Sunday, June 25, 2017

Applicability of the Doctrine of Corporate Veil to Societies

[Post by Munmi Phukon and Sagar Batra of Vinod Kothari & Company]

Meaning of Corporation or Body Corporate

Pursuant to Section 2(11) of the Companies Act, 2013 (CA, 2013), “body corporate” or “corporation” includes a company incorporated outside India, but does not include—

(i)        a co-operative society registered under any law relating to co-operative societies; and

(ii)       any other body corporate (not being a company as defined in this Act), which the Central Government may, by notification, specify in this behalf.

However, the definition in CA, 2013 is inclusive and not an exhaustive one. The term has been elaborated under various judgments and has been interpreted with reference to the international scenario. A reference may be drawn to Halsbury's Laws of England, 3rd Edn. Vol.9, page 4, which reads:

A corporation aggregate has been defined as a collection of individuals united into one body under a special denomination, having perpetual succession under an artificial form, and vested by the policy of the law with the capacity of acting in several respects as an individual, particularly of taking and granting property, of contracting obligations and of suing and being sued, of enjoying privileges and immunities in common, and of exercising a variety of political rights, more or less extensive, according to the design of its institution, or the powers conferred upon it, either at the time of its creation or at any subsequent period of its existence. A corporation aggregate has therefore only one capacity, namely, its corporate capacity.

An essential element in the legal conception of a corporation is that its identity is continuous, that is, the original member or members and its or their successors who are composing it are persons wholly different from the corporation itself.  Thus, it has been held that a name is essential to a corporation and that a corporation can, as a general rule, only act or express its will by deed under its common seal.

Whether a Corporation Includes a Society?

A society is united together by mutual consent of its members to deliberate, determine and act jointly for the same common purpose. While on a reading of various provisions of the Societies Registration Act, 1860 (Societies Act), a registered society has the privileges analogous to that of a corporation such as separate legal personality, the power to sue or be sued, holding separate property, it does not however prove the intention of the law to provide for the creation of a corporation. The context holds its authority from the leading case law The Board of Trustees, Ayurvedic and Unani Tibia College v. The State of Delhi, in which the Supreme Court of India deliberated at length whether the nature of society is that of a corporation, and analysed the provisions of the Societies Act. The Court, while interpreting the provisions, held that a society is not a body corporate, by observing:

The most important point to be noticed in this connection is that in the various provisions of the Societies Registration Act, 1860, there are no sufficient words to indicate an intention to incorporate, on the contrary, the provisions show that there all absence of such intention. Section 2 no doubt provides for a name as also for the objects of the society. Section 5, however states that the property belonging to the society, if not vested in trustees, shall be deemed to be vested in the governing body of the society and in all proceedings, civil and criminal, the property will be described as the property of the governing body. The section talks of property belonging to the society; but the property is vested in the trustees or in the governing body for the time being. The expression “property belonging to the society" does not give the society a corporate status in the matter of holding or acquiring property, it merely describes the property which vests in the trustees or governing body for the time being. Section 6 gives the society the right to sue or be sued in the name of the president, chairman etc. and 7 provides that no suit or proceeding in a civil court shall abate by reason of the death etc. of the person by or against whom the suit has been brought. Section 8 again says that any judgment obtained in a suit brought by or against the society shall be enforced against it.

The Supreme Court also placed reliance on extracts from Dennis Lloyd’s ‘Law relating to Unincorporated Association’ (1938 edn.) as follows:

Registration does not result in incorporation, but merely entitles the society so registered to enjoy the privileges conferred by the Act. These privileges are of considerable importance and certain of them go a long way toward giving registered societies a status in many respects analogous to a corporation strictly so- called, but without being technically incorporated. Thus something in the nature of perpetual succession is conceded by the provision that the society's property is to vest in the trustees for the time being of the society for the use and benefit of the societies and its members and of all persons claiming through the members according to the society's rules, and further (and this is the most noteworthy provision) that the property shall pass to succeeding trustees without assignment or transfer. In the same way, though the society, being unincorporated, is unable to sue and be sued in its own name, it is given the statutory privilege of suing and being sued in the name of its trustees. Those provisions undoubtedly give certain privileges to a society registered under that Act and the privileges are of considerable importance and some of those privileges are analogous to the privileges enjoyed by a corporation, but there is really no incorporation in the sense in which that word is legally understood.”

The Supreme Court, in light of the aforesaid judgement, has read the status of the entity as that of a corporation in the light of intention to incorporate with disregard to the fact that it possesses the character of the corporation. Status of being a corporation in the said case was linked to it being incorporated under a statute. Therefore, in simple terms, an entity is a corporation if its incorporated, where incorporation is governed by statute or some express provisions, and an entity is not said to be incorporated merely because it possesses privileges as that of a corporation like separate legal entity. Accordingly, societies, though registered, are not corporation or body corporate.

Status of a Society as a Separate Legal Entity

Even if a society is not registered under the Societies Act and is considered as merely an unincorporated society, yet it has privileges similar to that of a corporation. Hence, for the purpose of calling it incorporated for the purpose of Union and State List under the Constitution, it is not a corporation but it is a separate legal entity, as held by the Bombay High Court in Satyavart Sidhantalankar v. The Arya Samaj:

It is significant to observe that the members of the society are a fluctuating body. A member of the society is a person who having been admitted therein according to the rules and regulations thereof has paid the subscription or signed the roll of the members thereof and has not resigned according to the rules and regulations. The governing body of the society is the governors, council, directors, committees, trustees or other body to whom by the rules and regulations of the society the management of its affairs is entrusted. The members as well as the governing body are not always the same and that is the reason why it has been necessary to provide that no suit or proceeding in any civil Court shall abate or discontinue by reason of the person by or against whom such suit or proceedings may have been brought or continued dying or ceasing to fill the character in the name whereof he shall have sued or been sued, but the same suit or proceedings shall be continued in the name of or against the successor of such person. Even though the members of the society or the governing body fluctuate from time to time, the identity of the society is sought to be made continuous by reason of these provisions. The identity of the original members and their successors is one. The liability or obligation once binding on the society binds the successors even though they may not be expressly named, and in this the society savours of the character of a corporation. The resignation or the death of a member does not make any difference to the legal position of the society. The increase or decrease of the members of the society similarly does not make any difference to the position. A partnership under similar circumstances would come to an end, but not the society. The society continues to exist and to function as such until the dissolution thereof under the provisions of the Societies Registration Act. The properties of the society continue vested in the trustees or in the governing body irrespective of the fact that the members of the society for the time being are not the same as they were before nor will be the same thereafter.

The aforesaid judgement succinctly lays down the existence of separate legal entity of a society from its members and the correctness of the same was not overruled in Board of Trustees case (discussed earlier). But, it was held that even though the society has separate legal existence, it nevertheless cannot be said to be a corporation in the sense of being incorporated, and the decision cannot be interpreted to make it a corporation.

In line with the aforesaid judgement, the Department of Corporate Affairs had also notified that society should not be deemed to be a body corporate, although such a society can be treated as a person having separate legal entity apart from its members constituting it.

Applicability of the Doctrine of Corporate Veil to Societies

In the landmark ruling of Salomon v. Salomon, the House of Lords held:

a corporation is separate from the individuals. Only the corporation held the debt; the individual shareholders did not hold the debt. As part of a legal incorporation, the liability was more minimal than that of a partnership or sole proprietorship, according to Examination Preparation Services. 

The case of Salomon v. Salomon gave rise to the legal fiction of corporate veil, enunciating that a company has a legal personality separate and independent from the identity of its shareholders. Hence, any rights, obligations or liabilities of a company are discrete from those of its shareholders, where the latter are responsible only to the extent of their capital contributions, known as "limited liability.

The doctrine of ‘piercing the corporate veil’ stands as an exception to the principle that a company is a legal entity separate and distinct from its shareholders with its own legal rights and obligations. It seeks to disregard the separate personality of the company and attribute the acts of the company to those who are allegedly in direct control of its operation and impose liability upon the persons exercising real control over the said company. The doctrine rests on the recognised principle of separate legal entity. This forms an important constituent of a body corporate/corporation, where to the contrary, a separate legal entity may or may not be a body corporate (as decided in the cases aforesaid). Hence, the doctrine has applicability where the separate legal entity persists, and in the instant case, society though not being a corporation, yet qualifies for being a separate legal entity.

Most of the cases subsequent to the Salomon case, attributed the doctrine of piercing the veil to various grounds such as that the company was mere a ‘sham’ or a ‘façade’. The law has been crystallized around the six principles formulated by Munby J. in Ben Hashem v. Ali Shayif, [2008] EWHC 2380 (Fam) and the same have been reiterated by the UK Supreme Court by Lord Neuberger in Prest v. Petrodel Resources Limited and others, [2013] UKSC 34

The six principles, as found at paragraphs 159–164 of the Ben Hashem are as follows:

1.         ownership and control of a company were not enough to justify piercing the corporate veil;

2.         the Court cannot pierce the corporate veil, even in the absence of third party interests in the company, merely because it is thought to be necessary in the interests of justice;

3.         the corporate veil can be pierced only if there is some impropriety;

4.         the impropriety in question must be linked to the use of the company structure to avoid or conceal liability;

5.         to justify piercing the corporate veil, there must be both control of the company by the wrongdoer(s) and impropriety, that is use or misuse of the company by them as a device or facade to conceal their wrongdoing; and

6.         the company may be a ‘façade’ even though it was not originally incorporated with any deceptive intent, provided that it is being used for the purpose of deception at the time of the relevant transactions.

The Court would, however, pierce the corporate veil only so far as it was necessary in order to provide a remedy for the particular wrong which those controlling the company had done. As noted in Prest:

35. I conclude that there is a limited principle of English law which applies when a person is under an existing legal obligation or liability or subject to an existing legal restriction which he deliberately evades or whose enforcement he deliberately frustrates by interposing a company under his control. The Court may then pierce the corporate veil for the purpose, and only for the purpose, of depriving the company or its controller of the advantage that they would otherwise have obtained by the company's separate legal personality. The principle is properly described as a limited one, because in almost every case where the test is satisfied, the facts will in practice disclose a legal relationship between the company and its controller which will make it unnecessary to pierce the corporate veil.”

In Life Insurance Corporation of India v. Escorts Ltd. & Ors., (1986) 1 SCC 264, while discussing the doctrine of corporate veil, the Supreme Court held that:

Generally and broadly speaking, we may say that the corporate veil may be lifted where a statute itself contemplates lifting the veil, or fraud or improper conduct is intended to be prevented, or a taxing statute or a beneficent statute is sought to be evaded or where associated companies are inextricably connected as to be, in reality, part of one concern. It is neither necessary nor desirable to enumerate the classes of cases where lifting the veil is permissible, since that must necessarily depend on the relevant statutory or other provisions, the object sought to be achieved, the impugned conduct, the involvement of the element of the public interest, the effect on parties who may be affected etc.

Some of the cases decided, in particular relating to a society, with respect to the piercing of corporate veil are notable. In Harbir Singh vs Shaheed Udham Singh Smarak Shiksha Samiti & Ors, the Delhi High Court held that courts should refrain from interfering in the internal management of a society or a club, as they are governed by their own charter, and that the Court should not sit in appeal over the decisions taken by the management and the majority of the society, as long as the court is prima facie satisfied that the said decisions are taken by the persons authorized to do so and as per the rules and regulations of the said society. However, for adequate reasons made out, the court will ignore the corporate veil to reach out to the true character of the concerned company or, in the relevant case, the society.

In A.V. Krishnan Moosad vs The District Collector, the Kerala High Court held that the corporate veil can be pierced when the corporate personality is found to be opposed to justice, convenience and interest of the revenue or workman or against public interest. If it is seen that the society does not have any asset and there are no persons responsible to settle the liability of the society, it is certainly open for the statutory authorities to pierce the corporate veil of the society and to find out the actual persons who are in management of the society and then take steps according to law.

In Madan Mohan Sen Gupta And Anr. vs State Of West Bengal And Ors, the Calcutta High Court was faced with the question whether a corporate veil or the veil of the society, should be lifted to see what sort of a face, statutory or otherwise, it has and under whose control it remains and whether the affairs are purely private or otherwise.

In the light of aforesaid judgements, it can be concluded that the doctrine of lifting of corporate veil has been applied in a restrictive manner, in the scenario wherein it is evident that the company was a mere camouflage or sham deliberately created by the persons exercising control over the said company for the purpose of avoiding liability. Similarly, in case of a society, the grounds where the corporate veil be lifted to disregard the separate legal entity of the board or the society in itself, shall also be based on the principle as enumerated in the leading cases with the intent to seek a remedy for a wrong done by the persons controlling the company.

The Doctrine of piercing of Corporate Veil has gained clarity on its scope and applicability and the principles were also discussed at stretch in the recent case of Balwant Rai Saluja & Anr v. Air India Ltd. & Ors. (2013). However, the applicability of the doctrine is ultimately within the discretion of the courts and is subjective based on the facts and circumstances of each case.

- Munmi Phukon and Sagar Batra


Friday, June 23, 2017

Intention of the Legislature Under Section 14A of the Income Tax Act, 1961

[Post by Akash Santosh Loya, 3rd year B.A. LL.B.(Hons.) student from National University of Advanced Legal Studies, Kochi.]

In the case of Godrej Boyce & Manufacturing Ltd. v. Deputy Commissioner of Income Tax and Anr decided last month, the Supreme Court of India decided on the issue relating to the disallowance of expenditure under section 14A of the Income Tax Act, 1961 (the ‘Act’) incurred with respect to the earning of dividend income and income from mutual funds in the hands of a shareholder and unitholder respectively.

In this post, I will at the outset state and elaborate on the provisions relevant towards understanding of the issue. Thereafter, I will discuss the decision of the Supreme Court. Lastly, I will provide an analysis of the said decision.

Relevant provisions

Section 10(34)

Section 10 of the Act exempts certain income. Such income is not chargeable to tax under any provisions of the Act. In accordance with sub-section (34), dividend income referred to in section 115-O was exempt from tax. Before 2003, the said provision was numbered as section 10(33).

Section 10(35)

Section 10(35) exempts income received in respect of units mutual fund or a specified company. Before 2003, the said provision was part of section 10(33). 

Section 14A

Section 14A was enacted by the Finance Act, 2001. It states that any expenditure incurred by assessee with respect to income which does not form part of total income will be disallowed. Therefore, any expenditure incurred with respect to exempt income is disallowed. Further sub-sections (2) and (3) state that the assessing officer (‘AO’) shall determine the expenditure incurred as per the method prescribed in rule 8D of the Income Tax Rules, 1962, provided the AO is not satisfied with the expenditure claimed by the assessee. 

By virtue of decisions of the Supreme Court in Rajasthan State Warehousing Corporation v. C.I.T.,[1] C.I.T. v. Maharashtra Sugar Mills Limited[2] and C.I.T. vs. Indian Bank Limited,[3] the settled position of law was that in case of composite and individual businesses which earned both taxable and non-taxable income, expenditure towards non-taxable income could not be isolated by apportionment, and a disallowance could not be made. Thus, section 14A was enacted to remove the basis of the aforesaid decisions.

Section 115-O

Section 115-O was introduced by the Finance Act, 2003. Sub-section (1) of section 115-O states that an additional income tax will be charged on the profits distributed by the company. This income tax will be in addition to the tax paid by the Co. on its total income. Therefore, firstly, the company will be liable to pay normal income tax with respect to its total income mentioned in the tax return (which will include the profits distributed by the company). Secondly, it will be liable to pay the additional tax on the profits distributed by the company. Sub-section (2) states that the aforesaid additional income tax will be payable by the company even if it is liable to pay zero tax on its total income. Sub-section (4) states that no credit can be claimed either by the company or by the shareholder with respect to the amount of the tax paid under this section. The tax paid will be treated as the final payment of tax. Further sub-section (5) states that no deduction will be allowed to either the company or the shareholder in respect of the tax paid under this section.

Section 115-R

Section 115-R states that additional tax will be paid by the specified company or the mutual fund with respect to the income distributed to the shareholders or unit holders respectively. The other provisions of section 115-R are similar to that of section 115-O. Therefore, a reference to the aforesaid explanation can be made.

The statutory provisions summarised above can be found here.

Section 10(34) [which was then numbered as section 10(33)] and section 115-O were introduced in the Act by the Finance Act, 1997. Subsequently, both the provisions were deleted by the Finance Act, 2002. However, by virtue of Finance Act, 2003, sections 10(34) and 115-O were reintroduced into the Act. Similarly, sections 10(35) and 115-R were reintroduced together by the Finance Act, 2003.

Background

The assesse, Godrej Boyce, had earned a total income of Rs. 34.34 crores in the assessment year 2002-03. The following is the division of dividend income towards various sources:

1.      
Sister Godrej companies
98%
2.      
Non-Godrej companies
0.05%
3.      
Mutual Funds
1.95%

A substantial part of the investment was in form of bonus shares. Further, on the last date of the relevant financial year, i.e., 31 March 2002, Godrej Boyce had total reserves, surplus, share capital of Rs. 280.64 crores by way of interest-free funds.

Accordingly, Godrej Boyce claimed exemption of the aforesaid dividend income under sections 10(33) and 10(34). It contended that it had incurred zero expenditure in earning the said income and, therefore, no disallowance should be made section 14A. The AO rejected the claim of Godrej Boyce and made the disallowance. This order was upheld by Income Tax Appellate Tribunal (‘ITAT’). Godrej Boyce filed an appeal before the High Court of Bombay. The High Court upheld the view of ITAT and dismissed Godrej Boyce’s appeal.

In the previous assessment years as well, i.e., 1998-99, 1999-2000 and 2001-02, the AO had disallowed expenditure towards earning of dividend income and income from mutual funds under section 14A. However, the same was reversed and an order in favor of Godrej Boyce was granted by the ITAT. Therefore, the end result in previous assessment years was that the entire dividend income was exempt without any deductions.

Issues Raised

I.          Whether the phrase ‘income which does not form part of total income’ appearing in section 14A includes dividend income and mutual fund income on which tax is payable under sections 115-O and 115-R?

II.        Whether on the findings provided by lower authorities over a period of time, can there be any question of disallowance under section 14A in Godrej Boyce’s case?

Decision

Issue I

The Supreme Court upheld the judgement of Bombay High Court on the said issue. It held that section 14A would apply to dividend income on which tax is payable under section 115-O and income from mutual funds on which tax is payable under section 115-R. It came to the aforesaid conclusion on the basis of following grounds:

-           Section 14A states that expenditure incurred by an assessee for earning an income will be disallowed if the said income does not form part of the total income of the assessee. Therefore, on a plain reading of section 14A, it is very clear that section 14A does not cover a situation where firstly, income is exempt in the hands of an assessee shareholder and secondly, the tax on the said income is payable by the dividend paying company. Therefore, only by virtue of tax being paid by the dividend paying company on the said income, it does not confer the benefit to the shareholder assessee in whose hands the income is exempt. Further, it was held that the wordings of section 14A do not give rise to any absurdity and, therefore, section14A should be construed strictly.

-           There are various species of dividends other than those covered under section 115-O. However, the only specie of dividend exempt under section 10(33) (later engrafted as section 10(34)) is dividend covered under section 115-O. Therefore, section 14A will not be applicable to other species of dividend. However, whenever the dividend covered under section 115-O is earned, the applicability of section 14A will be beyond doubt.

-           The fact that section 10(33) (later engrafted as section 10(34)) and section 115-O were introduced, deleted and reintroduced together does not conclude that the intention of the legislature was to propose a composite scheme of taxation. The composite scheme being that on one hand the dividend income is taxed in the hands of dividend paying company, and on the other hand the same income is not being included in the total income of the assesse shareholder.

-           Sub-sections (4) and (5) of section 115-O clearly state that no benefit can be availed of the payments made either by the company or the shareholder. Therefore, the proposition that the tax on dividend income is paid by the company on behalf of the assesse shareholder cannot stand.

The Court also referred to its judgement in the case of Commissioner of Income-Tax vs. Walfort Share and Stock Brokers P. Ltd.[4] to reach the aforesaid conclusion.

Issue II

The Supreme Court reversed the ruling of the Bombay High Court on the said issue. It held that normally the principle of res judicata does not apply to assessment proceedings. However, strong reasons should be provided by the AO to deviate from the consistent findings made over the years. In the instant case, since no strong reasons were provided by the AO for deviating from the consistent findings over the years, Godrej Boyce is entitled for full benefit of exemption of dividend income without any deduction.

Implications

In the instant case, Godrej Boyce had no tax implications whatsoever. Even though Issue I was decided against it, by virtue of a decision in its favor with respect to Issue II the end result was that no tax liability was to be discharged by Godrej Boyce. Therefore, looking at the decision from a monetary angle, the revenue was the one who lost.

Analysis

It is a well settled principle of interpretation of statutes that one has to adopt a construction that will promote the general legislative intent and purpose underlying the provisions.[5] One of the sources for ascertaining the intention of the Legislature is the Memorandum of Finance Bill. Section 115-O and amended section 10(34) were introduced by virtue of Finance Act, 2003. The Memorandum of Finance Bill, 2003 should be referred to ascertain the intention of the legislature for the introduction of the aforesaid provisions. It states:

It has been argued that it is easier to collect tax at a single point, i.e., from the company rather than compel the company to compute the tax deductible in the hands of the shareholders.

It is, therefore, proposed to substitute sub-section (1) of section 115-O of the Income-tax Act to provide that the amounts declared, distributed or paid on or after 1st April 2003 by a domestic company by way of dividends shall be charged to additional income-tax at the flat rate of twelve and one-half per cent, in addition to the normal income-tax chargeable on the income of the company.

From the Memorandum of Finance Bill, 2003 it is apparent that the intention for the introduction of the aforesaid provision was only for the purpose of simplification of procedure. There was no intention to exempt any kind of income. Initially, when dividend income was chargeable in the hands of the shareholder, the company had to calculate and deduct the tax deducted at source on the dividend income earned by every shareholder. Considering the large number of shareholders that may be present in a corporation, the entire procedure was very cumbersome and time consuming. Therefore, in order to simply the procedure, the legislature imposed an additional burden on the company by making it liable to pay the additional tax. Further, in order to prevent the same income from being doubly taxed, an exemption under section 10(34) was granted. This arrangement ensured that the same income was not doubly taxed.

Further, a careful reading of section 14A also shows that the intention of legislature was not to disallow the expenditure incurred for earning dividend income and income from mutual funds.[6] For understanding the same, it is necessary to take closer look at the section 14A (1) and (2).

Expenditure incurred in relation to income not includible in total income.

14A. (1) For the purposes of computing the total income under this Chapter, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under this Act.

(2) The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if the AssessingOfficer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under this Act.

From a perusal of the above provision, the two highlighted terms need to be taken into consideration for providing a correct understanding regarding the intention of legislature

-           Total income under this Chapter – It means the total income of the assessee computed under Chapter IV, i.e., sections 14 to 59;

-           Total income under this Act – It means the total income computed under the entire Act. Thus, the income chargeable to tax under sections 115-O and 115-R also falls within the ambit of this expression.

Therefore, from a careful reading of the aforesaid provision, the intention of legislature is very clear. It is to not disallow expenditure incurred for earning income which is chargeable not only under Chapter IV of the Act but also under any other Chapters of the Act. Further, the intention is also to allow expenditure with respect to income directly or indirectly earned by the assesse. If the intention was only to allow expenditure incurred towards income which forms a part of Chapter IV or towards income which is earned directly by assesse, the same would have been expressed clearly. The aforesaid intention would have been expressed by using words ‘total income under this Chapter’ or ‘total income of assessee’ instead of ‘total income under this Act’.

Further, this intention is clear by virtue of sub-section (2) of section 14A as well. It states that the AO can compute the disallowable expenditure when the said income does not form part of total income under this Act. Therefore, the AO will compute the disallowable expenditure when the income does not form part of the total income under the Act, and not when the income does not form part of total income of assessee.

- Akash Santosh Loya



[1] (2000) 109 Taxman 145.
[2] (1971) 3 SCC 543
[3] AIR 1965 SC 1473
[4] (2010) 326 ITR 1 (SC)
[5] The Sole Trustee, Lok Shikshana Trust v. CIT, Mysore, AIR 1976 SC 10.
[6] CA Dev Kumar Kothari, ‘S. 14A: Scope of disallowance explained’, available at http://www.itatonline.org/articles_new/section-14a-scope-of-disallowance-explained/.