Chapter INCOME 1 IN INDIAN TI~ COME TAX: SOURCES OF EROSION

Chapter II 1 INCOME 1 IN INDIAN TI~ COME TAX: SOURCES OF EROSION

Chapter II 23 'INCOME' ln INDIAN 11~ COME TAX: SOURCES OF EROSION The scheme of the Indian income tax 1s in principle a global one. So far as residents' are concerned,incomes accruing or arising from all sources 1n a Year (whether actually 1 received or not) are aggregated for purposes of taxation. However tbe base on which the tax is actually levied is far from comprehensive. In fact the base gets systematic ally narrowed 2 down through a four-stage process as outlined below: l. Exclusion: Not all gains embodied 1n the wealthincrement and consumption of a given period of time are eligible for taxation. Income recognized for taxation compr.ises only those gains which are more or less recurrent or capable of recurrence ~nd are 'realized' in the accepted legal sense. Gross income in law is thus equivalent to economic gain minus those segmen.ts of the wealth and consumption flow which get excluded because of judicial and accountancy notions of what is income. These are conveniently called the exclusions. 2. Exemption: From gams recognized 1n law as income l In the case of non-residents only income received and income accruing or arising in India are required to be aggregated (Sec. 5 of the Income-tax Act, 1961}. The status viz. whether resident' or 'non-resident' depends largely on the length of stay of the taxpayer in India during the relevant year (Sec. 6). 2 See v. v. Borkarl :Wc;gme Tax Beform in lqdia (1970, p.5) tor a sl1ghtl3 d fferent presentation of the stages through which computation of taxable income proceeds.

again certain items are lett out tor purposes ot taxation as a matter ot state policy. These are usually categorized as exemptions. Receipts recognized as income minus exemptions constitute what may be called gross taxable income. 3. Deduction tor cost ot earning: In arrivi~ at.!t'.. net taxable income allowance has to be made for all costs ot earning. Base erosion occurs at this stage also because conswmption often partakes ot the character ot an intermediate good and gets mixed. up with costs and there is no foolproof method ot distinguishing 'business' f'rom 'personal' in expenditures. ~ncome 4. Incentive and equity deduction: From net taxable again certain deductions are allowed to provide tax relief in order to promote various objectives or public policy. The residue ot economic gains after allowing for the exclusions, exemptions and deductions as enumerated above constitutes the base on which income tax is levied. Apart tram the exclusions, exemptions and deductions, the scheme or the Indian. income tax offends the spirit or the comprehensive approach in two other respects. First, though incomes from all sources are aggregated in arriving at the tax base assessment in respect ot income from different sources is required to be made under specified heads. The mode of computation is laid down separately tor each head and these are marked by considerable diversity. Disparity in the rules of computation ot income under different heads (especially that of income from employment as compared to business income) has been a

25 source of' inequity and in essence constitutes a violation of the comprehensive principle. Secondly, the basic unit for personal taxation is the individual and not the family. What is worse, a 3 number of other entities - as many as six - are recognized as taxable units. Multiplicity of units, especially the recognition of' the Hindu Undivided Family (HUF) as a distinct unit of 4 taxation has facilitated income-splitting and tended to trustrate the progressivity of the personal income tax. Lack of proper arrangement to integrate the surpluses of' intermediaries like companies and co-operatives with the income of their members has also led to base erosion and undermined the progressivity of tbe tax. The legislature has of course attempted to neutralize the influence of judicial pronouncements and accountancy practices on the amplitude of the base by introducing special provisions in the law. Thus several categories of receipt3 or gains which the courts are reluctant to treat as income have been brought under 5 taxation by virtue of special provisions in the statute. Deductions for costs are also regulated through special provisions. 3 Vide Sec. 2(31) of the IncolJ!.!:tax Act, 1961. 4 Until very recently income of HUFs. was taxed quite independently of that of their mej11bers. Since 1973 HUFs of which at least one member has taxable income are. assessed to tax at a higher rate than others. 5 Sec. 2{24) of' the Act which declares a number of receipt~ or gai.w; to be included in income, is intended to serve precisely this purpose.

26 Similarly there are provisions in the law designed to counter avoidance through income or wealth splitting. Even so, the gap between the comprehensive base as contemplated in the net accretion concept. applied on a household or family basis and the actual tax base remains. The question is, how significant is this gap for the: equity and yield of the tax? And, granting that the comprehensive concept cannot be implemented in its pure form, are all the modifications that are actually made called tor or justified? For evaluating the tax system from these. a.ogles it is necessary first to identify the basic' factors underlying the exclusions, exemptions and deductions and see how they I influence the shape.:, ot the baseh In this chapter we attempt to identity these sources and. assess the significance of their influence. Egooomic lncgme and StatutQrY Ingpmc: _. aource gt diyergeoce -1. Jndigiil ngtigns gt incgme: The tests of recurrence and rea11zatign we have noted that the divergence between the concept ot economic income and the base on which income tax is levied occurs at the very first stage of income computation because ot the tact that certain gains which add to economic po-r, alld so are income in the net-wealth accretion sense, are not recognized as income for purposes of taxation. These exclusions have come about not through an..v stipulation in the law but as a result or notions reflected in judicial rulings and accounting practices.

27_ In the absence of any indication in the statute as to what precisely is income judicial.notions about the concept of income have come to pla3 an important role in determining its content. In a celeberated Privy Council rulibg bearing on the concept of income as contemplated in Indian income tax it was said that "Income in this Act connotes a periodical monetary return 'coming in' with some sort of regularity, or expected 6 regularity, from definite sources". This formulation was of 7 colirse qualified in subsequent judgements. But the basic criteria implied in the earlier formulation were not given up. Fundament_ally, 'i~come' as contemplated by the ;courts is a gain.. realized' in money or money's worth, from some source, and. - occurring or capable of occurring periodically... The tests of income, so evolved,atfected the coverage of the base in man.y W8 S The test or realization itself has been a source of considerable erosion. First, by requiring that a.. gain must be realized in the accepted legal sense before it can be treated as income, this test barred the taxation of a major. - ingredient of economic power ~~ ot property-owners, viz. unrealized value apprecia:t1on of wealth. Secondly, all imputed incomes were also excluded as they did not come in through the 6 CIT v. Shaw Wallace & Co. 6 I.T.C. 178. 7 For instance, in a ease reported in 1943 it was said, "Income is not necessarily the recurrent return from a definite source though-it 1 s generally of that character 11 (Kamakshya Narain Singh v. CIT, 1943 ITR 513).

28 market. In-kind benefits or the 'perks' of office were also left out as they failed to satisfy the money-or-money's-worth criterion. The periodicity test in its turn ruled out the inclusion of windfalls, and non-recurring gains whether derived from transactions in capital assets or otherwise. All such gains were considered either 'eaaaal' or capital' in nature, not income. Base erosion from the operation of the realization and periodicity tests was aggravated by avoidance facilitated by their application especially to corporate source gains. Since mere appreciation in the value of -wealth is not income, accumulation of profits in companies invited no tax even if that led to appreciable increase in the value of equity shares. Profit realized on the sale of such shares was regarded as capital'. 8 Even allocation out of past profits whether as bonus shares or 9 in some other form came to be treated as capital. Attempts have been made to neutralize these effects through legislative action. Corporate profits are taxed separately through an absolute corporation tax. In the case of closely held companies,failure to distribute profits is subjected 10 to a penal tax. Dividend has been so defined as to take care 8 I.R. v. Blott 8 T.C. 101. 9 10 I~R~ v. Burrell 9 T.C. 27. distribution of profits of not income in the hands of Vide Sec. l04.0f the Act. In this case it was held that a. compan_v on liquidation is shareholders.

29 of distribution of past profits. Distribution of accumulated proti t s is treated as di viden.d, when accompanied w1 th release ll of assets. Even an_y advance or loan taken from a close com- Pan by persons in control (as specified in the statute) is now liable to tax as dividend to the extent the compao-,y J>Ossesses 12 accumulated profit : Despite all these measures the tax advan- J tage of retaining profits in companies and issuing bonus shares remains. Capital gains as well as casual receipts (bu.t not gifts and bequests) are also included in income now and taxed, though somewhat leniently. Most of these measures however have been taken piecemeal in an ad hoc manner and only limited success has been achieved in removing the infirmities resulting from court rulings. Taxation of capital gains has failed to produce the expected results. The possible reasons are gone into in Chapter III. Unrealized capital gains, the well-known avenue for the enrichment of the wealth~, untouched by income taxation. remain by and large Arguments can of course be advanced in support of the tests applied by'courts in the matter of income recognition. For instance, it may be argued that the periodicity and related tests serve as a convenient operational device to distinguish income, which is a flow, from capital, a stock. Similarly, the realization test might be de~ended on the ground that it is necessary for an objective measurement of income and that ll Sec. 2(22) (a) to 2(22) (d). 12 Sec. 2(22) (e).

30 evaluation of unrealized gains introduces an intolerable degree of subjectivity in income measurement. best left ou~. Hence such gains are However, the tact that these tests are responsible for the exclusion of certain substantial sources of wealth accretion like capital gains and for creating opportunities for avoidance necessitating elaborate legislative measures weakens these arguments considerably. Also, inconsistent application of 13 the tests in practice raises doubt even about their operational merit. In view of their profound influence on the coverage of the base, the rationale of these tests and the effects of various legislative measures undertaken to limit the area of their operation call for close examination. next two chapters. This is undertaken in the Problems of valuation are invoked to justify the exclu sion of imputed incomes too. Distortions and inequities caused by this exclusion however give rise to misgivi~ s about the wisdom ot not including such income in the tax base. The only item of imputed income which is taxed in India is the notional rent from owner-occupied houses. There is however a ceiling on the income which can be imputed tor home-owning - it cannot exceed 10 per cent of the aggregate of other incomes of tbe tax Pa.Y&r (vide Sec. 23) - which takes away much of the edge of the provision. No other variety of imputed income is assessable to 13 As implied in the provision for depreciation allowances and the rule tor stook valuation which permits losses to be recognized before realization, but not gains.

:i1 tax. The e.tfects and the rationale of this exclusion are dis- - cussed in Chapter IV. even weaker. The rationale tor the exclusion of in-kind bene!i ts seems The money or money s worth test which is responsible tor this exclusion, however appealing in logic, is unacceptable as a principle of taxation because o! the avoidance opportunities it opens up. Legislation!or the purpose of securing the inclusion of in-kind receipts in the base has also been fairly extensive. It cannot be said however that the deficiencies caused by this rule have been tully cured. At first the law gave 14 in and faithfully followed the judicial line. It was not until 1923 that legislation was undertaken to tax the value or renttree residence. Originally the provision was applicable only to salaried employees. were of course exempted from the burden. High officials like the Governor-General Value of rent-free accommodation provided by a company to its directors also remained excluded. other kind was taxed. Even in the case of salary-earners perquisite of no It was only in 1955 that the scope ot taxable income was expanded, on the recommendations of the TEC, to cover a few other categories of benefits. At present, perquisites of most varieties are taxable when received by a salaried employee from Ris employer or by a compan.y director or an.,y one having substantial interest in a compa.d1 or an.y one of their 14 Thus the!it Act of 1918 contained a provision Csec. 3(2)(1x)_7.wh1ch said that a perquisite or benefit which was neither money nor reasonably capable or being converted into money wa~ not liable to tax.

relatives of specified category from the compb.d Receipt of in-kind benefits' in business or profession was made taxable in 15 1964. In the absence of a general provision to tax all non-cash gains,. however, significant gaps remained. Thus even now none ot the perquisites allowed to MPs and MLAs can be treated as part of their income since these facilities are not derived by them in the capacity ot anyone's employee. Although perquisites are taxable when received by an employee from his employer, in the case of employees of government and semi-government organizations, the mode of valuation laid down for coneessionally charged accommodation is so liberal that they may be regarded as virtually 16 exempt. For employees of the private sector the rules are not 15 Sec. 28(iv). 16 Under Rule a of the Income-tax Rules 1962 (hereafter the Ru~es) officers of government. do not have to pay ad1 tax on the value of the accommodation provided to them if they p8j1 the rent fixed by Government which invariably happens to be a small fraction of the prevailing market rent for similar accommodation. Employees of semigovernment institutions and public undertakings also do not have to pay any tax on the perquisite Val'9e of accommodation provided to them if only they pay 10~ of their salary as rent to their employer. Thus, when a public undertaking provides to an officer drawing Rs.2,500 per mont~ an accommodation hired on a rent of Rs.l,OQO and charges Rs.250 as rent, the officer is not required to include anything by We of perquisite value of the accommodation in his salary although clearly he derives a benefit of Rs.760 p.m. from this arrangement which means a tax _saving of nearly Rs.400 per month. Recently, the Rules have been amended to provide that in the case of employees or public sector undertakings, if (Contd. on next page)

so liberal but even in their ease a portion of the value of the accommodation (upto 10 per cent of the salary and, if the accgmmodatlon is in one of the big cities, upto 20 per cent) is deducted before arriving at their taxable value. Besides, under administrative instructions value of certain benefits like ordinary medical facilities provided by the employer is left out of 17 taxable income. Thus even now 'the base of the Indian. tax bears soars of the money or money 1 s worth doctrine. In terms ot loss to the exchequer the cost of these concessions may not be very sigllitican.t (perhaps not more than. Rs.5-6 crores a year). But the cost in terms ot equity is not inconsiderable. Besides, virtual exclusi.on of the perquisite value of accommodation provided by Government to its employees,from the tax base gave rise the accommodation is furnish~(! free of charge! 15 per cent of the. original eost ot ' furniture includ ng refrigerator~ TV sets, and airconditioners is addedjo the income L vide Income Tax (Amendment) Rules 19?4 This rule however does ~ot apply to.government servants. The inequity of inadequate taxation of the perquisite value of accommodation. provide d to Government servants is aggravated by the tact that. the rent charged by the G_overnment often forms a smaller percent~e of one's income as one goes up the income sc.ale L vide C&AG s Report for the year 1972-73, Union Govt. (Civil). PP 11o-111)J. ff"ts Interesting to note that though the tradition of preferential tax treatm~nt ~t Government officers in India originated during the British days, in Britain officers of the Crown..who had to live in houses belonging to the Crown vere required to pay income tax on the perquisite value of such residence except where the accommodation happened to be in the royal palaces. Th1s provoked a canment from. Niyogi (1929, P l88) that it was a 'self-contradiction' on the ~t ot th~ ~r_itish authorities. (J. P. N.iyog1, B'i211\t1on of!qd ian Inc:ome Tax;, 1929) 17 Circular No. 33 (LXXVI-5) of 1955 of CBR, dated August 1, 1955. '..

to demand for exemption of house rent allowance received by those not provided with official accommodation and this in turn led to demand for deduction or house rent in the case of all taxpayers who do not own. aqy property. Thus these concessions have tended to widen the area of exclusion more than is justifiable.. we will revert to the issues raised by this exclusion in a later chapter (Ch. VIII). Insistence on receipt in money or money s worth curtailed the coverage of the tax base in several other ways. Gains arising from certain transactions, for instance, were not allowed to be recognized when the consideration was received in the form or assets other than money. Thus in.a case where a company sold its depreciated assets and the consideration was received not tn cash but in preference shares of' another company, the balancing charge (that is, the provision that seeks to recapture the depreciation allowed in the past and bring it back 18 into ~ncome to the extent 1 t is recovered by the owner) could not be brought into operation, because the money consideration 19 was thought to be an essential part or sale. Hence the law had to be ch~ed to make it clear that 'sale' includes 20 exchange'. 18 Under proviso to See. 10(2) (vii} of lit A.et 1922, coresponding to See. 41(2) of the 1961 Act. 19 CIT v. Motor, & General Stores Ltd. (1967) 66 ITR 692. 20 See. 32(1).

35 Application or the realization principle and rejection or the,.,ealth-accretion approach also stood in the way of recognizing income even when a clear gain had accrued in a few other situations, e.g. When a trading liability for which deduction was allowed in the past ceased because of remission, or any other reason, and a bad debt written orr in the accounts earlier 21 was paid off by the debtor. To bring such gains within the meaning or income' a suitable provision had to be made eaeh,time in the law and items sought to be so treated enumerated in the definition of income which had been introduced in the Income- 22 tax Act in 1939 tor this purpose. It is difficult to sa how. tar the provisions made in this W83 have succeeded in preventing the kind of base erosion whieh occurred in the past because of the rigid application of the money -or-money' s-worth rule. we will have occasion to refer to it While discussing the taxation of' capital gainsin Ch. III. Another result or the realization test was that surplus of mutual insurance societies and cooperatives could not be treated as income and these had to be included specifically in the definition of income to get over the judicial objections to 23 their being treated as taxable gain. 21 22 23 Kaog 9 a & 9 Palkhivala,.. Thl 14w and Practice or Incomg Tax. (1969) pp.8 - o.. Sec. 2(24) of the present Act. Styles v. New York Life Ins. Co. 2 TC 460 (H.L.).

36 Wid ning of the meanipg of 1 QQSts' Judicial opinion has influenced the shape of the tax base from another direction. In arriving at net income from the gross receipts, deduction has to be allowed for costs. In periodic income determination this gives rise to the problem of allocation when the expenditure incurred during a particular period does not expire during that period and wnen they relate to several activities carried on jointly. There is also the problem of disting1lishing between costs from consumption as in real life the tw often get inextricably mixed up. Corresponding to the tests of an income receipt, the basic rule for resolving these problems is that a cost must be realized' if it is to qualify tor deduction and that it must be 'current and not capital' in nature. For sifting costs from consumption the law has stipulated that the expenditure must be incurred for purposes of business and should 24 not be personal in nature. There was at first an attempt to restrict the area of deductible costs only to those incurred unavoidably for the earning of income. But judicial authorities were disinclined to put such a restrictive construction on the business expense deduction rule. As a result,the line separating personal from business has been increasingly blurred. To prevent the deduction of personal expenses as 1 business' the legislature has sought to impose limits on certain categories of expenditure (like remuneration and other benefits paid or provided by companies 24 See Sec. 37 of the Act.

to directors and expenditure on entertainment). But the courts approach to the mode of income determination bas tended to undermine the efficacy of these limits. How this has come about and what are its consequences on the tax base are discussed in Chapters V and VI. ~reatment of Losses over and above the allowances for costs,deduction is allowed also on account of losses. Since 1939 the law also permits carry forward and set-off of losses, subject to certain conditions. Sinee losses essentially represent a diminution of capitalj it is illogical to permit losses to be offset against ordinary income unless all accretions to capital including gifts and bequests are subjected to tax in the same way. Some justification can be found for permitting deduction for losses in the argument that loss offset serves as an averagi.og device needed to mitigate the inequity caused by progressive taxation of fluctuating incomes. The option which taxation based on the realization principle allows to taxpayers t_o. realize losses and postpone realization of gains as and when it suits them, holi&ver, calls for caution in granting allowance tor losses in income computation. The law, in India, while permitting offset and carry forward of losses, provides certain safeguards against abuse. But the liberal interpretation put by the courts on these provisions seems to have undermined these safeguards. The effect has been to moderate the incidence of tax to an extent that goes

beyond averaging. 'ln fact the loss offset provisions have acquired notoriety as an excellent avenue for avoidance. has come about is gone into in Chapter VII. 2. Measures W. t;he P!E.Uiic o.f ecgoomic~~al obdectiyes How this Next to judicial and accountancy notions of income and cost, the most important factor that serves to reduce the coverage of the income tax base are the exemptions and deductions explicitly provided for in the statute. While some of the exclusions could be regarded as the inadvertent products of the judiciary's attempt to derive the meaning of the word 'income from its common usage, exemptions and deductions reflect the legislature's attempt to use the income tax system as an instrument of social and economic policy. Exemptions are specifi~d both according to source as well as the character of the recipient (e.g. in the case of charitable institutions) and, logically occur at a stage prior to the derivation of net taxable income, that is, before the cost deductions come into the picture. Deductions are related to source as well as certain uses of income. Some of the incentives are provided by widening the area of costs e.g. by current expensing of certain capital expenditures like scientific research or by permitting wighted deduction for some (e.g. export market development allowance). Capital allowances like developm.en t rebate fall within the latter category. At first, exemptions and deductions were few in number. The Act of 1886 which furnished the basis for income taxation 1D.

39 India on a permanent footing contained only a handful of them. At present the deductions occupy one whole chapter of tbe Act (Chapter VI A) nearly thirty clauses r~i-s while one lengthy Section (Sec. 10) running into taken up in enumerating the exemptions. Besides; such exemptions and deductions occur at several other 25 places in the Income-tax Act. Activitie-s or objectives sought to be achieved through the ~ncentive -provisions in income tax are wide ranging. Of the various exemptions provided expressly in the law, the one which has had a profound impact on the scope of income tax in India is that of agricultural income. Other notable items of exclusion/ 26 deduction are, remuneration of foreign technicians, house rent allowance of salaried employees, inte_rest on certain categories of deposits, income from livestock breeding, poultry and dairy Z7 farming, contributions to life insurance, provident fund and other specified saving media, income from certain foreign sources like teaching abroad,. income of new industrial undertakings, allowances for investment in plant and machinery, income of charitable and religious organizations (other than private 25. Some of the exemptions are provided through provisions in other Acts, e.g. salary of employees of U.N. agencies (vide U.N. Immunities and Privileges Act, 1955).. - Subject to certain limits and conditions as prescribed in the Act. This exemption has since been withdrawn under the Finance Act 197 5. Deduction is hot."ever allowed from such income tor Rs.lo,ooo or one-third of the income whichever is higher.

religious trusts) and income or organizations for promoting sports and supervising the professions of law, medicine, accoun- 28 tancy and. the like. Whatever be their underlying objectives all these provisions have the effect of reducing coverage of the tax base. Whether the costs entailed by the deductions and exemptions are justified by the gain is examined with reference to some of the major items in.ch_. VIii~, 3. Multiplicity of tax; units Though patterned on the U.K. model the Indian inco1:11e tax did not follow the U.K. practice in one important respect. While in U.K. personal taxation was based until very recently on the marital unit (taking the husband and wife as one), in India the individual has been the basic unit. The Act of 1886 recogl11zed, besides the individual, three other entities viz., the comp~, the firm and the Hindu Undivided Family (HUF). Income, once assessed in the hands of these entities,was not taxable again in 29 the hands of the individual. Had the tax been proportional, this arrangement would not make much difference to its incidence. Income tax in India has however been marked by a degree of progression since long. The possibility of base erosion from the multiplicity of units was accentuated with the introduction of the super-tax in 1917. Much effort and investment have gone into 28 Vide Sections 10, 11, 12 and 13 and Chapter VI A of the Act. Sec. S of Act II of 1886.

securing the maximum advantage in taxation through income splitting. Despite extensive anti-avoidance legislation advantages of income splitting remain. The main thrust of the anti-avoidance measures taken so far has been l) to neutralize the advantage of intra-famil.y transfers of assets/or income and 2) to reduce the advantage of the corporate cover tor persons in upper brackets of income. Provision for aggregating the income from assets transferred to one' s wife and minor children in the total income of the transferer was 30 first introduced in 1937. The use ot the company cover to defeat progression in personal income tax was sought to be countered first by imposing the supertax only on the undistribu- 31 ted profits of companies. Since 1930, a penal supertax for excessive retention is levied only in the case or 'closely held' 32 companies. Recognition of the 'firm too as a separate taxable entity paved the way for avoidance in numerous ways. To prevent this, a system or registration' was introduced whereby income of... registered firms was made taxable only in the hands or the partners. Income of unregistered firms was taxed at rates appropriate tor individuals. But there was no let up in the effort on the part or the taxpayers to locate the loopholes. The institution 30 Sec. i6(3) of the 1922 Act introduced through the IIT (Amendment) Act, 1937. 31 This system was, however, discontinued in 1920. 32 These are companies other than those in which the public are substantially interested' Definition of the ltiter category is given in Sec. 2(18).

42 of the HUF and its recognition as a tax entity also facilitated avoidance through income splitting. The legislature has tried to counter all this by introducing more and mor~ 33 in the law and some more are in the offing. stringent provisions Deficiencies of these measures are taken up for consideration in Chapter IX. structure of company taxation in-so-far as it bears on the question of' base erosion is gone into in Ch. X. intermediaries is also discussed in Chapter X. Treatment of' other The schedular system of computing income adds to base erosion by introducing inequities and providing opportunities for avoidance. Although the scheme of taxation is 'unitary' in character, the Act enjoins that taxable income must be computed under six spec itied he ads. These are : 1 B al aries, Interest on securities', 'Income from house property, 'Profits and gains. of' business or profession, 'Capital gains' and 'Income from other sources'. To be taxable, a receipt must come under one of' 1t.t listed heads. The system ot computing income under different heads originated in India trom the practice of tax1og income of' different sources at different rates. Aggregation of income from different soqrces to arrive at 'total income on which the tax is levied was f'irst.provided under the 4ct of 1918 and it has come to stay since then. But the system or computing income from 34 different sources under their respective heads continues. It 33 Vide Taxation Laws (Amendment) Bill 1973.S1nce enacted. 34 It is interesting to note that in England when it was.first introduced by.pitt in 1799, income tax was levied (Contd. on next page) The

has been emphasized in several court rulings that these heads 35 are mutually exclusive, being 'specific' and not 'general'. Such rigid differentiation of income according to source often gives rise to inequity because of the fact that the mode of' computation of' income is not uniform :for all heads. Thus while income f'rom business and prof'e ssion is taxed on 1 cash' or actual' basis according to the system of accounting followed by the taxpayer, income from salaries' is assessed on accrual' basis. Income from house property is assessed on a presumptive 36 or notional basis. More serious are the equity effects of' the disparity in the cost deduction rule prescribed-for ditterent income heads. While aeything laid out in the course of' business is deductible in the case of' business income, tor employment income the rule is much more stringent. So substantial is the advantage of' getting one 1 s income assessed under the head 'business' that cases are fought right up to the Supreme Court, as a charge upon an individual in respect of his aggregate income from all sources (Simon s Taxes, A. 1. 404) But to meet the objections that such assessment violated privacy the general tax on income was given up. Addington s income tax of 1803 wb.ich set the pattern f'or the British income tax right up to the present d$y followed the schedular system. 35 United Commercial Bank Ltd., v. CIT (1957) 32 ITR 688 (S.C.)..... 36 This has resulted in the position that f'or notional purposes only the rent permissible under the law can be taken into account and not the actual rent even when the latter is considerably higher. The lbw' Ha.s --now'beteu changed through the Taxation Laws (Amendment) Jtct: 197S.

the costs notwithstanding, simply to resist assessment under any :n other head. Apart from creating inequity, a rigid application of the schedular method of income taxation sometimes leads to anomalous results such as the failure of the tax base to include a given receipt even When the receipt bears all the characteristics of 38 i'ncome. The law has since been changed to meet such situations but sharp differences in the cost deduction criterion as between different income heads continue to be a source of inequity as between taxpayers with similar incomes. can be removed is considered inch. V. guaati Signif.cance ot base erosion - tatiye aspects How these disparities That the progressive edge of the income tax is blunted by &D thing that reduces the ceverage of the base is obvious enough. It is however not possible to assess the effect of base erosion in precise quantitative terms such as by comparing the nominal and effective rates of tax in the different income 37 S.ee,. for instance, Karnani Properties Ltd. v. CIT (1971) 82 ITB 547 (S.C.) and Sultan Brothers v. CIT 51 ITR 533 (1964) (S.C.).. 38 An instance of the absurd results which this system ' 9ould produce is provided by the case of a lawyer who after being elevated to the Bench continued to receive. tees for professional service rendered by him prior to his elevation. These receipts could not be brought under taxation simply because they could not be brought under any of the heads after he had become a High Court judge. Even the r~siduary head, other sources' was of no help l~_).~s instance. i:n.a. Mody, v. Narayan Row <('1966) 67 IlrR

brackets with and without the exclusions, deductions and exemptions, for the simple reason that data about personal income in the net accretion sense is not available. But it can l:)e demonstrated with the help of some hypothetical examples, which may be regarded as typical, that the tax system is in reality much less progressive than it appears from the marginal rates of income and wealth taxes if the tax burden is measured not against the taxpayers statutory.income but against the 1r economic income. And this turns out to be the position if the impact of only a few of. the eroding factors is taken into account. Take for example two individuals representing two house holds of the same size of whom one - let us call A - derives income entirely from salary and happens to be in the lowest bracket of taxable income, while the other, say B, is in business and has investments in company shares as well as bouse property. On the assumption that real property appreciates at the rate of 39 5 per cent per annum., and that business aff~rds scope for camouflaging personal consumption as business expense, the total tax burden of the two individuals works out as below: 1. Source of income Individual A Employment Individual B Business (propr ietory or par tnersbip) ; investment 1n company shares, and bouse property (selfoccupied) 39 Reasons behind this assumption are indica ted in the Appendix to this Chapter.

2. Net Weal tb Provident Fund accumulation and insurance policy:- Rs.lo,ooo 3. Money Income: Salary: (per annum) including bouse rent allowance of Rs.l, 200: 4. Accrued Income {not realized or not received) : 5. Consum_ptien Benefits not included in line 3: Rs.l2,000 Employer's contri but ign to provident fund, superannuation fund etc. : Rs. 1,200 subsidised lunch, medical benefit, travel concession etc. Rs. 1,000 Investment in business: Shares: Deposit in banks~ House property: Business: Capital gain (long- term) from sale of shares: Interest from P.s 2, 00, 000 Rs. 50,000 Rs. 20,000 Rs.3,00,000 Rs.5,7o,ooo Rs. 30,000 Rs. 10,000 bank: Rs. 1,000 Dividend on shares in Indian Companies: R.c;. Rs. Unrealized capital gain from ap preelation of asset values (assumed at 5 per cent on all assets other than bank de- - posits): Rs. i) Consumption financed through business (transport, telephone, entertainment, travelling abroad, use of expensive articles, etc.) Rs. 5,000 ~;ooo 27,500 25,000 ii) Imputed consumption {notional rent of selfoccupied bouse): Rs. 24,000-49,oo6

6. Total of lines a, 4 and 5 Bs.l4, 200 Rs. ~, 22, 500 40 Computation ot income tax and wealth tax (as tor 1975-76 assessment year) is set out belo1r. Individual A: Salary Less (i) House rent allowance Bs.1,200, being 10 per cent of salary, as permissible under Section 10( 13A) of the Act read with rule 2A of the Income-tax Rulesl962 (ii) Standard deduction under Section 16(1) ot the Act 7. Saving in forms qualifying for deduction in computing taxable income (insurance premia, provident fund contribution etc.) Bs. 1,100 It. 12,000 40 8. Tax Base Hs. 7,500 Bs. 33,550 Deduct:- For contribution to provident fund etc. under Section SOC Income tax on this: IG. 1,200 Bs. 2,200 Tax Base: Bs. 198 Bs. 12,000 Bs. 3,400 Bs. 8,600.as. 1,100 Bs. 7, 500 Ipdiyidua1 B: i) Business ii) Interest on bank deposits and dividend, Bs.e,ooo, of which Bs.3,ooo exempt under Section SOL iii) Long-term capital gain from sale of shares: Bs.1o,ooo Bs. ao,ooo Bs. a,ooo (Contd. on next page)

9. Income Tax R;. 198 10. Disposable income: (line 3 minus line 9) 11. Saving in other forms (i.e. other than those covered in line 7) 41 Bs.11,802 Nil R;. 8,255 R;. 37,745 Bs. 4,ooo Less (Bs.5,000+5$ of Bs.5,000) deductible under Section SOT of the Act Bs. 7,750 R;. 2,250 Bs. 35,250 i v) Imputed income from dwelli~ house restricted to 10 per cent of other income as given in line a, under proviso to Section 23(2) of the Act Less: Deduction tor saving in specified forms under Section SOC of the Act wbi. oh comes to ~.6,300 (Bs.2,000+ 50% of a,ooo+~ ot 7,ooo): Income Tax on this Bs. 8, 255 Wealth Tax liability of B is worked out thus: Total value of assets Less: 1) residential house under Section S(l)(iv) of the Wealth Tax Act 1981: ii) Financial assets (investment in business etc.) under Section 5( 1) ( xx111) and 5( l) of the Wealth-tax Act Tax on this: Bs. 1, 00, 000 Bs.l, 50,000. Bs. 3,200 Bs. 4,600 R;. 39,850 Bs. 6,300 Bs. 33,550 Rs.5,7o,ooo Bs.2,5Q 1 000 Bs.3,2o,ooo 41 Saving (i.e. total of lines 7 and 11) is estimated on the basis (Contd. on next page)

49 12. Consumption expenditure including purchase of durables ~Line 10 minus (line 7+line 1ll7 Rs.1o, 702 R!;.21, 745 13. Indirect Tax on oonsnmption expend! ture (line 12) 42 IS. 1, 723 ( 16.1 p.c. of ~. 4,392 ( 20. 2 p. c. of line 12) line 12) 14. Wealth tax Nil Bs. 3,200 15. Total Tax Liability: (line 9+-line 13+ line 14) Rs. 1,921 Rs.15,847 16. Total tax burden (line 15 as percentage of line 6) 13.5 12.93 --------------------------~------------------------------------------ The above examples suggest that if the tax burden is measured against economic income which alone is the true measure of ability to pay the incidence of taxes is probably 43 barely proportional, if not regressive. It the assumptions on which the examples have been worked out look unrealistic it ma_y be pointed out that they 42 43 of the saving ratio for different income groups in the urban areas as indicated by the NCAER survey of 1971, after making some ro;ggh allowance for price rise in the last few years L NCAER 1g'72J. For individual A, saving ratio is assumed to be around 10 per cent of the disposable income and for B, a little over 40 per cent. Incidence of indirect taxes assumed here is based on the findings of B. Dey, ("Impact of Indirect Taxes on Distribution of Consumer Expenditure", EPW, Sep. 7, J974). Measures of incidence derived by Musgrave & Musgrave (1973) and also others show that in USA the overall incidence of the taxes is in most part ~roportional. LR. A. Musgrave and P B. lius grave, Pub ic Finance in Theory and Pras;t!iice (1973.l/.

do not take account of all the avoidance opportunities that are currently available (e.g. income splitting). In fact the incidence might turn out to be much more regressive, than is indicated by these examples if all such opportunities are considered. Whether this is.so in the totality depends on the extent to which the facilities of avoidance and the tax shelters are availed of by taxpayers in the upper income brackets. This information again is not available. There is, however, reason to think that such facilities are open more to the relatively better-off among the taxpayer s, particularly those who happen to o~ property and are fully exploited by those who are in a position to do so. Wanchoo Committee's sample study of the use of the HUF as a tax avoidance device revealed that 44 income splitting throllgh this _device is widely resorted to. There is also evidence to show that the corporate cover is put to good use by property owners as a device for accumulating wealth witho.ut incurring any liability to pay income tax. The. gap between the. nominal -and the real worth of the equity of some of the holding companies bears this out. In some cases, shares with a nominal value of Rs.lo turn out to be worth nearly IS.!s600 each' if valued on the basis of' the company s net worth. ------ 44 DTEC,, Final. Repor t, para 3.27. 45 These figures are derived from the balance sheet of Indore Exporting & Importing Co. Ltd. which is a holding company in the con~rol of a leading bllsiness bouse (f.n con td ) 50

51 This gap is a measure of the scope of avoidance :facilitated by the exclusion of unrealized gains. For what accounts for the gap is obviously the retention of profits by companies, m&qy of whom, though liable to pay tax on their profits, enjoy tax benefits in various forms. These examples, though they are telling enough, do not help assess the significance of base erosion in the aggregate in India. The net worth of the compaey as per balance sheet as on 31st March 19'73 was Rs.50.80 lakhs. If the investments of the_ company - mostly compacy shares - are, taken at their net worth or market value the net worth of the holding company (i.e. Indore Exporting and Importing) works out to Rs.798.49 lakhs as shown below: Net worth as per balance sheet as at 31.3.1973. Add: Appreciation in the value of' assets: ( i) quoted investments: market value 101.59 Less book value 36.35 65.24 (Rs. lakhs) 50.80 65.24 (ii) Unquoted investments (shares in subsidiaries) a) Gwalior Commercial Co. Ltd. (a wholly owned subsidiary) Net worth 443.47 (taking the value of quoted shares held by the subsidiary compaey at their m~rket ~alue) 1 Less cost: - 1.99 441.48 441.48 b) Industrial Trust Ltd.: Net worth Less value at cost 241.48 50 240.97 240.97 798.49 (Contd, on next page)

in the absence of any information about the distribution of income taken in the sense of accretion to economic power (that is, command over goods and services) and also of the distribution of the tax benefits embodied in the exclusions, exemptions and deductions among taxpayers in the different income ranges. One has therefore to rely on indirect methods. Thus some idea of consequence of the exclusion of unrealized capital gains can be derived by looking at the possible dimensions of the gains, and then comparing the same with what is actually subjected to tax. Estimates made for USA show that the bulk of the gains resulting from appreciation of share values - according to some, as much as 80 to 90 per cent - remain untaxed because 46 they are unrealized. In an appendix to this chapter we attempt an estimate of unrealized gains for India. Even making allowance for a large margin Of error it would appear that the value of annual wealth accretion to property owning income taxpayers in Ind:La. :in the form of unrealized capital gain would be of the order of ~.1,000 erores. The amount of capital gain brought under taxation 1n the -dtvenyears 1960-61 to On a.)net worth of' Bs.798.49 lakhs, value of 50,000 shares of Rs.10 each, which happens to be the size of' the paid up equity capital of the company, comes to Bs.l,597 per share. 46 M. David (Alternatiye Approaches to Capital Gains ~axetion,-1968), pp. 60-61; For another estimate and a discussion of conceptual problems involved in measuring capital gains, see Kul Bhatia, "Accrued Capital Gains, Personal Income and Savings in the United States, 1948-1964", gyiew of_lne,o.me and Wealth, Dec. Hr?O.

53 1971-72 averaged about Rs.17 crores (Table 2.1). The tax on capital gains has been yielding only about Rs. 5 crores. The maximum amount realized through taxes on capital (that is, wealth tax, estate duty and gift tax) during this period did. 47 not exceed Rs.75 crores in a.oy year. For an idea of the quantitative signit'icance of the exclusion of capital gains it is necessary to have inf'ormation about the distribution of such gains among the taxpa_yers. the absence of such data one may use the available income tax data and proceed on the basis of some assumptions reg ardiog the capital-income ratio and the rate of _appreciation of capital values. Computations based on 1969-70 data show that the incidence of income tax ceases to be progressive in the upper ranges if unrealized gains are regarded as part of income (Table 2.2). It will be seen from the table (by comparing col. 12 with col. 7) that when accrued capital gains (estimated at 5 per cent per annum) are taken into account the eff'ecti ve rates of income tax in the top tour brackets are reduced to 36.95, 35.54, 35.26 and 41~ per cent from 59.11, 56.85, 56.42 48 and 65.75 per cent, respectively, that is, by almost one-third. In 47 This is based on the figures g-iven in the All India Income-tax Statistics and All India Estate Duty, Gift tax and Wealth tax Statistics published by Directorate of' Inspection {Research Statistics and Publication), Income Tax Department, Government of India. 48 For a discussion of the assumptions underlying this table see Appengix: t6., tfit~.chapter.

PBII 1.1 m crmea). -----.--------.---------------- --.- -1'.... I Caplta1Ja2A.I ta~ an Ca~1tal l Bate ot!ax CD Y I A. 1l I assess 1 :. Ge1Da! 1 Cap1. tal S.lns. 'I. Colfa_ s J ot. :. 1 1 i l : :. :a 1 ~ i 1960- Sl 1961.;. 62 1962-63 1963-64 1964-66 1965 ~ 66.. 1966-67 196.7-68 1968-69 1969-70. ' 19'71 - '12 3.83. 6.32 8.46 S.-?3 7.9S. 8.78,,!... 30.66 30~83... 08 c.. 1.4 a.1 1~3 ' 2~ot.,r 2.4'1 f 9.24 9.S2 7~58.. 14.95. 82~0 22~;2 ' aft. a aa.,, 2S;s as ~ rfl~? I. 30~1.. 30~9 ae~a 37~4.. ~..., ~. _, ". L ' ------ ---... - ------- - -.-- -- - -- -- ~.. All Illd1a Incaae ~x ~ue Statistic ~ 5.06 30~

TABLE 2.2 55 '..... mm~:tm MD OF INCQIE m d PRQPiiTg owning IBDUIDVMrB Cti a.zo1 Income (Bs ) Number ot Assessee a + I I ldoqme + Assessed (Rs.09()) cerued :verage ac Ayerace tteot1ye Capital sam -capt!c)tal Inc ate ot!_.'f-. (Jt.OOO) Fc1n per per tax-. Oll Total. (5~ ot. Col ~. - XP&Jer lpe.rer(mc- lid.coile 8) @ _ < Co1 9 t ~ludiag ae~ J<col.a ~s ~.. 1 Col.a)).Jrue4 c.g~,j. ot Co1.11) 1 (Rs.OOO (Co1.10 f.. I.. D tel s> J 4001,. '"- 5001. 7501 10001 12501 15001 17501 20001 25001 30001 40001 50001 60001 70001 100001. 200001 300001 400001 Belmt Above - --- - - - - - ---- - - - ~ ~ ~ ~ --- -- -- --- - ----- - - ~ --- --- --- - - ~- -- --.- ~. - - -(- ----- ---.------. - - -.-- ---- -- -~ 4000 5000?500 10000 la500 15000 17500 20000 25000 30000 40000 50000 60000 70000 '1()0000 aooooo 300000 400000 500000 500000 7684 ' 1~714 275565 143559 8?803 J 62625 448'75 33304 41813 25548 26735 U919 6433 3786 47ll 28$6 486 167 62 152 1~~ 5190'18 16?96lS 1247933 98U51- S5?873 '?2l2l.l 621897 930277 696023 916156 528514 349536 243609 385898 337548 110570 57497 r/045 151914 '722 3930 426U 62941. 89866 73541 72458 72011 132070 124571 216581 154134 115365 89414 158628 1742'79 65362 32691 15259 99888 2.2$5 4.775 6.095 a.s9o U.l?4 13~698 16.0'71 18.6?3 22~ae f!'/.243 34.268 44.342 54 335 64.345 81.914 132.081 242.478 344.293 436.2<» 999.434 o.o.;,4 o.osa o.l54 0.438._, 0 '710 1.174 1.614 s.1sa 3 158 4.876 8.101 12.931 17.933 aa.gl? 33.6?2 68.184 143.387 195.754 246.J.J.a 657.158 4.~2 I 0.76 2.54 5.04 6.90 8.58 10~05 11~58 14.19.J.?.?S 23.64 29~13 33.01 36.'10 4l U 51. 63 59. 11 156.85 56 49 65.75 211'704 6228936 20155416 149'15196 U7738l2 10294476 8.,54532 '7462764 U163324 83522'76 10993872 6342168 4194432 2923308. 4630716 4050576 1326840 689964 324540 1822968 10585. 311447 1007771 748160 588691 514724 432727 373138 558166 417914 549694 317108 209722 146165 231539 202529 66342 34498 1622'1-91148 1-.an~ 2.864 3.657. 5.a14 6~704 8'.219' 9'~'642 11.203 13'~349 16~'3~ ao.sso 26.605 32~600 38.~1 49~148 79~236 ' 145.4.86 206'~574 261.725 599~657 3'.672?.639.9.'152 13.904 17.878 21.917 25.713 29~876 35~59'7 43.589 54.828 70.9~7 86.96 103~136 131.062 2Uea9? 387.964 550.867 697.834 1599~091 2.56 0~47 1.-58 3~15 4.31 5.36 6~28 7.24 8.8'7 11.18 14.78 18~~ 20~62 S2.~o 25.69 32.27 36.95 35.54 35~26 41.09 + lols. 2t'3t'4 relate to the total number ot Jnd1viduals assessed to 1nccae-tax other than rialuy~~rs-, 1 their asaessea mcoae and tax le~ied respect!vely,-as given 1n Jl.l India Income -tax Statistics 1969-70 (Statement 5-B). Col.S, that 1s, capital (invested) is est1 ted by asswd.nc s a cap1tal1sat1oa factor of. ~ - It 11 assumed that wealth values't--appreoiate at tbe rate ot per annum. Far reascns underl.11rlg this assudlptian see.appendh: to Gbapter a..