Wednesday, October 12, 2011

Delhi HC Applies Mischief Rule!

By Daksha Baxi, ED- Direct Taxation, Khaitan & Co
In a recent decision in case of National Travel Services, the Delhi High Court has ruled that a loan given to a partnership by a company, whose partners are the shareholders of the said company, is indeed deemed dividend under section 2(22)(e) of the Income Tax Act, 1961 (�IT Act�). National Travel Services (Assessee) was a partnership firm consisting of three partners: Naresh Goyal, Surinder Goyal and Jet Enterprises Private Limited. The Assessee had taken a loan of a certain amount from Jetair Private Limited (Jetair) in which it held 48.18% shares. Though the beneficial owner of the shares of Jetair was the Assessee they were held in the name of the Partners.
The Income Tax Authorities (Tax Authorities) assessed this loan as �deemed dividend� under section 2(22)(e)  of the IT Act and regarded it as taxable in the hands of the Assessee. The Commissioner of Income Tax Appeals (CIT (A)) upheld the order of the Tax Authorities.
The Assessee went in appeal before the Income Tax Appellate Tribunal which reversed the order of the CIT (A).
Being aggrieved by the order of the Tribunal, the Tax Authorities went in appeal before the High Court of Delhi (�HC�).
The HC was called upon to decide on the issue whether section 2(22)(e) applies to the Assessee even though the shares of Jetair were held in the name of the Partners.
The HC, inter alia, referred to the decision of the Supreme Court (�SC�) in the case of CP Sarathy Mudaliar wherein the SC observed that section 2(22)(e) consists of three limbs and explained the same as under:
"Any payment by a company, not being a company in which the public are substantially interested, of any sum � made after 31 May 1987 by way of advance or loan:
First limb:(a) to a shareholder, being a person who is the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) holding not less than 10% of the voting power,
Second limb:
(b) or to any concern in which, such shareholder is a member or a partner and in which he has a substantial interest (hereafter in this clause referred to as the said concern)
Third limb:(c) or any payment by any such company on behalf, or for the individual benefit, of any such shareholder to the extent to which the company in either case possesses accumulated profits."
The HC observed that for attracting the first limb, the requirement of the provision is that the loan is advance by a company �to a shareholder, being a person who is the beneficial owner of shares� i.e. it is necessary that both the conditions, that such a person to whom the advance is made should be a registered shareholder as well as a beneficial owner of the shares.
However, in the instant case, the HC noted that the shares of Jetair were in the name of the Partners though the beneficial owner was the partnership, i.e. the Assessee. This was because the Assessee, being a partnership firm, was unable to hold the shares in its own name due to the provisions contained in this regard in the Companies Act, 1956. Thus, it was due to a legal bar that the Assessee, though a beneficial owner of the shares, was not a shareholder. The HC opined that in essence the partnership was a shareholder as well as the beneficial holder of the shares, though the registered holders were the partners.
The HC rejected the argument that a partnership firm cannot be treated as a �shareholder� only because the shares are held in the name of its partners. It stated that if this contention is accepted, no partnership firm will ever come with within the mischief of section 2(22)(e).
The issue is that in case of a partnership, even the second limb would not bring the advance within the ambit of section 2(22)(e), since in that case the loan would need to be made to a partnership in which the shareholder � being legal and beneficial owner- has substantial interest. In the instant case, while the partners who held the shares legally in Jetair and had substantial interest in the Assessee, they did not have beneficial interest in the shares. The HC thus seems to have inserted and interpreted the provision by adding something to the provision to make it applicable. The two principles of interpretation involved here seem to be:
(i) Rule of Literal Interpretation - the intention of the legislature must be found in the words used by the legislature itself. The Supreme Court, in the case of Mohammad Ali Khan and Others v. CWT (224 ITR 672) has upheld this principle. The Court opined that �It is a cardinal principle of construction that the words of a statute are first understood in their natural, ordinary or popular sense and phrase and sentences are construed according to their grammatical meaning, unless that leads to some absurdity or unless there is something in the context or in the object of the statute to suggest the contrary. It has been often held that the intention of the Legislature is primarily to be gathered from the language used, which means that attention should be paid to what has been said, as also to what has not been said. As a consequence, a construction which requires for its support, addition or substitution of words or which results in rejection of words as meaningless, has to be avoided.�
(ii) Purposive Interpretation - the Courts adopt this rule where they go beyond the language of the statute so as to determine the real legislative intent behind the concerned provision.  If the literal interpretation of the taxing statute results in absurdity, meaninglessness or futility of the statute then the Court may apply the principle of purposive interpretation which takes two forms viz. Contextual Meaning and Mischief Rule. The Court seeks to determine the mischief that any statute was enacted to remedy and find the rationale for that remedy and then interpret the statute in such a manner that the remedy is implemented.
Clearly, the HC has favored the mischief rule of the second principle of interpretation in arriving at this ruling.  This is an interesting and important trend to note.
1. This provision creates a fiction providing certain circumstances under which certain kinds of payments made to the persons specified therein are to be treated as dividend income of the recipient.

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