Test to Determine the Real Purpose of the Activities of an Educational Institution

Queen’s Educational Society v. Commissioner of Income Tax

 CIVIL APPEAL NO.5167 OF 2008

Recently, the Supreme Court delivered an important ruling on the “exemptions” claimed by the Educational institutions u/section 10 (23C) (iiiad) of the Income Tax Act 1961. Under the challenge were rulings from the Punjab and Haryana High Court[1] taking one view, and another other from the Uttarakhand High Court opting for the opposite view. The latter judgment was overruled in the present case. Though the provision in question in Punjab and Haryana Case was s. 10 (23C) (vi), but the provision, for the purposes of this post, was same in the material and relevant purposes to that u/s. 10 (23C) (iiiad).

The provision, whose interpretation was in question in the present case, runs as follows:

“Section 10: In computing the total income of a previous year of any person, any income falling within any of the following clauses shall not be included-

(23C) any income received by any person on behalf of –

(iiiad) any university or other educational institution existing solely for educational purposes and not for purposes of profit if the aggregate annual receipts of such university or educational institution do not exceed the amount of annual receipts as may be prescribed...”

A.    Issues

The important questions for interpretation that arose before the Supreme Court were:

   (a)    What if an educational institution makes profit in a previous year, would that make the educational institution, an institution existing only for profit purposes?

  

   (b)   What if an Educational institution makes profit in successive years,[2] and that excess profit is spent for Institutional Requirements only, would that take the Institution out of the purview of exemption?

B.     Judgment of the Court

On Issue (a)

The Court, firstly, answered the true interpretation of the phrase “for educational purposes” and “not for profit purposes”, for which it sought to construe the meaning of term “for” as used in the provision. So, the predominant object of the activity undertaken was referred to, which in essence means that an activity when done reference to something as end, is an activity done for that purposes. The Court held, therefore, that if the activity is not pervaded by profit motive but is carried primarily for serving the charitable purposes, the activity is not for profit. The Court, relying on the case of CIT v. Surat Art Silk Cloth Manufacturers Associations,[3] held exemption clause does not require that the activity must be carried on in such a manner that it does not result in any profit as that would be not only be difficult but also reflect unsound principle of management. Mere occurrence of incidental surplus, would not make the institution existing for the purposes of making profit.

On Issue (b)

In the case of American Hotel and Lodging Association Educational Institute v. CBDT,[4] the Court laid down the test for ascertaining the object of an institute, in the context of application of the surplus generated to an Institution, as the following:

“In order to ascertain whether the institute is carried on with the object of making profit or not it is the duty of the prescribed authority to ascertain whether the balance of income is applied wholly an exclusively to the objects for which the applicant is established... The test is—the nature of activity. If the activity like running a printing press takes place it is not educational. But whether the income/profit has been applied for non-educational purpose has to be decided only at the end of the financial year.”[5]

In the impugned judgment of the Uttarakhand High Court, the Court had earlier overruled the ITAT order, which had allowed exemption to the Educational Institute on the ground that earlier, the assessee (institution) trust was initially running the school in a rented building and had generated the surplus, i.e. the excess of the receipts over expenditure. The ITAT had reasoned that the assessee had acquired its own property, computers, library, sports equipment etc. for the benefit of the students and no part of such surplus was utilized by the members of the society for their own benefit. So, such surplus was held to not come within the ambit of denying exemption u/s 10(23C) (iiiad) of the Act.

The Supreme Court in the present case, was unequivocal in its opinion when, while overruling the Uttarakhand High Court, it stated:

“The final conclusion [of the High Court] that if a surplus is made by an educational society and ploughed back to construct its own premises would fall foul of Section 10(23C) is to ignore the language of the Section and to ignore the tests laid down in the Surat Art Silk Cloth case, Aditanar case and the American Hotel and Lodging case. It is clear that when a surplus is ploughed back for educational purposes, the educational institution exists solely for educational purposes and not for purposes of profit.” [emphasis mine]

  So, in the end what matters is as to for what purpose the surplus is spent, and not whether surplus is generated year after year (as wrongly advocated by the CIT, Chandigarh, whose order was set aside in the upheld judgement of the Punjab and Haryana High Court in the present case).

Observations on the ‘Presumption of Profit- oriented activity, unless otherwise shown’ concept

The Court also referred to the observations made in the cases of Sole Trustee, Loka Shikshana Trust[6] and Indian Chamber of Commerce[7] where were on the lines that if a trust consists of carrying on business with no restrictions on them making profits, then, the court would presume that the activity is undertaken for profit purposes, unless otherwise shown.

The Court reiterated the disagreement over such presumption being made and quoted, the observations made in the case of Surat Art Silk Cloth Manufacturers Associations (supra) where the Court had held that it is not necessary that there must be a provision in the constitution of the trust or the institution that the activity shall be carried on no profit or loss basis. So, even if there is no such express provision, the nature of the charitable purpose/ manner in which the activity is carried on/ surrounding circumstances may clearly indicate that the activity is not propelled by a dominant profit motive.

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[1] Judgment in the case of Pine Grove International Charitable Trust v. UOI, (2010) 327 ITR 273.

[2] See para 20 of the present case, where the para 6 of the overruled order passed by the Chief, CIT is quoted. The order was set aside by the Punjab and Haryana High Court and this judgment was upheld in the present case.

[3] (1980) 121 ITR 1.

[4] (2008) 301 ITR 86.

[5] Ibid, paras 29, 30.

[6] (1975) 101 ITR 234.

[7] (1976) 1 SCC 324.

Issuance of Shares and Transfer Pricing: An Analysis of Vodafone India Services Pvt. Ltd. v. Union of India & Ors – Part II

In the last post we saw that issuance of shares cannot be subjected to transfer pricing provisions of Income Tax Act. Continuing from this, in this post I will discuss hypothetical stimulation of arguments on merits of the Vodafone judgement. In this regard, two issues are discussed viz. first, whether Revenue was right in making the addition of notional interest by treating the addition on the subscription of the shares as deemed loan. Second, whether the Discounted Cash Flow (DCF) is the most appropriate method for the valuation of the shares or Net Asset Value (NAV).

Before doing so, it is notified that relying on Vodafone judgement, a Mumbai High Court bench of justices M S Sanklecha and SC Gupte on a petition filed by Shell India Markets upheld that issuance of share does not generate ‘income’. It is anticipated that Revenue is likely to approach Supreme Court. In this context, the arguments on merits become significant as even if SC overrules Shell India, revenue would not be able to impose notional interest.

Whether Revenue was right in making the addition of notional interest by treating the addition on the subscription of the shares as deemed loan.

An adjustment for the notional interest by re-characterization of equity into debt (as done in the present case) is referred to as “secondary adjustment” in the parlance of Transfer Pricing. Secondary adjustment creates a constructive transaction such as constructive loan, constructive dividend, constructive equity distribution etc.

With respect to applicability of secondary adjustment principles, the OECD has clarified in its commentary on Article 9 of the model treaty convention that sovereign countries can opt for secondary adjustments, if permissible under their domestic tax laws. Following this view, Canada, Korea, South Africa, 9 EU members (Austria, Bulgaria, Denmark, Germany, France, Luxemburg, Netherlands, Slovenia and Spain) have incorporated such provision in their respective taxing statute.

Currently, India does not have any express or specific provision for inflicting the secondary adjustment in Transfer Pricing rules and therefore the TPO/AO cannot impose notional interest by treating alleged unpaid money as loan. This view was recently confirmed by Mumbai ITAT tribunal in PMP Auto Components Pvt. Ltd. v. DCIT.[1]

However, it must be noted that re-characterization is permissible under Chapter X-A (General Anti-Avoidance Rules) of the Income Tax Act which is not in force yet. It would be interesting to see whether GAAR being a general law on tax-avoidance can capture transactions held permissible by Specific Anti-Avoidance Rule i.e. Transfer Pricing (Chapter-X).

Levy of penalty under section 271G by transfer pricing officers

Assuming the said transaction between V-India and V-Mauritius is hit by TP, the appropriate recourse of by the Assessing Officer or the Commissioner (Appeals) should have been levy of penalty under Section 271G of the Act and not secondary adjustment. [Finance (No. 2) Act, 2014 has amended section 271G to include Transfer Pricing Officer in addition to AO or Commissioner. This amendment will take effect from 1st October, 2014.]

V-India as against these penalties would have been validly arguing that arm’s length price was calculated in good faith and due diligence was taken while using NAV method for valuation of shares. With this I move on to the next issue regarding appropriate method for valuation of shares.

Whether the Discounted cash Flow is the most appropriate method for the valuation of the shares or Net Asset Value

 In case of long-term investment in the 100% subsidiary (as opposed to investment for capital gains), the valuation should be future prospective earning on the capital and should not be based on the present net worth of the subsidiary. This contention was accepted by the Mumbai ITAT tribunal in PMP Auto Components Pvt. Ltd. v. DCIT.[2] In this respect the Revenue was correct in applying DCF method as opposed to NAV. However, DCF method is surrounded by the clouds of legal uncertainty as it works on too many unruly economic assumptions. Consequently, it's vires may be challenged on the basis of arbitrary exercise of power.

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[1] [TS-263-ITAT-2014(Mum)-TP]

[2] Id.

Issuance of Shares and Transfer Pricing: An Analysis of Vodafone India Services Pvt. Ltd. v. Union of India & Ors – Part I

In this post, I will discuss judgement of High Court of Bombay in the case of Vodafone India Services Pvt. Ltd. v. Union of India & Ors[1] wherein it ruled that transaction of issuance of shares cannot be subjected to Transfer Pricing (TP) provisions of Income Tax Act. The judgement is important for Nokia, Shell India, WNS and 24 other companies who have the similar dispute with the Revenue.

It is important to state that High Court restricted its judgement to jurisdictional issue and did not go into merits of the case. In the next post, I will deal with hypothetical stimulation of arguments on merits of the case. In this regard, two issues will be discussed viz. first, whether Revenue was right in making the addition of notional interest by treating the addition on the subscription of the shares as deemed loan. Second, whether the Discounted Cash Flow (DCF) is the most appropriate method for the valuation of the shares or Net Asset Value (NAV).

Coming back to discussion on the judgement.

Facts of the Case

In August 2008, Vodafone India Services Private Limited (V-India), a wholly owned subsidiary of Mauritian entity Vodafone Tele-Services (India) Holdings Ltd. (V-Mauritius), issued 289,224 equity shares of face value of Rs. 10 each (applying NAV) at a premium of Rs. 8,591 per share to its holding company. On the issuance of these shares, V-India received a total consideration of Rs.246.38 crores from its holding company.

According to Assessing Officer (AO) and Transfer Pricing Officer (TPO) ought to have valued each equity share at Rs.53,775/- (applying DCF) and on that basis shortfall in premium to the extent of Rs.45,256/- per share resulted into total shortfall of Rs.1308.91 crores.

Both the AO and the TPO on application of the Transfer Pricing provisions in Chapter X of the Income Tax Act, 1961 held that this amount of Rs.1308.91 crores is income. Further, as a consequence of the above, this amount of Rs.1308.91 crores was treated as deemed loan given by the V-India to its holding company and notional interest thereon was charged to tax as interest income.

Vodafone India challenged the jurisdiction of AO or TPO under Article 226 of the Constitution.

Issue

Whether AO or TPO has jurisdiction to apply Transfer Pricing provisions in the present case. The answer to this issue boiled down to the question whether share subscription generates any income under Section 92 of the Income Tax Act.

V-India’s Arguments

    1.  ‘Income’ as under Section 92 must be interpreted as per Section 2(24)

To tax a receipt, requirement of Section 2(24) which defines income must be satisfied. The term ‘income’ as noted in Section 92 cannot be interpreted in isolation of Section 2(24).

    2.  Capital Receipt is not taxable except expressly provided

Capital receipts cannot be brought to tax unless specifically/expressly brought to tax by the Act. It is well settled that capital receipts do not come within the ambit of the word 'Income' under the Act, save when so expressly provided as in the case of Section 2(24)(vi) of the Act. This brings capital gains chargeable under Section 45 of the Act, to tax within the meaning of the word ‘Income’.

    3.   Present transaction does not attract Section 45

Section 45 is applicable in case of transfer of property. However, issuance of shares is creation of property.

   4. Section 56(2)(viib) is not attracted

Definition of ‘Income’ in Section 2(24)(xvi) of the Act includes in its scope amounts received arising or accruing within the provisions of Section 56(2)(viib) of the Act. However, reliance in the present case cannot be placed as it is applicable only with respect to issue of shares to a resident.

Further, Section 56(2)(viib) taxes consideration received in excess of fair market value the shares and not the alleged short-fall in the issue price of equity shares.

    5.   Sub-section (c) and (e) of Explanation (i) to Section 92B is not attracted

Explanation (i)(c) to Section 92B of the Act only states that capital financing transaction such as borrowing money and/or lending money to AE would be an International Transaction. However, what is brought to tax is not the quantum of amount lent and/or borrowed but the impact on Income due to such lending or borrowing. This impact is found in either under reporting/over reporting the interest paid/interest received etc., Similarly, Explanation (i)(e) to Section 92B of the Act, which covers business restructuring would only have application if said restructuring/reorganizing impacts income.

    6. Section 92(2) is not attracted

Section 92(2) deals with costs or expenditure allocated or apportioned between two or more Associated Enterprises. Section 92(2) only ensures that profits are not understated nor losses over stated by disclosing higher cost or expenditure, then the benefit received.

    7.  Assumption that short-fall money could have been invested and thereby generated income is not sustainable

Revenue’s Arguments

    1.  Subject matter of tax is cost incurred by V-India in passing of benefit to V-Mauritius

The subject matter for meaning of income under Chapter X is not share premium but is the cost incurred by V-India in passing on a benefit to its holding company by issue of shares at a premium less than arm’s length price. The accruing benefit to V-Mauritius here is its valuation in the international market by taking undervalued shares of V-India., by increasing the real net worth of the V-Mauritius.

    2.   Reading 92 with its corresponding provision in 1922 Act implies that profit which one would have normally made but did not make because of one’s close association with a non-resident are to be taxed [Mazagaon Dock Ltd. v. CIT, (1958) 34 ITR 368].

    3. Total income includes prospective income

‘Any income’ in Section 92(1) is not restricted to actual income. It includes income which could accrue by premium not received by V-India.

   4.  Charging Section is inherent in Chapter-X, therefore ‘income’ as in Section 92 has different connotations then income as in Section 2(24).

    5. Passing of benefit is covered under Section 56(1)

Even if there is no separate head of income under Section 14 of the Act in respect of International Transaction, such passing on of benefit by the Petitioner to its holding company would fall under the head ‘Income’ from other sources under Section 56(1) of the Act.

    6. ‘Income’ for TP provisions must be given broad interpretation

Charging provision (§ 4) creates charge in respect of the total Income. In the Scope of total income, Section 5 include all Income from whatever source which is received or accrues or arises or deemed to be received, accrued or arisen would be a part of the total Income. Thus, income is to be interpreted in a broad context.

Decision

The Court found based on the interpretation of section 2(24) of the IT Act that “income will not in its normal meaning include capital receipts unless it is so specified, as in Section 2(23)(vi) of the Act.” An issue of shares is a transaction on the capital account, the premium cannot be treated as income. The Court drew a contrast with Section 56(2)(viib) of the Act where a capital transaction is deemed by legal fiction to amount to income. However, that provision applies only to premium received from a resident and that too where that premium is in excess of the fair market value of the shares. Further, Section 56(2)(viib) governs an actual receipt of the excess of amount, whereas in the present case there is only an imputed amount of the difference without any actual receipt. Thus, issuance of share in international transaction does not find its place in any charging provision of the statute.

Court rejected argument of Revenue that for the purposes of TP provisions ‘income’ should be interpreted in isolation of Section 2(24). It held that even income arising from international transaction must satisfy the test of 'income under the Act and must find its home in one of the heads of income in the charging provisions viz. Sections 4, 5, 15, 22, 28, 45, 56. Further, Chapter-X of the Act is a machinery provision to arrive at the arm’s length price of a transaction, it does not have any specific head of income.

Analysis

To be very precise, investor-friendly, legal certainty, adherence to plain and strict interpretation, rejection of object and purpose of the statute are the ornaments of the judgements. The Court appropriately reiterated that in a taxing statute it is not possible to assume any intention or purpose of the statute more that what is stated by the black letter. It is not the economic results sought to be obtained by making the provision which is relevant in interpreting a fiscal statute. Further, treating issuance of shares as income without backing of any express provision would have amounted to filling the casus omissus which is impermissible.

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[1] 2014 SCC OnLine Bom 1496.

Priority of Lien Holder's claims as against the Dues to Income Tax Authorities over the proceeds from the security deposited

The Stock Exchange v. V.S. Kandalgaonkar[1] [Full Bench]

Background of the Case

The case pertains to the Income Tax Authorities’ right to recover its dues from an assessee (defaulter declared by the Stock Exchange) by having a first claim over the amount realized by the Stock Exchange at the auction of the Membership Card of such defaulter.

I. Contentions

Ø  Appellant’s Contentions

§  That the membership card is only a personal privilege granted to a member that cannot be attached by the Income Tax Department at any stage. The moment a member is declared a defaulter all rights qua the membership card of the member cease and even his right of nomination vests in the Stock Exchange.

§  That a conjoint reading of Rules 38 with 44 of the Rules made by the Stock Exchange shows that the security in form of shares that are given by a member is transferred and held either in the name of the trustees of the Stock Exchange or in the name of a Bank which is approved by the Governing Board. Therefore, the member is no longer an owner, consequently the Income Tax Department cannot lay hands on these shares or its sale proceeds as the member ceases to have ownership rights of these shares.

§  That by virtue of Rule 43, the Stock Exchange has a first and paramount lien for any sum due to it, and that this made it a secured creditor so that in any case income tax dues would not to be given preference over dues to secured creditors.

Ø  Respondent’s Contentions

§  That the High Court’s reasoning is correct where it had held that though a defaulting member had no interest in a membership card and that the Income Tax Department was not right in attaching the sale proceeds of such card, still money which is likely to come in the hands of the garnishee, that is the Bombay Stock Exchange, for and on behalf of the Assessee is attachable because the requisite condition is the subsistence of an ascertained debt in the hands of the garnishee which is due to the Assessee, or the existence of a contractual relationship between the Assessee and the Stock Exchange consequent upon which money is likely to come in the hands of the garnishee for and on behalf of the Assessee

§  That a conjoint reading of rules made by the Stock Exchange makes it clear the expression “transferred” would not refer to transfer of ownership but would refer only to the delivery made of shares for the purpose of realization in case a member defaults.

§  That the mere fact that a lien was provided in the Rules did not make such lien a statutory lien and that therefore Government dues would have a first preference over all the dues of the Stock Exchange.

II. Relevant Provisions

Ø  Income Tax Act

§  Section 226 3 (i) The assessing officer or tax recovery officer may, at any time or from time to time, by notice in writing require any person from whom money is due or may become due to the Assessee or any person who holds or may subsequently hold money for or on account of the Assessee, to pay the assessing officer or tax recovery officer either forthwith upon the money becoming due or being held or at or within the time specified in the notice (not being before the money becomes due or is held) so much of the money as is sufficient to pay the amount due by the Assessee in respect of arrears or the whole of the money when it is equal to or less than that amount:

§  Rule 26 of Schedule II of the Income Tax Act then provides Debts and Shares, etc. - (1) In case of

(a) a debt not secured by a negotiable instrument… c) other movable property not in the possession of the defaulter…the attachment shall be made by a written order prohibiting, (i) in the case of the debt - the creditor from recovering the debt and the debtor from making payment thereof until the further order of the tax recovery officer…(iii) in the case of the other movable property (except as aforesaid) - the person in possession of the same from giving it over to the defaulter.

Ø  Securities Regulation Act, 1956

§  Section 9. Power of recognised stock exchanges to make bye-law- (1) Any recognised stock exchange may, subject to the previous approval of the Securities and Exchange Board of India, make bye-laws for the Regulation and control of contracts.

Ø  Rules made by the Stock Exchange

§  Rule 5. Membership a Personal Privilege- The membership shall constitute a personal permission from the Exchange to exercise the rights and privileges attached thereto subject to the Rules, Bye-laws and Regulations of the Exchange.

§  Rule 7. Right of Nomination- Subject to the provisions of these Rules a member shall have the right of nomination, which shall be personal and non-transferable.

§  Rule 9. Right of Nomination of Deceased or Defaulter Member- On the death or default of a member his right of nomination shall cease and vest in the Exchange.

§  Rule 10. Forfeited or Lapsed Right of Membership- When a right of membership is forfeited to or vests in the Exchange under any Rule, Bye-law or Regulation of the Exchange for the time being in force it shall belong absolutely to the Exchange free of all rights, claims or interest of such member or any person claiming through such member and the Governing Board shall be entitled to deal with or dispose of such right of membership as it may think fit.

§  Rule 16. Allocation in Order of Priority- When as provided in these Rules the Governing Board has exercised the right of nomination in respect of a membership vesting in the Exchange the consideration received therefore shall be applied to the following purposes and in the following order of priority namely-…(iii) the payment of the surplus if any to the funds of the Exchange: provided that the Exchange in general meeting may at its absolute discretion direct that such surplus be disposed of or applied in such other manner as it may deem fit.

§  Rule 37. Form of Security- The security to be furnished by a member shall be provided either by a deposit of cash or it may be provided in the form of a Deposit Receipt of a Bank approved by the Governing Board or in Securities approved by the Governing Board subject to such terms and conditions as the Governing Board may from time to time impose…

§  Rule 38. Security How Held- Deposits of cash shall be lodged in a Bank approved by the Governing Board and Bank Deposit Receipts and securities shall be transferred to and held either in the names of the Trustees of the Exchange or in the name of a Bank approved by the Governing Board and lodged with a Bank approved by the Governing Board. Such deposit shall be entirely at the risk of the member providing the security but it shall be held by the Bank solely for and on account of the Exchange at the absolute discretion of the Exchange without any right whatever on the part of such member or those in his right to call in question, the exercise of such discretion.

§  Rule 41. Change of Security- A member may withdraw any security provided by him if he first provides in lieu thereof other security of sufficient value to the satisfaction of the Governing Board.

§  Rule 43. Lien on Security- The security provided by a member shall be subject to a first and paramount lien for any sum due to the Exchange or to the Clearing House by him or by the partnership of which he may be a member and for the due fulfillment of his engagements, obligations and liabilities or of the partnership of which he may be a member arising out of or incidental to any bargains, dealings, transactions and contracts made subject to the Rules, Bye-laws and Regulations of the Exchange or anything done in pursuance thereof.

§  Rule 44. Return of Security- On the termination of his membership or on his ceasing to carry on business on the Exchange or on his working as a representative member or on his death all security not applied under the Rules, Bye-laws and Regulations of the Exchange shall at the cost of the member be repaid and transferred either to him or as he shall direct or in the absence of such direction to his legal representatives.

Ø  Bye- Laws made by the Stock Exchange

§  Rule 326. Defaulter’s Assets- The Defaulters’ Committee shall call in and realise the security and margin money and securities deposited by the defaulter and recover all monies, securities and other assets due, payable or deliverable to the defaulter by any other member in respect of any transaction or dealing made subject to the Rules, Bye-laws and Regulations of the Exchange and such assets shall vest in the Defaulters’ Committee for the benefit and on account of the creditor members.

III. Issues

1.     Whether the membership card is a privilege or a right for the defaulting member.

2.     Whether in the Chapter entitled ‘Membership Security’, the phrase “securities shall be transferred to and held” in Rule 38, means a mere transfer of possession of security or transfer of ownership of security. In other words, whether the security furnished by the member (in form of shares in the present case), remains in his/her ownership or the ownership rests with the person keeping the ownership.

3.     Whether the government debts have precedence over secured creditors.

4.     What is the nature of the lien under rule 43, i.e., whether it is a statutory lien or a lien under an agreement of furnishing a security.

5.     Whether the lien under Rule 43 makes make the Stock Exchange a secured creditor.

IV. Judgment on the Issues

On Issue 1

The Court held that a conjoint reading of Rules 5 and 9 leads to the conclusion that a membership card is only a personal permission from the Stock Exchange to exercise rights and privileges, which can be taken away along with the right of nomination from the defaulting member. The Court here distinguished between any accrued right to that of any privilege. In its opinion, the member only had a privilege and not an accrued right to property. The Court, by relying on the Ahmedabad Stock Exchange case[2] where it had held that the membership under the above mentioned rules is merely a personal privilege granted to a member and is non- transferrable and incapable of alienation by the member and concluded that once a right of nomination vests in the Stock Exchange under the Rules, that right belongs to the Stock Exchange absolutely.

The Court also noticed that whenever under Rule 16 (iii) the Governing Board exercises the right of nomination in respect of a membership which vests in the Exchange, the ultimate surplus that may remain after the membership card is sold by the Exchange comes only to the Exchange - it does not go to the member. This shows that the member does not have any right to property.

On Issue 2

The Court construed the expression “securities shall be transferred to and held” so as to be providing only for transfer by delivery of security to the Stock Exchange, while the ownership still remains with the member. For that it noted, amongst other reasons, that (i) the expression “transferred” must take colour from the expression “lodged” in Rule 38 when it came to deposits of cash. So, when understood in this sense, transfer only means delivery for the purposes of holding such shares as securities, (ii) the language employed in Rule 38 states “such deposit shall be entirely at the risk of the member providing the security…”, which shows that the deposit of cash or security is entirely at the risk of the member who provides the security. Thus, making it clear that such member continues to be the owner of the said shares by way of security for otherwise they cannot possibly be at the member’s risk, (iii) Rule 41 allows a member to withdraw any security provided by him if he satisfies the conditions of the Rules, (iv) Rule 43 provides for a lien on securities to the Stock Exchange. Such a lien is only compatible with the member being owner of the security, for otherwise no question arises if the Stock exchange (as contended by ld. Counsel for appellants) is the owner of the security.

On Issue 3

The Court while noting that the Income Tax Act itself does not provide for any paramountcy of dues by way of income tax, cited with approval the judgment in the case of Dena Bank v. Bhikabhai Prabhudas Parekh Co,[3] where it was held that the common law of England or the principles of equity and good conscience (as applicable to India) do not accord the Crown a preferential right for recovery of its debts over a mortgagee or pledgee of goods or a secured creditor. Here, Article 372 of the Constitution of India is relevant where the common law of England qua Crown debts becomes applicable to our jurisdiction. In fact, in the case of Collector of Aurangabad and Anr v. Central Bank of India and Anr[4] the Court held that the claim of the Government to priority for arrears of income tax dues stems from the English common law doctrine of priority of Crown debts and has been given judicial recognition in British India prior to 1950 and was therefore “law in force” in the territory of India before the Constitution and was continued by Article 372 of the Constitution. However, such right of priority of Government dues only extends to priority over unsecured debts.

On Issue 4

The Court chose not to address the issue of whether the lien provided under the Rule 43 made by the Stock Exchange is a statutory lien or a lien under an agreement. Therefore, the Contention (iii) of the respondent’s was not relevant. The Court stated that the precedents cited by the respondent’s counsel for the proposition that the statutory lien is a paramount lien only which can override the claims of all other creditors including secured creditors, is not in issue in the present case. Since, to overrule the Income Tax Department’s decision of claiming priority of Government debt over the Stock Exchange’s claims, would only require to prove that the Stock Exchange’s claims make it a secured creditor.

On Issue 5

The Court here referred to the judgment in the case of K.S. Saradambal v. Jagannatham K Brothers[5], where on a consideration of Section 529 of the Companies Act 1956 read with the relevant provisions of the insolvency law, came to the conclusion that the holder of a statutory lien or the holder of a lien created by contract and registered as required by Section 125 is a secured creditor in the matter of winding up of the insolvent company with regard to, among other things, debts provable in the winding up proceedings.

Explaining the meaning of the term ‘lien’ which is the right to retain possession of a thing until a claim be satisfied which is either particular or general,[6] the Court noted that a secured creditor is one, who has some mortgage, charge or lien on the company’s property. Therefore, a solicitor who holds a lien on documents of a liquidating company for his costs against the company is a secured creditor, and must mention his lien in his proof.[7]

Therefore, the Court concluded that the Stock Exchange being the one holding a lien (irrespective of the fact whether it is a statutory lien or lien by agreement) is a secured creditor and consequently has higher claim over the government’s debts.

V. Conclusion

So, the Court has held that the TRO was not right in attaching the sale proceeds of the nomination rights of the Defaulter-Member’s membership card as the ownership of such nomination rights and the membership card were on default vested in the Stock Exchange and not the defaulter. Since, the membership rights were only a privilege and can be taken away, there was no accrued right to the member. Also, the surplus that may remain after the membership card is sold by the Exchange comes only to the Exchange and does not go to the member as per Rule 16 (iii).

The Court further held that under Rule 43 the security provided by a member should be subject to the paramount lien for any sum due to the Exchange or to the Clearing House, then, the Income Tax Department can recover its dues.

The Court in that regard rejected the submission of the appellant’s seeking to avoid any recovery by the Income Tax from the security transferred by him to the Stock Exchange on the ground that he had transferred the ownership of thing given in security to the Stock Exchange and the Stock exchange after clearing all debts should transfer back the assets to him or his representative, and consequently concluded that the said security still remained in the member’s ownership.

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[1]  Civil Appeal No. 4354 of 2003, Decided On: 25.09.2014.

[2] 2001 (3) SCC 559.

[3] 2000 (5) SCC 694.

[4] 1967 (3) SCR 855.

[5] (1972) 42 Companies Case 359.

[6] Stroud's Judicial Dictionary, third edition, at page 1644.

[7] Palmer's Company Law, 21st edition, at page 765.