Supreme Court Upholds Tax on Distributed Profits: Section 115O of the Income Tax Act, 1961 (20 September 2017)

Introduction

Date of the Judgment: 20 September 2017

Citation: Not Available

Judges: A.K. Sikri, J., Ashok Bhushan, J. (authored the judgment)

Can the government tax the profits that companies distribute as dividends, even if those profits come from agricultural activities? The Supreme Court of India addressed this question in a case concerning the constitutional validity of Section 115O of the Income Tax Act, 1961. This section imposes a tax on the dividends that companies distribute to their shareholders. The core issue was whether this tax was an overreach by the Parliament, particularly when it came to taxing agricultural income, which is usually under the purview of the State Legislature.

Case Background

Several tea companies, including M/s Tata Tea Co. Ltd., challenged the constitutional validity of Section 115O of the Income Tax Act, 1961. These companies cultivate tea, which is considered an agricultural activity, and process it in their factories. They argued that since a significant portion of their income comes from agriculture, which is a state subject, the Parliament cannot impose a tax on the dividends distributed from this income. The companies contended that Section 115O effectively taxes their agricultural income, which is beyond the Parliament’s legislative competence.

Timeline

Course of Proceedings

The Calcutta High Court initially dismissed the writ petitions challenging Section 115O through a learned Single Judge. However, a Division Bench of the same court overturned this decision, ruling that while Section 115O was constitutional, the additional tax should only apply to 40% of the income, which is considered taxable under the Income Tax Act. Simultaneously, the Gauhati High Court dismissed a similar writ petition, upholding the full validity of Section 115O. These conflicting judgments led to the appeals before the Supreme Court.

Legal Framework

The case revolves around the legislative powers of the Union (Parliament) and the States as defined in the Constitution of India.

• Article 246 of the Constitution outlines the subject matters of laws made by the Parliament and State Legislatures. It divides legislative powers into three lists:
  • List I (Union List): Matters over which the Parliament has exclusive power to make laws.
  • List II (State List): Matters over which the State Legislatures have exclusive power to make laws.
  • List III (Concurrent List): Matters over which both the Parliament and State Legislatures can make laws.
• Entry 82 of List I grants the Parliament the power to impose “taxes on income other than agricultural income.”
• Entry 46 of List II grants the State Legislatures the power to impose “taxes on agricultural income.”
• Section 2(1A) of the Income Tax Act, 1961 defines “agricultural income.”
• Section 2(24) of the Income Tax Act, 1961 defines “income” to include “dividend.”
• Section 115O of the Income Tax Act, 1961, as inserted by the Finance Act, 1997, imposes a tax on distributed profits of domestic companies:
  
  “115-O. Tax on distributed profits of domestic companies.—(1) Notwithstanding anything contained in any other provision of this Act and subject to the provisions of this section, in addition to the income-tax chargeable in respect of the total income of a domestic company for any assessment year, any amount declared, distributed or paid by such company by way of dividends (whether interim or otherwise) on or after the 1st day of June, 1997, whether out of current or accumulated profits shall be charged to additional income-tax (hereafter referred to as tax on distributed profits) at the rate of ten per cent.
  (2) Notwithstanding that no income-tax is payable by a domestic company on its total income computed in accordance with the provisions of this Act, the tax on distributed profits under sub-section (1) shall be payable by such company.
  (3) The principal officer of the domestic company and the company shall be liable to pay the tax on distributed profits to the credit of the Central Government within fourteen days from the date of—
  (a) declaration of any dividend;or
  (b) distribution of any dividend;or
  (c) payment of any dividend, whichever is earliest.”

Arguments

The petitioners argued that Section 115O of the Income Tax Act, 1961, is unconstitutional because it imposes a tax on dividends, which are derived from agricultural income. They contended that since 60% of their income is from agriculture, which is a state subject, the Parliament lacks the legislative competence to tax this portion of their income through a tax on distributed profits. The petitioners submitted that at best, the additional tax can only be imposed on the 40% of the income which is taxable under the Income Tax Act.

The Union of India, on the other hand, argued that once the income is distributed as dividends, it loses its character as agricultural income. The Union contended that the tax is on the act of distributing profits and not on the agricultural income itself. Therefore, the Parliament has the legislative competence to enact Section 115O under Entry 82 of List I, which allows for taxes on income other than agricultural income.

Issues Framed by the Supreme Court

The Supreme Court framed the following issue for consideration:

1. Whether the provisions of Section 115O of the Income Tax Act, 1961, which impose an additional tax on dividends declared, distributed, or paid by a company, are within the legislative competence of the Parliament under Entry 82 of List I, or whether it relates to the legislative field assigned to the State legislature under Entry 46 of List II, which is tax on agricultural income.

Treatment of the Issue by the Court

Authorities

The Supreme Court relied on the following authorities:

Judgment

How each authority was viewed by the Court?

• A.L.S.P.P.L. Subrahmanyan Chettiar vs. Muttuswami Goundan, AIR 1941 FC 47*: The Court applied the principle of “pith and substance” as laid down in this case.
• Prafulla Kumar Mukherjee and others vs. Bank of Commerce, Limited Khulna, Vol.74 1946-47 Indian Appeals 23*: The Court affirmed the doctrine of “pith and substance” based on this case.
• Kartar Singh vs. State of Punjab, 1994 (3) SCC 569*: The Court reiterated the principle that when entries overlap, the true intent and purpose of the legislation must be examined.
• Union of India and others vs. Shah Govedhan L. Kabra Teachers’ College, 2002 (8) SCC 228*: The Court applied the principles of reading entries in different lists as laid down in this case.
• Mrs. Bacha F. Guzdar, Bombay vs. Commissioner of Income Tax, Bombay, AIR 1955 SC 74*: The Court relied on this case to establish that dividend income in the hands of shareholders does not retain the character of agricultural income.
• The Commissioner of Income-Tax, Calcutta vs. Nalin Behari Lal Singha, etc., 1969 (2) SCC 310*: The Court affirmed that dividend distributed by a company does not retain the character of the profits from which it is derived based on this case.

What Weighed in the Mind of the Court?

The Supreme Court’s decision was primarily influenced by the principle that once agricultural income is distributed as dividends, it loses its original character. The Court emphasized that the tax under Section 115O is on the act of distributing profits, which falls under the Union’s legislative power to tax income other than agricultural income. The Court also highlighted that the nature of dividend income in the hands of shareholders is distinct from the company’s income, as established in previous judgments.

The Court’s reasoning was based on the following points:

• The tax under Section 115O is on the distribution of profits by a company, not on the agricultural income itself.
• When a company distributes dividends, the income loses its character as agricultural income.
• The Parliament has the legislative competence to impose taxes on income other than agricultural income, as per Entry 82 of List I of the Constitution.
• The nature of dividend income in the hands of shareholders is distinct from the company’s income, as established in previous judgments.

The Court rejected the argument that the tax under Section 115O is an indirect tax on agricultural income. The Court held that the tax is on the act of distributing profits, which is a separate taxable event. The Court also rejected the Calcutta High Court’s view that the tax should be limited to 40% of the income, stating that there is no such provision in Section 115O.

The Supreme Court’s decision was unanimous, with both judges concurring on the reasoning and the final outcome.

Key Takeaways

• Section 115O of the Income Tax Act, 1961, is constitutionally valid.
• The Parliament has the legislative competence to impose a tax on distributed profits by domestic companies.
• The tax under Section 115O is on the act of distributing profits, not on the source of the income.
• Dividend income in the hands of shareholders does not retain the character of agricultural income.
• Companies are liable to pay additional tax on the full amount of dividends distributed, without any limitation to the taxable portion of their income.

Directions

The Supreme Court allowed the appeals filed by the Union of India and dismissed the appeal filed by the writ petitioner.

Specific Amendments Analysis

No specific amendments were discussed in this judgment.

Development of Law

The ratio decidendi of this case is that the tax imposed under Section 115O of the Income Tax Act, 1961, on the distribution of profits by domestic companies is within the legislative competence of the Parliament. The Supreme Court clarified that the tax is on the act of distributing profits and not on the source of income, and that dividend income in the hands of shareholders does not retain the character of the profits from which it is derived. This judgment reinforces the Parliament’s power to tax income other than agricultural income and clarifies the nature of dividend income in the context of legislative competence. There is no change in the previous position of the law.

Conclusion

The Supreme Court upheld the constitutional validity of Section 115O of the Income Tax Act, 1961, ruling that the Parliament has the legislative competence to impose a tax on the distribution of profits by domestic companies. The Court clarified that the tax is on the act of distributing profits, not on the source of income, and that dividend income does not retain the character of agricultural income. The Court allowed the appeals filed by the Union of India and dismissed the appeal filed by the writ petitioner.