be spent for the requisite purpose
• M Chandru - levy of Infrastructure Development Charges by the Chennai Municipal
Development Authority for planning permission issued to builders
 HC finding: levy was to strengthen water and sewage infrastructure; SC: principle of
equivalence not satisfied
 Of course the quid pro quo need not be understood in mathematical equivalence but
only in a fair correspondence between the two. A broad co-relationship is all that is
necessary.”
 “A charge fixed by statute for the service to be performed by an officer, where the
charge has no relation to the value of the services performed and where the amount
collected eventually finds its way into the treasury of the branch of the government
whose officer or officers collect the charge is not a fee but a tax” (Coole’s exposition
quoted in M Chandru)

Cess

 Ordinarily, a cess is a tax which raises revenue which is applied for a specific purpose
 “it means a tax and is generally used when the levy is for some special administrative
expense which the name (health cess, education cess, road cess, etc.) indicates. When
levied as an increment to an existing tax, the name matters not for the validity of the
cess must be judged of in the same way as the validity of the tax to which it is an
increment.” (Hidayatullah, J. in Shinde Brothers v. Commissioner Raichur & Ors)
 Appears in the tax revenues of the government – may be levied on various tax bases
 Excepyion for union cesses –ART 270

Tolls

 Entry in List II, distinct from tax and fee

 Kamaljeet Singh v Municipal Board (AIR 1987 SC 56) – Toll tax levied by Municipal
Board on vehicles entering the municipal limits was challenged. It was contended as
being a compensatory tax.
 ‘Usually, the consideration for a toll is some amenity, service, benefit or advantage
which the person entitled to the toll undertakes[sic] to provide for the public in
general, or the persons liable to pay the toll[sic].’
 Decision: The Municipal Board provides no facilities whatever to the owners of
vehicles...Even assuming that the Municipal Board has to incur expenditure on
maintenance of the connecting road and the allay, but they are facilities provided for
the residents for which it recovers various taxes. Hence, the toll tax must be struck
down as ultra vires.

Compensatory and Regulatory Taxes

For a tax to be considered ‘compensatory’ for the purposes of Article 301 of the Constitution,
it must be broadly proportionate to the special benefits derived as a result of it. a tax whose
quantum is approximately equal to the benefit conferred on trade as a result of the tax will not
attract Article 301, as it is ‘compensatory’ in nature. In other words, if the proceeds of a tax
are used to improve trade facilities through, for instance, building infrastructure, and the
extent of this benefit to trade is not disproportionate to the levy itself, the tax will be beyond
the pale of Article 301.

Regulatory measures or measures imposing compensatory taxes for the use of trading
facilities do not come within the purview of the restrictions contemplated by Article 301 and
such measures need not comply with the requirements of the proviso to Article 304(b) of the
Constitution

Since a compensatory tax actually benefits trade, there is no question of it violating a

provision that states that trade shall be free. It follows that the crux of a compensatory tax is
the robust relationship between the quantum of the levy, and the benefit to trade as a result of
the levy.
The concept of compensatory nature of tax has been widened and if there is substantial or
even some link between the tax and the facilities extended to such dealers directly or
indirectly the levy cannot be impugned as invalid.
It is of the essence of compensatory tax that the service rendered or facility provided should
be more or less commensurate with the tax levied. A ‘specific, identifiable object behind the
levy’ and a ‘nexus between the subject and the object of the levy’ are required.

Cases: Atiabari, Automobile, Bolani Ores, Jindal Stainless Steel - IMP

Difference between Fee and Compensatory Tax

The fact that a fee is a proportionate levy does not prove the converse, that every
proportionate levy is a fee. Briefly, a fee is levied on an individual as such, while a
compensatory tax is levied on him as a member of a class.
The difference between a compensatory tax and a fee was explained on the basis of the
‘principle of equivalence’. The principle behind a tax, the Court said, was the ability or
capacity to pay, or the ‘principle of burden’. A fee, on the other hand, was based on the
‘principle of equivalence’, which required that the exaction approximate the benefit flowing
from the exaction. The Court held that the basis for a compensatory tax was also the principle
of equivalence.
A fee is ‘compensatory’ if that particular fee improves the flow of trade, and if so, it will be
outside the purview of Article 301. But that does not make it a compensatory tax, because a
fee is not a tax in the first place. In other words, equivalence is a necessary but not sufficient
condition for a levy to be considered a fee. A tax is generally not compensatory. However,
that does not mean that a tax which is compensatory becomes a fee. It continues to be a
compensatory tax, and is outside the purview of Article 301 for that reason. A fee, on the
other hand, usually has elements of quid pro quo, but will not be ‘compensatory’ unless it
improves trade.

WEEK 4: DIRECT TAX

Objectives of Tax-
• Raising Revenue
• Regulation of Consumption and Production
• Encouraging Domestic Industries
• Stimulating Investments
• Reducing Income Inequalities
• Promoting Economic Growth
• Development of Backward Regions
• Ensuring Price Stability
WHAT IS A TAX
A tax may be defined as a "pecuniary burden laid upon individuals or property owners to
support the government, a payment exacted by legislative authority. A tax "is not a
voluntary payment or donation, but an enforced contribution, exacted pursuant to
legislative authority". Taxes consist of direct tax or indirect tax.

DIRECT TAX AND INDIRECT TAX

1. Direct Tax: A Direct tax is a kind of charge, which is imposed directly on the
taxpayer and paid directly to the government by the persons (juristic or natural)
on whom it is imposed. A direct tax is one that cannot be shifted by the taxpayer to
someone else. It is imposed on the income and property of a person. Thus, income
tax, corporation tax, property tax, death tax, capital gains tax etc. are all the
direct taxes. Impact and incidence is on the same person.

Merits
• The larger burden of the direct taxes falls on the rich people who have capacity to
bear these and the poor people with less ability to pay have to bear less burden.
• Direct taxes are important instrument of reducing inequalities of income and wealth.
• Unlike indirect taxes, direct taxes
• do not cause distortion in the allocation of resources. As a result these leave the
consumers better off as compared to indirect taxes.
• Revenue elasticity of direct taxes, especially if they are of progressive type is quite
high. As the national income increases, the revenue on these taxes also rises a great deal.
• Economical: cost of collecting these taxes is relatively less as they are usually
collected at the source and are paid directly to the government.
• CERTAINTY: Tax payers know how much they have to pay and on what basis they
have to pay. The government also knows fairly the amount of tax it is going to collect.
• Equity: ability to pay – progressive tax slabs in income tax
• Aids in redistribution: Since, the same amount which one pay as tax is used for the
welfare of general public i.e., infrastructure, defence, health etc. So, the amount is
redistributed.
• Civic consciousness: knowledge of contribution
Demerits
• TAX EVASIONS: In the direct taxation, people are aware of their tax liability and
therefore they would try to avoid or even evade the taxes. The practice and possibility of
tax evasion and avoidance is more in direct taxes than in case of indirect taxes.
• INCONVENIENCE: Direct taxes are generally payable in lump sum or even in
advance and become quite inconvenient.
• Another demerit of direct taxes is their supposed effect on the will to work and save.
It is assessed that work (given Income) and leisure are two alternatives before any taxpayer.
If therefore, a tax is imposed say on income, the taxpayer will find that the return from work
has decreased as compared with return from leisure. He therefore tries to substitute leisure for
work.
• Unpopular: As the burden to pay tax cannot be shifted
• Adverse effects on the will to work and save: Higher rates of income tax may
discourage people to work hard or work overtime. Similarly, the taxes may reduce their
willingness to save.
• Inconvenience: to the tax payers. Sometimes, the tax payers are required to pay the
entire tax in a lump sum. Besides, the tax payers have to give elaborate documents on their
income and expenditure. So, here the procedure is complex and is quiet inconvenient.

Indirect Tax
An indirect tax is a tax collected by an intermediary (such as a retail store) from the
person who bears the ultimate economic burden of the tax (such as the customer). An
indirect tax is one that can be shifted by the taxpayer to someone else. An indirect tax may
increase the price of a good so that consumers are actually paying the tax by paying more
for the products.
Indirect taxes are those whose burden can be shifted to others so that those who pay these
taxes to the government do not bear the whole burden but pass it on wholly or partly to
others. Indirect taxes are levied on production and sale of commodities and services and
small or a large part of the burden of indirect taxes are passed on to the consumers.
Excise duties on the product of commodities, sales tax, service tax, customs duty, tax on rail
or bus fare are some examples of indirect taxes.
Merits
• Indirect taxes are usually hidden in the prices of goods and services being transacted
and, therefore their presence is not felt so much.
• If the indirect taxes are properly administered, the chances of tax evasion are less.
• Indirect taxes are a powerful tool in moulding the production and investment activities
of the economy i.e. they can guide the economy in its resource allocation.
• Convenience: paid in small amounts and in installments instead of lump sum -
included in the price of the commodity and hence burden is not felt
• Elastic: when imposed on essential goods and services like edible oils, flour etc.
whose demand is inelastic, government can get adequate revenue by increasing the tax rate
• Less chances of tax evasion: difficult to be evaded as they are included in the price
of the commodity.
• Wide coverage: imposed on a large variety of goods so that the purview is wide
• Equity: can be equitable by differentiating between luxury goods and essential
commodities.
Demerits
• Regressive and unjust: Indirect taxes are generally imposed on the consumption of
the goods. They are unjust in the sense that poor people have to pay as much as rich
people. They negate the principle of ability to pay and therefore their burden is more on
poor people.
• Inflationary impact: Leads to an increase in ultimate price of a commodity. This
may lead to rise in the cost of production as a result of which the workers union demands
more of wages that again increases the price of the commodity and this spiral goes on.
• Uneconomical: administrative cost of collecting indirect taxes is generally high as
they have to be collected from a large number of persons.
• Uncertain: rise in the price of the commodity – effect on demand cannot be predicted
with certainty
• No civic consciousness: disguised - through market prices - indifference towards their
responsibility

• It is claimed and very rightly that these taxes negate the principle of ability- to-pay
and are therefore unjust to the poor. Since one of the objectives is to collect enough revenue,
they spread over to cover the items, which are purchased generally by the poor. This makes
them regressive in effect.
• If indirect taxes are heavily imposed on the luxury items, then this will only help
partially because taxing the luxuries alone will not yield adequate revenue for the State.
• indirect taxes are added to the sale prices of the taxed goods without touching the
purchasing power in the first place. The result is that in their case inflationary forces are fed
through higher prices, higher costs and wages and again higher prices.

Week 7 Corporate Tax in India

Indian Company [Section 2(26)]

“Indian Company” means a company formed and registered under the Companies Act, 1956
and includes :

(i) A company formed and registered under any law relating to companies
formerly in force in any part of India other than the State of Jammu and
Kashmir or and the specified Union Territories; [Sec. 2 (26) (i)]
(ii) A corporation established by or under Central, State or provincial Act ; [Sec.
2(26) (ia)]
(iii) Any institution, association or body which is declared by the Board to be a
company: [Sec. 2 (26) (ii))]
(iv) In the case of Jammu & Kashmir, a company formed and registered under any
law for the time being in force in that State ; [Sec. 2 (26) (ii)]
(v) In the case of any of the Union territories of Dadra and Nagar Haveli, Goa,
Daman and Diu, and Pondicherry, a company formed and registered under any
law for the time being in force in that Union Territory. [Sec. 2 (26) (iii)]

In all the above cases, the Principal office of the company, corporation, institution,
association or body must be situated in India.

2. Company in which public are substantially interested [Section 2(18)]

A company is said to be a company in which public are substantially interested, if:

(i) It is a company owned by the Central or State government or the Reserve

Bank of India [Section 2(l8)(i)] ; or
(ii) At least 40% of its shares (by monetary value) are held (singly or jointly by
the Govt. or the Reserve Bank of India or a corporation owned by that Bank
(Section 2 (18) (a)] or
(iii) It is a company which is registered under section 25 of the Companies Act,
1956 (Sec. 2 (18)(aa)J ; or
(iv) It is a company having no share capital and if, having regard to its objects,
the nature & composition of the membership and other relevant
considerations, it is declared by order of the Board to be a company in which
the public are substantially interested provided that such order shall hold good
for only such assessment year or years specified in the declaration [Section 2(1
8)(ib) ; or
(v (vi) Society participating company. It is a company wherein shares (not being
shares entitled to a fixed rate of dividend) carrying ‘at least 50% of the voting
power have been held by one or more cooperative society, throughout the
relevant previous year; [Section 2(1 8)(ad)1 or
 (vii) It is a company which is not a private company (as defined in the Companies
Act, 1956) fulfilling any one of the following two conditions namely [Section
2(1 8)(b)J
(a) Its equity shares were, as on last day of relevant previous year listed in
recognised Stock Exchange in India.
(b) Its equity shares carrying not less than 50% of voting power (40% in
case of Indian industrial company) have been allocated unconditionally
to or acquired unconditionally by and were held throughout the
relevant previous year beneficially by
(i) the Government, or
(ii) corporation established by a Central State or Provincial Act, or
any company in which public are substantially interested or its
100% Subsidiary company.
(viii) Indian Industrial Company. It means an Indian company whose business
consists wholly of the construction of ships or in the manufacture or
processing of goods or in the mining or in the generation or distribution of
electricity or any other form of power.

The income attributable to any or more of the aforesaid activities included in the total income
of the previous year is not less than 51% of such total income.

Widely Held Company

A company in which the public are substantially interested is known as Widely held
company.

4. Closely held Company

A company in which the public are not substantially interested is referred to as a Closely held
company.

5. Domestic Company [Section 2(22A)]

Domestic company means an Indian company, or any other company, which, in respect of its
income liable to tax under this Act, has made the prescribed arrangements for the declaration
and payment, within India of the dividends (including dividends on preference shares)
payable out of such income.

7. Foreign Company [Section 2(23A)]

A company which is not a domestic company.

8. Investment Company [Section 109 (ii)(i)]

Investment company is a company whose gross total income consists mainly of income
chargeable to tax under the heads ‘Income form House Property, Capital Gains’ and ‘Income
from Other Sources’. An investment company is a company whose main business is
holding securities for investment purposes. Investment companies invest money
on behalf of their clients who, in return, share in the profits and losse

Residential Status (following also in week 5 &6)

Section 6 (1) and its exceptions
• An individual is said to be resident in India is he satisfies any one of the following
two conditions under Sec. 6(1):
(a) He is in India for a period or periods amounting to 182 days or more in the relevant PY; or
(c) He is in India for 60 days or more during the relevant PY and has been in India for 365
days or more during four PYs immediately preceding the relevant PY.
• Exceptions:
(1) Indian citizen who leaves India in any PY as a member of the crew of an Indian ship or
for purposes of employment outside India, the period of 60 days in condition 2 supra, shall be
substituted by 182 days.
(2) Indian citizen or Person of Indian Origin, who comes on a visit to India in any PY, the
period of 60 days in condition 2 supra, shall be substituted by 182 days.
• In effect, condition 2 becomes redundant for the assessees covered in the exceptions.
• Person of Indian origin- Sec.115 C (e) “non-resident Indian” means an individual,
being a citizen of India or a Person of Indian Origin who is not a “resident”.
Explanation : A person shall be deemed to be of Indian origin if he, or either of his parents or
any of his grand-parents, was born in undivided India
• NOR- The law has not prescribed the conditions but the test can be derived by
looking at Sec.6(6) which refers to the condition to be satisfied for proving that an
individual is not ordinarily resident in India. The conditions are as follows:
 The individual has been resident in India for at least 2 out of 10 PYs immediately
preceding the relevant PY and
 has been in India for 730 days or more, during 7 previous years immediately
preceding the relevant PY.

• Sec 6 (3) defines it as A company is said to be resident in India in any previous year,
if—
(i) it is an Indian company ; or
(ii) during that year, the control and management of its affairs is situated wholly in India.
• A company’s residential status depends on incorporation and control and management
of affairs.
• Control and management must be wholly in India
• Narottam (AIR 1954 Bom 67) – Facts: Company is a subsidiary of the Scindia Steam
Navigation Co. Ltd. incorporated in Bombay with its registered office in Bombay.
Business is stevedoring in Ceylon. Two managers in Ceylon, acting under wide
powers-of-attorney look after all the affairs of the company in Ceylon. However, all
board and shareholder meetings are held in Bombay.
• It was sought to be argued that the whole of the company’s business is done in Ceylon
and that the whole of the income which is liable to tax has been earned in Ceylon. But
is this the relevant factor?
• It is entirely irrelevant where the business is done and where the income has been
earned. What is relevant and material is from which place has that business been
controlled and managed…It is that authority to which the servants, employees and
agents are subject, it is that authority which controls and manages them, which is the
central authority, and it is at the place where the central authority functions that the
company resides.
• On facts, the PoAs could be cancelled at any moment, the officers had to carry out
any orders given to them from Bombay and were required to submit an explanation of
what they have been doing, and a vigilant eye was kept over their work from the
directors’ board room in Bombay. Bombay exercised not only a ‘de jure’ control and
management, but also a ‘de facto’ control and management.
• In Hindu undivided family, firm or other association of persons case they are resident
unless the control and management of its affairs is situated wholly without the taxable
 territories. Therefore, whereas in the case of an Hindu undivided family or firm or
association of persons any measure of control and management within the taxable
territories would make them resident, in the case of a company any measure of control
and management of its affairs outside the taxable territories would make it non-
resident.’

Place of effective management test -Alternate test for corporate residence proposed in the
Draft Direct Tax Code which has been spelt out as follows:
The place where the board of directors of the company or its executive directors, as the case
maybe, make their decisions; or In a case where the board of directors routinely approve the
commercial and strategic decisions made by the executive directors or officers of the
company, the place where such executive directors or officers of the company perform their
functions.
• Residential Status of other persons - Sec.6 (4) Every other person is said to be
resident in India in any previous year in every case, except where during that year the
control and management of his affairs is situated wholly outside India.
• Resident: If the control and management of the affairs of a firm or AOP or other
person is situated wholly or partly in India then such a firm or AOP or other person is
said to be resident in India.
• Non-Resident: If the control and management of the affairs of a firm or AOP or other
person is situated outside India then such a firm or AOP or other person is said to be
non-resident in India
Residential Status impacts the incidence of taxation – Section 5

RADHA RANI CASE HOLDING

The words 'control and management' have been figuratively described as 'the head and brain.
The head and brain of a company is the board of directors, and if the board of directors
exercised complete local control, then the company is also deemed to be resident.
The legal position is now well-settled that the expression "control and management"
means central control and management and not carrying on a day-to-day business.
POEM READING
POEM refers to the place where key management and commercial decisions necessary for
the business as a whole, are in substance made. (SUBSTANCE OVER FORM)
The guidance contemplates different tests for companies with active and passive businesses
outside India. An active business is one where less than 50% of the income is passive and
less than 50% of its employees are situated in India, with payroll expenses on such employees
being less than 50% of total payroll expenses. Passive income covers dividends, interest,
royalties, capital gains, rent and income from related party transactions.
The POEM for an active company is presumed to be outside India if the majority of its
Board meetings are held outside India. This presumption would not apply if
management authority is exercised by a person other than the Board, who is resident in
India. This determination will be made based on data over the past 3 years, or lesser if the
company has been in existence for lesser than 3 years.
To determine the POEM of passive companies, the persons who actually make key
management and commercial decisions for the business as a whole will be identified,
followed by identifying the place where decisions are actually taken.
The following guiding principles would be considered while determining POEM of a
company:
 Location where the Board regularly meets, provided it retains and exercises governing
authority over the company and in substance takes key management and commercial
decisions.
The place where key decisions are in fact taken would have more relevance than where
formal Board meetings are held.
If the Board routinely ratifies decisions made by senior management, executive committee or
any other person, the place where such person takes decisions will be considered as POEM.
The location of a company's head office is an important factor and the following facts
have to be considered in this regard: (i) Location where the company's senior management
and support staff are based and which is held out to the public as its headquarters.
(ii) In a more decentralised company, the head office would be the place where the
senior management is predominantly based, normally return to after travel, or meet
when formulating key strategies or policies for the company as a whole. (iii) If senior
management permanently operate from different locations, and participate in meetings via
telephone or video conferencing, the location of the highest level of management such as the
managing or financial director will be considered as the head office. (iv) The head office
would not be of much relevance in a highly decentralised company where it is not possible to
determine its location with reasonable certainty.
Day to day routine operational activities of junior or middle management are not
relevant for determining POEM.
With the use of modern technology, physical location of meetings may not be where the key
decisions are in substance made. In such situations, place of residence of majority of directors
or decision making persons may also be a relevant factor.
As secondary factors, place of main and substantial activity of the company and place where
accounting records are kept may be considered if the primary factors are inconclusive.
Ownership of a foreign company by an Indian company, residence of some of the directors of
the foreign company in India, location of local management of a foreign company in India
and existence of support functions of preparatory or auxiliary character in India will not be
conclusive of POEM in India.

WEEK 12: DOUBLE TAXATION AVOIDANCE AGREEMENTS

In the current era of cross -border transactions across the world, due to unique growth in
international trade and commerce and increasing interaction among the nations, residents of
one country extend their sphere of business operations to other countries where income is
earned.
One of the most significant results of globalization is the noticeable impact of one country’s
domestic tax policies on the economy of another country. This has led to the need for
incessantly assessing the tax regimes of various countries and bringing about indispensable
reforms.
Therefore, the consequence of taxation is one of the important considerations for any trade
and investment decision in any other countries.
Where a taxpayer is resident in one country but has a source of income situated in
another country, it gives rise to possible double taxation.
This arises from two basic rules that enable the country of residence as well as the
country where the source of income exists to impose tax, namely,
 Source rule: The source rule holds that income is to be taxed in the country in
which it originates irrespective of whether the income accrues to a resident or a
nonresident
 Residence rule: The residence rule stipulates that the power to tax should rest
with the country in which the taxpayer resides.
In other words, different countries have their own tax laws. If you are resident in one country
and have income and gains from another, you may have to pay tax on the same income in
both countries. This is known as ‘double taxation’. For example, an individual who is
resident in the UK, but has rental income from a property in another country, may have to
pay tax on the rental income in both the UK and that other country.
If both rules apply simultaneously to a business entity and it were to suffer tax at both
ends, the cost of operating in an international scale would become prohibitive and deter
the process of globalization. It is from this point of view that Double taxation avoidance
Agreements (DTAA) become very significant.
In cases, where cross country economic activity is carried out, it is a tricky affair to identify
and justify the appropriate jurisdiction of tax authorities. In order to mitigate the
hardships of multiple jurisdictions, the Governments enter into bilateral arrangements, which
are commonly denoted as “Double Taxation Avoidance Agreements” (DTAA). DTAA refers
to an accord between two countries, aiming at elimination of double taxation. These are
bilateral economic agreements wherein the countries concerned assess the sacrifices and
advantages which the treaty brings for each contracting nation. It would promote exchange of
goods, persons, services and investment of capital among such countries.
International double taxation has adverse effects on the trade and services and on
movement of capital and people. Taxation of the same income by two or more countries
would constitute a prohibitive burden on the tax-payer.
The domestic laws of most countries, including India, mitigate this difficulty by affording
unilateral relief in respect of such doubly taxed income (Section 91 of the Income Tax Act).
But as this is not a satisfactory solution in view of the divergence in the rules for determining
sources of income in various countries, the tax treaties try to remove tax obstacles that inhibit
trade and services and movement of capital and persons between the countries concerned. It
helps in improving the general investment climate.
UN AND OECD MODEL CONVENTIONS
The double tax treaties (also called Double Taxation Avoidance Agreements or “DTAA”) are
negotiated under public international law and governed by the principles laid down
under the Vienna Convention on the Law of Treaties.
The first international initiative regarding DTAA was taken by the Organization for
Economic Co-operation and Development. OECD presented the first draft of DTAA in
‘Model Tax Convention on Income and on Capital’.
In the first draft, DTAA was proposed as a tool of standardization and common solutions
for cases of double taxation to the taxpayers who are engaged in industrial, financial or
other activities in other countries. The double tax treaties are negotiated under
international law and governed by the principles laid down under the Vienna Convention on
the Law of Treaties.
It is in the interest of all countries to ensure that undue tax burden is not cast on persons
earning income by taxing them twice, once in the country of residence and again in the
country where the income is derived. At the same time sufficient precautions are also
needed to guard against tax evasion and to facilitate tax recoveries.
CLASSIFICATION OF DOUBLE TAXATION AVOIDANCE AGREEMENTS
Double taxation avoidance agreements may be classified into comprehensive agreements
and limited agreements based on the scope of such agreements. Comprehensive Double
Taxation Avoidance Agreements provide for taxes on income, capital gains and capital
investments whereas Limited Double Taxation Avoidance Agreements denote income
from shipping and air transport or legacy and gifts. Comprehensive agreements ensure
that the taxpayers in both the countries would be treated on equitable manner in respect of the
issues relating to double taxation.

Double Taxation
The fiscal committee of OECD in Model Double Taxation Convention on Income and
Capital, 1977 defines double taxation as: ‘The imposition of comparable taxes in two or
more states on the same tax payer in respect of the same subject matter and for
identical periods’.
Double Taxation of the same income would cause severe consequences on the future of
international trade. Countries of the world therefore aim at eliminating the prevalence of
double taxation. Such agreements are known as "Double Tax Avoidance Agreements"
(DTAA) also termed as "Tax Treaties”.
In India, the Central Government, acting under Section 90 of the Income Tax Act, has been
authorized to enter into double tax avoidance agreements with other countries.
Necessity of Double Taxation Avoidance Agreements
The need and purpose of tax treaties has been summarized by the OECD in the ‘Model Tax
Convention on Income and on Capital’ in the following words: ‘It is desirable to clarify,
standardize, and confirm the fiscal situation of taxpayers who are engaged, industrial,
financial, or any other activities in other countries through the application by all countries of
common solutions to identical cases of double taxation’.
Objectives of Double Taxation Avoidance Agreements
Avoiding and alleviating the adverse burden of international taxation, by-
1. Laying down rules for division of revenue between two countries
2. Exempting certain incomes from tax in either country
3. Reducing the applicable rates of tax on certain incomes taxable in either countries.

HOW TAX TREATIES HELP TAX-PAYERS OF A COUNTRY

1. Tax treaties help a taxpayer of one country to know with greater certainty the
potential limits of his tax liabilities in the other country.

2. Another benefit from the tax-payers point of view is that, to a substantial extent, a tax
treaty provides against non- discrimination of foreign tax payers or the
permanent establishments in the source countries vis-à-vis domestic tax payers.

Tax Treaties must ensure that there is no prejudice between foreign tax payers who has
permanent enterprise in the source countries and domestic tax payers of such countries.
Treaties are made with the aim of allocation of taxes between treaty nations and the
prevention of tax avoidance. The treaties must also ensure that equal and fair treatment of tax
payers having different residential status, resolving differences in taxing the income and
exchange of information and other details among treaty partners.

Functions of DTAA
DTAAs ensure that countries adopt common definitions for factors that determine
taxing rights and taxable events. Crucial among these is the definition of a permanent
establishment.
Most treaties also specify a Mutual Agreement Procedure (MAP) which is invoked when
interpretation of treaty provisions is disputed.
To prevent abuse of treaty concessions, treaties increasingly incorporate restrictions and
rules, such as a general anti- avoidance rule (GAAR), that allow tax authorities to determine
if a transaction is only undertaken for tax avoidance or not.
Benefit limitation tests and controlled foreign corporation (CFC) rules also place limits on
claims of residence in countries eligible for treaty concessions.
Exchange of tax information on either a routine basis or in response to a special request is
provided for in most treaties to assist countries counter tax evasion.

Salient Features of Double Taxation Avoidance Agreements (DTAAs) agreements

between India and Other Countries
As of now there exists 88 Double Taxation Avoidance Agreements (DTAAs) between
India & other countries. These treaties are usually between countries with substantial trade
or other economic relations. Most treaties are between pairs of developed countries while, of
the balance, most are between developed and developing countries.
DTAA’s:
 Provide reciprocal concessions to mitigate double taxation,
 Assign taxation rights roughly in accordance with that “existing consensus” and
 Largely though not rigidly follow the OECD Model Tax Convention or, for
developing countries, the UN Tax Convention.

Recent treaties contain new clauses following the OECD Model Tax Conventions of 2005 to
2010 which extend areas of cooperation to administrative and information issues.

A typical DTA Agreement between India and another country covers only residents of
India and the other contracting country who has entered into the agreement with India.
A person who is not resident either of India or of the other contracting country cannot
claim any benefit under the said DTA Agreement.
Such agreement generally provides that the laws of the two contracting states will govern the
taxation of income in respective states except when express provision to the contrary is made
in the agreement.

Relevant Provisions of Income-Tax Act, 1961 for DTAA’s

Section 90 - Agreement with foreign countries or specified territories –Bilateral Relief

 Since the tax treaties are meant to be beneficial and not intended to put tax payers of a
contracting state to a disadvantage, it is provided in Sec. 90 that a beneficial provision
under the Indian Income Tax Act will not be denied to residents of contracting state
merely because the corresponding provision in tax treaty is less beneficial.

Section 90A - Double taxation relief to be extended to agreements (between specified

Associations) adopted by the Central Government
Section 91 - Countries with which no agreement exists-Unilateral Agreements
Some Double Taxation Avoidance agreements provide that income by way of interest,
royalty or fee for technical services is charged to tax on net basis.
This may result in tax deducted at source from sums paid to Non-residents which may be
more than the final tax liability. The Assessing Officer has therefore been empowered under
section 195 to determine the appropriate proportion of the amount from which tax is to be
deducted at source.
There are instances where as per the Income-tax Act, tax is required to be deducted at a rate
prescribed in tax treaty. However this may require foreign companies to apply for refund.
To prevent such difficulties Sec. 2(37A) provides that tax may be deducted at source at the
rate applicable in a particular case as per section 195 on the sums payable to non- residents or
in accordance with the rates specified in D.T.A. Agreements.
 TRANSFER PRICING (Week 13)

Related Party transaction means the transaction between/among the parties which are
associated by reason of common control, common ownership or other common interest.
The mechanism for accounting, the pricing for these related transactions is called
Transfer Pricing. Transfer Price refers to the price of goods/services which is used in
accounting for transfer of goods or services from one responsibility centre to another or
from one company to another associated company. Transfer price affect the revenue of
transferring division and the cost of receiving division. As a result, the profitability, return
on investment and managerial performance evaluation of both divisions are also affected.
This may be understood well by the following example:
1. Arihant & Companies is a group of Companies engaged in diversified business. One
of its units i.e. Unit X is engaged in manufacturing of automotive batteries. Another
Unit Y is engaged in manufacturing of Industrial Trucks. Unit X is supplying
automotive batteries to Unit Y. In such cases transfer price mechanism is used to
account for the transfer of automotive batteries.

IMPORTANCE OF TRANSFER PRICING

Transfer pricing mechanism is very important for following reasons:

1. Helpful in correct pricing of Product/Services - An effective transfer pricing mechanism

helps an organization in correctly pricing its product and services. Since in any organization,
transaction between associated parties occurs frequently, it is necessary to value all
transaction correctly so that the final product/ services may be priced correctly.

2. Helpful in Performance Evaluation: For the performance evaluation of any entity, it is

necessary that all economic transactions are accounted. Calculation of correct transfer price is
necessary for accounting of inter related transaction between two Associated enterprises.

3. Helpful in complying Statutory Legislations: Since related party transaction have a direct
bearing on the profitability or cost of a company, the effective transfer pricing mechanism is
very necessary. For example, if the related party transactions are measured at less value, one
unit may incur loss and other unit may earn undue profit. This will result in income tax
imbalances at both parties end. Similarly, wrong transfer pricing may lead to wrong payment
of excise duty, custom duty /sales tax (if applicable) as well.
International Transfer Pricing provisions are covered under: Section 92 to 92F in the Indian
Income Tax Act, 1961;

The economics of Transfer Pricing

 Where tax rates are different between tax jurisdictions,
 there is a strong incentive to shift
 income to a lower tax jurisdiction
 and deductions to a higher tax jurisdiction
 so that the overall Tax Rate is minimized.

What it means to the Jurisdiction

• As the aggregate tax payable by MNCs is reduced, tax authorities across the world
incur significant losses.
 • To guard against such losses, many countries have introduced transfer pricing
legislation to govern the pricing of cross border transactions between related parties.
Transfer Pricing Regulations ("TPR") are applicable to the all enterprises that enter into an
'International Transaction' with an 'Associated Enterprise'. Therefore, generally it applies to
all cross border transactions entered into between associated enterprises. The aim is to arrive
at the comparable price as available to any unrelated party in open market conditions and is
known as the Arm's Length Price ('ALP').

ARM’S LENGTH PRICE

In general arm’s length price means fair price of goods transferred or services rendered. In
other words, the transfer price should represent the price which could be charged from an
independent party in uncontrolled conditions. Arm’s length price calculation is very
important for a company. In case the transfer price is not at arm’s length, it may have
following consequences
A. Wrong performance evaluation
B. Wrong pricing of final product (In case where the goods/services are used in the
manufacturing of final product)
C. Non compliances of applicable laws and thus attraction of penalty provisions.

Arm’s length price as per section 92 F is the price applied (or proposed to be applied) when
two unrelated persons enter into a transaction in uncontrolled conditions. Persons are said to
be unrelated if they are not associated or deemed to be associated enterprise according to
Section 92 A. Uncontrolled conditions are conditions which are not controlled or suppressed
or moulded for achievement of a pre-determined results are said to be uncontrolled
conditions. If a buyer is related to a seller, or where the prices are governed by the
government policy then transaction is said to be taking place under controlled conditions.

Therefore, to constitute arm’s length price:

a. The price should be applied or proposed to be applied in a transaction
b. The transaction is between unrelated person
c. The transaction is taking place in uncontrolled conditions

ASSOCIATED ENTERPRISES (AE)

Associated Enterprises has been defined in Section 92A of the Act. The basic criterion to
determine an AE is the participation in management, control or capital (ownership) of one
enterprise by another enterprise. The participation may be direct or indirect or through one or
more intermediaries. Clause (a) of Section 92A(1) is about participation by one enterprise
into other enterprise. While clause(b) of the said section is about participation by a third
enterprise into both the enterprises. Clause (a) of Section 92 A(1) provides that the enterprise
which participants in management, control or capital is an associated enterprise for the other
enterprise. The language of the provision should be construed harmoniously such that both
the participating enterprise and the other enterprise are regarded as associated enterprises.

Participation in Management
Appointment of more than half of Board of Directors/ Board of Members/ one or more
Executive Directors/ Executive Members by:
● - The other Enterprise
● - The same person(s) in both the enterprises.
Participation through Capital
Holding not less than 26% of the voting power directly or indirectly
- in the other enterprise
- in each of such enterprise

Participation through Control

• Loan not less than 51% of Book value of Total Assets
• Guarantee not less than 10% of Total borrowings
• Use of knowhow, patents, copy right, etc., of which other enterprise is owner or has
exclusive rights
• Purchase of 90% or more Raw Materials and Consumables for which prices and other
conditions are influenced
• Sale of goods manufactured or processed to other enterprise or person specified by it
for which prices and other conditions are influenced or Controlled by same person
• Apart from these, any relationship of mutual interest, as may be prescribed shall also be
considered as Associated enterprise.
Thus, from above definition we may understand that the basic criterion to determine an AE is
the participation in management, control or capital (ownership) of one enterprise by another
enterprise whereby the participation may be direct or indirect or through one or more
intermediaries, control may be direct or indirect.

DEEMED ASSOCIATED ENTERPRISES

Mere fact of participation by one enterprise in the management or control or capital of the
other enterprise, or the participation of one or more persons in the management or control or
capital of both the enterprises shall not make them enterprises, unless the criteria specified in
section 92A(2) are fulfilled. For instance, where one enterprise is holding preference shares
in other enterprise then they shall not be regarded as associated enterprise because though one
is participating in the capital of other enterprises but still they are not satisfying any of the
thirteen categories mentioned in Section 92A(2).

MEANING OF INTERNATIONAL TRANSACTION

International Transaction have been defined vide Section 92B of Income Tax Act.
International transaction’ means any of the following nature of transactions between two or
more “Associated enterprise” where, either or both of whom are non-residents
● (a) purchase,
● (b) sale,
● (c) lease of tangible or intangible property,
● (d) provision of services,
● (e) lending or borrowing money, or
● (f) any other transaction having a bearing on the profits, income, losses or assets of such
enterprise.
● (e) Mutual agreement between AEs for allocation/apportionment of any cost, contribution
or expense.

DEEMED INTERNATIONAL TRANSACTION

As per Section 92B(2) of Income Tax Act, A transaction entered into by an enterprise with a
person other than an associated enterprise shall, for the purposes of sub-section (1), be
deemed to be a transaction entered into between two associated enterprises, if there exists a
prior agreement in relation to the relevant transaction between such other person and the
associated enterprise, or the terms of the relevant transaction are determined in substance
between such other person and the associated enterprise.

TRANSFER PRICING – APPLICABILITY TO DOMESTIC TRANSACTIONS

Honourable Supreme court in the case of CIT v. Glaxo SmithKline Asia (P) Ltd., (2010) 195
Taxman 35 (SC) has advised that it needs to be considered whether the regulations should be
applied to domestic transactions in cases where such transactions are not revenue-neutral

TRANSFER PRICING – METHODS

Section 92C of Income Tax Act defines the methods which are to be used in determination of
Arm's Length prices for International Transaction and specified domestic transaction. The
arm's length price in relation to an international transaction/specified domestic transaction
shall be determined by any of the following methods, being the most appropriate method,
having regard to the nature of transaction or class of transaction or class of associated persons
or functions performed by such persons or such other relevant factors as the Board may
prescribe, namely :-
(A) Comparable Uncontrolled Price Method (CUP)
(B) Resale Price Method (RPM)
(C) Cost Plus Method (CPM)
(D) Profit Split Method (PSM)
(E) Transactional Net Margin Method (TNMM)
(F) Such other method as may be prescribed by the Board.

Where an assesse has entered into various types of international transactions with associated
enterprises, arm’s length price should be determined on a transaction by transaction basis and
not on an aggregate basis.The Arm’s Length Price shall be taken to be the arithmetic mean of
such prices, or, at the option of the assessee, a price which may vary from the arithmetical
mean by an amount not exceeding 3% of such arithmetical mean.

Various transfer pricing methods which are prescribed by Income Tax Act, 1961 are as
under:

(A) COMPARABLE UNCONTROLLED PRICE METHOD

Comparable Uncontrolled Price (“CUP”) method compares the price charged for property or
services transferred in a controlled transaction to the price charged for property or services
transferred in a comparable uncontrolled transaction in comparable circumstances.
In this method, price charged in an uncontrolled deal between comparable entities is
recognized and evaluated with the verified entity price to determine the Arm’s Length
Principle. The CUP method offer the finest evidence of ALP. An Uncontrolled price is the
price agreed between the unrelated parties for the transfer of goods or services. If this
uncontrolled price is comparable with the price charged for transfer of goods or services
between the Associated Enterprises, then that price is Comparable Uncontrolled Price (CUP).
This is the most direct method for the determination of the Arms’ length price.

Methods of CUP
CUP can be either
(a) Internal CUP or
(b) External CUP
Internal CUP is available, when the tax payer enters into a similar transaction with unrelated
parties, as is done with a related party as well. This is considered a very good comparable, as
the functions performed, processes involved, risks undertaken and assets employed are all
easily comparable – more so, on “an apple to apple basis”.
The external CUP is available if a transaction between two independent enterprises takes
place under comparable conditions involving comparable goods or services. For example an
independent enterprise buys or sells a similar product, in similar quantities under similar term
from / to another independent enterprise in a similar market will be termed as external CUP.

Computation of Arm’s Length Price under CUP Method

Step 1: Determine the price charged or paid for the property transferred or services provided
in a comparable uncontrolled transaction
Step 2: Such Price is then adjusted to account for the Functional Differences between the
International Transaction & the Comparable Uncontrolled Transaction, which could
materially affect the price in the open market.
Step 3: Such Adjusted Price is the Arm’s Length Price

Applicability of the CUP Method

Comparable Uncontrolled Price method is treated as most reliable method of transfer pricing
calculation but it is not easy to find the controllable price method easily. The CUP is believed
to be the most reliable / best method, if one could identify and map it. CUP method can be
applied without any difficulty in following circumstances.
(1) Interest payment on a loan
(2) Royalty payment
(3) Software development where products are often licensed to a third party
(4) Price charged for homogeneous items like traded goods

(B) RESALE PRICE METHOD

This method is used where the vendor adds similarly little value to goods owned from
associate enterprises. Here, Arm’s Length Price is determined by reducing the relevant gross
profit mark-up from the sale price charged to free entity.
Example
1. A sold a machine to B (Associated enterprise) and in turn B sold the same machinery to C
(an independent party) at sale margin of 30% for `2,10,000 but without making any additional
expenses and change. Here Arm’s length price would be calculated as
Sales price to B = 2, 10,000
Gross Margin = 10,000 × 30% = 63,000
Transfer price = 1, 47,000
2. A sold a machine to B (Associated enterprise) and in turn B sold the same machinery to C
(an independent party) at sale margin of 30% for `4,00,000 but B has incurred 4000 in
sending the machine to C. Here Arm’s length price would be calculated as
Sales price to B = 4, 00,000
Gross Margin = 4,00,000 × 30%=1, 20,000
Balance = 2, 80,000
Less: Expenses incurred by B = 4,000
Arm’s length price= 2,76,000

Computation of Arm’s Length Price under Resale Price Method

Step 1: The Price at which the Property purchased or the Services obtained by the enterprise
from an associated enterprise are sold to an unrelated enterprise is first determined.
Step 2: Such Resale Price is reduced by the Normal Gross Profit Margin accruing to the
Enterprise from the purchase and resale of Similar Goods in a comparable uncontrolled
transaction. If there is no comparable uncontrolled transaction, then take the Gross Profit of
an unrelated person from purchase and resale of Similar Goods
Step 3: Then reduce the expenses incurred by the enterprise in connection with purchase of
property.
Step 4: The price so arrived is adjusted to account for the functional differences in the
International Transaction & the Comparable uncontrolled Transaction which could materially
affect the Gross Profit Margin in the Open Market.
Step 5: The adjusted Price is the Arm’s Length Price

C) COST PLUS METHOD

In CP method first the cost incurred is determined.
● An appropriate cost plus mark up is then added to the cost to arrive at an appropriate profit.
● The resultant is the ALP
Cost plus method is more relevant where raw materials or semi finished products are
sold. Similarly, it can also be used where joint facility agreements or long term buy and
supply arrangements or provisions of services are involved.

(D) PROFIT SPLIT METHOD

PSM is used when transaction are inter related and is not possible to evaluate separately.
PSM first identifies the profit to be split for AE. The profit so determined is split between the
AE on the basis of the function performed.

Two step Approach of Profit Spilt Method

Step 1: Allocation of sufficient profit to each enterprise to provide a basic compensation for
routine contributions. This basic compensation does not include a return for possible valuable
intangible assets owned by the associated enterprises. The basic compensation is determined
based on the returns earned by comparable independent enterprises for comparable
transactions or, more frequently, functions.
Step 2: Allocation of residual profit (i.e. profit remaining after step 1) between the associated
enterprises based on the facts and circumstances. If the residual profit is attributable to
intangible property, then the sallocation of this profit should be based on the relative value of
each enterprise’s contributions of intangible property.

Computation of Arm’s Length Price under Profit Split Method

Profit split method is relevant where the transactions involved provision of integrated
services by more than one enterprise. PSM method is used when associate enterprises are so
combined that it turns into difficult to make transfer pricing analysis on transactional methods
basis.

(E) TRANSACTIONAL NET MARGIN METHOD (TNMM)

Compares the net profit margin of a taxpayer arising from a non-arm's length transaction with
the net profit margins realized by arm's length parties from similar transactions; and
Examines the net profit margin relative to an appropriate base such as costs, sales or assets.

Computation of Arm’s Length Price under Transactional Net Margin Method

Transactional net marginal method is used in most of the cases including transfer of semi
finished goods, distribution of products where resale price method appears to be
inappropriate and also in case involving provision of services.

WEEK 14: ADVANCE RULING (Relevant Sections – Section 245 N-V)

The Authority for Advance Rulings has emerged as an important adjudicatory body on tax
matters. Recent rulings by the AAR in Castleton Investment Limited and the MAT
controversy have brought the importance of the institution in tax disputes and related matters.
The Responsibility of the AAR is to provide the facility of ascertaining the income-tax
liability of a non-resident as well as that of certain special categories of residents. If an entity
or company has any doubt about the tax liability of its business, it can go to the AAR. The
AAR here gives a ruling and it will become policy guide to the company as well as to the tax
authorities. Hence, the companies can plan their income-tax affairs well in advance and to
avoid long drawn and expensive litigation.
In the case of Income Tax Appellate Tribunal, a company goes to it if it has a grievance
related to the tax notice it has got from the tax authorities. But in the case of AAR, such a
notice is not needed to seek its ruling.
It is in essence a binding statement from the Revenue Authorities, upon the voluntary request
of a private person, with respect to the treatment and consequences of one or a series of
contemplated future actions or transactions having exigible consequences.
Scope of Advance Ruling:
It is a mode of Alternate Dispute Resolution mechanism or better put, a dispute prevention
mechanism.
Objectives
• To reduce litigation
• Lowering compliance costs to the Assessee.
• Introducing a level of certainty in taxation.
• To promote better Revenue-Taxpayer relations.
• To Provide a more congenial and investor friendly business environment to promote
investment.

Advance Ruling in India

• Relevant law-

Chapter – XIXB , under sections 245N to 245V of the Income Tax Act, inserted via
the Finance Act, 1993, with effect from June 1st, 1993.
• Relevant Rules-

1. Income Tax Rules 44E & 44F – Forms 34C, 34D and 34E
2. Authority for Advance Rulings (Procedure) Rules 1996

3. Authority for Advance Rulings (Salaries and Allowances, Terms and

Conditions of Service of Chairman and Members) Rules, 1994

Constitution of AAR
• It is provided for under section 245-O of the Act.

• It shall consist of:

 1. Chairman – A retired judge of the Supreme Court
2. Member (Revenue) – An officer of IRS qualified, to be member of CBDT

3. Member (Legal) – An officer of Indian Legal Service, qualified to be an

Additional Secretary of GOI

The office of the Authority shall be located in New Delhi.

It is permissible for an applicant under Section 245Q to approach the Advance Ruling
Authority for questions which pertain to the taxability of its employees serving in India.

Definition
The term Advance Ruling is defined under Section 245N of the IT Act, and includes:
 Primarily available to non-residents only, though the Finance Act of 2014 has stated
extending AAR to residents also

 Residents can apply but in relation to the determination of tax liability of the non-
resident

 PSUs can apply as notified category of persons

 The intent was to permit Non-Residents to seek and obtain Advance Rulings on issues
that could arise in determining their Income Tax liability.

Questions on which ruling can be sought

• The advance ruling can be sought on any question of law or fact in relation to a
transaction which has been undertaken, or is proposed to be undertaken, by the non-
resident applicant, in respect of Income Tax liability of the non-resident in India.

• The Authority does not have the jurisdiction to pronounce a ruling on matters relating
to taxes levied under other statutes.

• The Authority cannot give a ruling that is hypothetical in nature.

Who can apply

• The non-resident whose tax liability is being determined

• A resident entering into or proposing to enter into a transaction with a non-resident

• A resident falling in a class notified by the Central Govt. (PSUs) in respect of

questions pending before Income tax Authority or Appellate Tribunal, relating to
computation of income.

While section 245N stipulates that a non-resident can make an application under Chapter
XIX-B, it does not say in specific terms that he should be a non-resident as on the date of the
application. Residence or non-residence for the purposes of the act has to be determined with
reference to previous year.
Meenu Sahi Mamik case
• The Applicant, a resident of Netherlands, wants to establish a manufacturing unit for
formulation of pharmaceuticals in partnership with her husband, in the State of
Himachal Pradesh
 • The applicant sought ruling of the Authority on the question of law under section 80-
IC, with regard to direct business procured by it, and processing charges

Ruling:
• The AAR ruled that since de facto control and management of the firm would be with
the applicant’s husband in India, the firm could not be said to be a non-resident entity

• The application was held to be not maintainable

Other pertinent pronouncements

• Indian company making payment to a foreign company seeking ruling on the question
of TDS to be made: Dell International Services India Pvt. Ltd. 305ITR37

• Non-resident shareholder of an Indian company seeking ruling in respect of

deductions available to the company: Umicore Finance: 318 ITR 78

• Indian company purchasing shares from foreign company can apply for ruling
regarding tax liability of the foreign company on capital gains on such transaction u/s.
245N(b)(ii): Mcleod Russel India Ltd 299ITR 79

Barred Applications

The first proviso to section 245R(2) prescribes that Advance Ruling cannot be sought if the
matter in question is already:

 pending before any income tax authority, the Appellate Tribunal or any court;

 involves determination of fair market value of any property; or

 relates to a transaction which is designed prima facie for avoidance of income-tax.

L.S. Cables Ltd. v. Director of Income tax

• The issue before the authority was the determination of the scope of proviso (i) of
section 245R (2) vis-à-vis pending applications.

• The Revenue argued that the application of the applicant is not maintainable since
similar question of law has been pending before the High Court in case involving the
assessee and another third party, not connected with the transaction before the AAR in
this matter.

• Assessee contended that the transaction giving rise to the said dispute is different and
the contract is with a different party and hence the application is out side the purview
of provisio (i), thus maintainable.
 • It was held that the first clause of the proviso to section 245R(2) ought not to be read
in isolation from other provisions other provisions of the Act.

• It was held that the term ‘Already pending’ would be restricted to applications only in
respect of the same transaction and applicants before the AAR.

• The mere possibility of conflicting decisions is not a good ground to truncate or

restrict the scope of the remedy provided under the Act.

Airport Authority of India case

• Applicant sought advance ruling in respect of its obligation to deduct tax under
section 195 in connection with contracts entered into by it with a US based company
called Raytheon Company.

• However the question of Raytheon Company’s liability to pay income tax in India
was already pending before the income-tax appellate authority.

• The applicant argued that it was Raytheon Company’s liability under the provisions
of the Act, read with DTAA entered into between India and the US that was under
consideration with the appellate authority and not the question of tax deduction at
source specifically.

Held
• While the issues were inter-related they were not identical. The application was
maintainable

Procedure upon receipt of Application

 Section 245R of the Act prescribes the procedure to be followed by the AAR after
receipt of an application.

 Copy of the application is sent to the jurisdictional CIT.

-The CIT may resist/challenge the admission.

 The application is rejected only after giving the applicant an opportunity of being
heard

 If no objection to admission, then the application is admitted without formal hearing

and date is fixed for hearing on merits.

 Applicant as well as the CIT are heard, either in person or through authorized
representative

 The Proceedings before the Authority are not open to public. Accordingly, only the
applicant or the authorized representative can remain present during such
proceedings.
  AAR may at its discretion permit the applicant to submit the additional information to
enable it to pronounce its ruling.

 The Applicant cannot urge or be heard in support of any additional question not set
forth in the application filed before the AAR, except without the leave of the AAR
(Rule 12)

 The AAR shall pronounce its ruling within six months of the receipt of the
application.

Applicability of the AAR Ruling as per section 245-S

The ruling pronounced is binding on:
 The Applicant who had sought it

 In respect of the transaction in respect of which the ruling is sought

 On the Commissioner and the revenue authorities subordinate to him, in respect of the
Applicant and the said transaction

It will also be binding on the commissioner and the income tax authorities to the
commissioner. The ruling will continue to remain in force unless there in a change in law or
in fact on the basis of which the advance ruling was pronounced.
Thus, the pronouncement of AAR is not a judgment in rem but a judgment in personam
For other transaction and other parties the ruling has a persuasive value
The ruling is binding as long as there is no change in law or facts on the basis of which the
advance ruling was rendered
Moreover, the Authority is not itself bound by its previous rulings.
Appeal against Advance Ruling
• No specific provision for appeal against the Ruling in the Act.

• However, the applicant/department can invoke the writ jurisdiction of the High Courts
under Article 226 and 227 and extraordinary jurisdiction of the Supreme Court under
Article 136 of the constitution.

U.A.E Exchange centre LLC v. UOI and Anr.

• Issue before the Delhi High Court was whether a ruling by the AAR can be
challenged by way of writ, under Articles 226 and 227 of the Constitution.

• The Court observed that Section 245-S neither expressly nor implicitly exclude the
Courts jurisdiction under Article 226. it further added that there is no provision that
gives finality to the order/decision of the AAR.

• Court held that the AAR is a tribunal since it is invested with powers similar to a civil
court under the Civil Procedure Code, i.e., it has ‘Trappings of a Court’. Hence the
AAR would qualify as a tribunal within the scope of both Articles 226 and 227.

Indirect Tax (Week 15)

An indirect tax is a tax collected by an intermediary (such as a retail store) from the person
who bears the ultimate economic burden of the tax (such as the customer). An indirect tax is
one that can be shifted by the taxpayer to someone else. An indirect tax may increase the
price of a good so that consumers are actually paying the tax by paying more for the products.
Indirect taxes are those whose burden can be shifted to others so that those who pay these
taxes to the government do not bear the whole burden but pass it on wholly or partly to
others. Indirect taxes are levied on production and sale of commodities and services and
small or a large part of the burden of indirect taxes are passed on to the consumers. Excise
duties on the product of commodities, sales tax, service tax, customs duty, tax on rail or bus
fare are some examples of indirect taxes.
Excise Duty – Union List, Entry 84 (excise on tobacco and other goods manufactured in India
except alcoholic liquors, opium, narcotic drugs) and State List, Entry 51
State Sales Tax or VAT (intra state) – State List, Entry 54 (presently 15.2%)
Central Sales Tax (inter state trade or commerce) – Union List, Entry 92A

Charging Section: Section 3 of Central Excise Act stipulates that excise duty is levied if: -
• There is a good (moveable and marketable)
• Goods must be mentioned in the Central Excise Tariff Act (CETA).
• Goods must have been manufactured or produced in India.
 Excluded Excisable goods: if production or manufacture is in a SEZ then no excise
duty is levied.
 Excise duty is not concerned with ownership / sale it is an event based duty which
revolves around the concept of manufacture / production. Taxable event for excise
duty is manufacture but the duty payable is as applicable on date of removal
(clearance from factory). While the collection is deferred, if the goods are not
excisable at the time of manufacture, excise duty cannot be levied at the stage of
removal of such goods. CCE v Vazir Sultan (1996) 3 SCC 434.

Merits
 Indirect taxes are usually hidden in the prices of goods and services being transacted
and, therefore their presence is not felt so much.
 If the indirect taxes are properly administered, the chances of tax evasion are less.
 Indirect taxes are a powerful tool in moulding the production and investment activities
of the economy i.e. they can guide the economy in its resource allocation.
 Convenience: paid in small amounts and in installments instead of lump sum -
included in the price of the commodity and hence burden is not felt
 Elastic: when imposed on essential goods and services like edible oils, flour etc.
whose demand is inelastic, government can get adequate revenue by increasing the
tax rate
 Less chances of tax evasion: difficult to be evaded as they are included in the price of
the commodity.
 Wide coverage: imposed on a large variety of goods so that the purview is wide
 Equity: can be equitable by differentiating between luxury goods and essential
commodities.

Demerits
 Regressive and unjust: Indirect taxes are generally imposed on the consumption of
the goods. They are unjust in the sense that poor people have to pay as much as rich
people. They negate the principle of ability to pay and therefore their burden is more
on poor people.
  Inflationary impact: Leads to an increase in ultimate price of a commodity. This may
lead to rise in the cost of production as a result of which the workers union demands
more of wages that again increases the price of the commodity and this spiral goes on.
 Uneconomical: administrative cost of collecting indirect taxes is generally high as
they have to be collected from a large number of persons.
 Uncertain: rise in the price of the commodity – effect on demand cannot be predicted
with certainty
 No civic consciousness: disguised - through market prices - indifference towards their
responsibility
 It is claimed and very rightly that these taxes negate the principle of ability- to-pay
and are therefore unjust to the poor. Since one of the objectives is to collect enough
revenue, they spread over to cover the items, which are purchased generally by the
poor. This makes them regressive in effect.
 If indirect taxes are heavily imposed on the luxury items, then this will only help
partially because taxing the luxuries alone will not yield adequate revenue for the
State.
 indirect taxes are added to the sale prices of the taxed goods without touching the
purchasing power in the first place. The result is that in their case inflationary forces
are fed through higher prices, higher costs and wages and again higher prices.
 The term ‘goods’ has not been defined in the Central Excise Act.
 Excise duty is chargeable on different goods at different rates. Therefore, goods are
classified for determination of duty.
Sales Tax
 The sales tax structure had come under severe criticism on account of problems of
double taxation of commodities and multiplicity of taxes, resulting in a cascading tax
burden.
 For instance, in the existing structure, before a commodity is produced, inputs are
first taxed, and then after the commodity is produced with input tax load, output is
taxed again.
VAT
 It is based on the value addition to the goods, and the related VAT liability of the
dealer is calculated by deducting input tax credit from tax collected on sales during
the payment period.
 In reality: broadly there are a number of rates applied – 1% (gold and silver
ornaments, precious and semi-precious stones), 5% (goods of basic necessities),
13.5% to 15% (normal rate on all goods other than those mentioned elsewhere), 20%
(ATF, petroleum products) and no restrictions on liquor, cigarettes and lottery tickets.
Problems with current regimes
Cascading effect ( inevitable and sometimes unforeseen chain of events due to an act
affecting a system.) – limitations of present structure
 Classification disputes and blurring of distinction between goods and services –
works contracts, as an example
 International competitiveness
 Adminstrative issues
GST
 A comprehensive tax on the manufacture, sale and consumption of goods as well as
services, and it is proposed to replace all indirect taxes on goods and services.
 Definition as per amended Article 366: “goods and services tax” means any tax on
supply of goods, or services or both except taxes on the supply of the alcoholic liquor
for human consumption. Services defined to be anything apart from goods.
  Exempt category of goods and services -
 Designed to be a destination based tax, that is, a tax that accrues to the State where
goods / services are consumed.
 Through a tax credit mechanism, this tax is collected on value added on goods and
services at each stage of sale or purchase in the supply chain and thereby reduces
cascading of taxes. The system allows the set-off of GST paid on the procurement of
goods and services against the GST, which is payable on the supply of goods or
services.
Amendment
 Article 246A: States shall have power to impose goods and service tax along with the
Union Government. Union Government shall have exclusive power only where the
supply of goods or services is in inter-state trade.
 Article 279A: constitutes the GST Council and outlines its powers
 Omission of Article 268A and entry 92 C relating to service tax
 Omission of entry tax under Entry 52, State list
 Entry 84, List I amended to provide for duties of excise on crude petroleum, high
speed diesel, motor spirit (petrol), natural gas, aviation turbine fuel and tobacco and
tobacco products. Amendment led to confusion on legality of power to impose Union
excise duties until April 1, 2017 : read into entry 97, List I.
 Entry 54, List II – provides for sales taxes on the aforementioned items from entry
84, List I.
 Some other entries omitted: Entry 55 and 62 (List II) and Entry 92 (List I)
 The Constitution (122nd) Amendment Bill, 2014 was passed by both houses of
Parliament on August 8, 2016. To come into effect from April 1, 2017.
 Article 368 - constitutional amendment would require ratification of one half of the
States if the amendment seeks to make a change in the Lists in the Seventh Schedule
which contains the specific taxing entries. After such ratification, the GST Bill has
received the Presidential assent and has come into force as an Act on September 8,
2016.
 The proposed tax system will take the form of “Dual GST”, which is concurrently
levied by the Central and State Government. This will comprise of :
 Central GST (CGST) – which will be levied by the Centre.
 State GST (SGST) – which will be levied by the State.
 Integrated GST (IGST) – which will be levied by the Central Government on
inter-State supply of goods and services. The IGST will then be distributed by
the Central Government to the Centre and the destination State.
 Proposed rate structure – four tier structure (5, 12, 18, 28) with an additional
sin cess to compensate State governments for losses for the first 5 year period.
GST Council
 The GST Constitutional Amendment Act provides for a GST Council to be
constituted to make recommendations to the Union and the States on matters
including – taxes to be subsumed under GST; goods / services to be subjected to or
exempted from GST; date on which GST should be levied on petroleum, crude, high
speed diesel, petrol , natural gas etc.; principles governing place of supply; threshold
limit of turnover for exemption from GST; rates including floor rates with bands of
GST.
 It shall also lay down a mechanism to adjudicate disputes between Centre and States.
 GST Council to comprise of Union Finance Minister (Chairman of GST Council);
Minister of State (Revenue) and State Finance / Taxation Ministers.
 Vote of Central Government to have a weightage of 1/3rd of the votes; and 2/3rd of
the weightage to the votes of all State Governments taken together. Every decision to
be taken by a majority of at least 3/4th of the weighted votes of members present and
voting.