More Uncertainty in the Law on Penalties

Earlier posts have noted and examined a few recent decisions of the Supreme Court and the ITAT on the law governing the imposition of penalties under the Income Tax Act, 1961. In what is perhaps the best restatement of the position of law today, the Pune Bench of the ITAT appears to have altered the course of the law back towards the assessee-friendly Dilip Shroff decision, in Kanbay Software India Pvt. Ltd. v. DCIT (ITA 300/PN/07, decided on 28 April, 2009). A copy of the judgment is available here.

The events leading up to this judgment have generated controversy primarily because there is uncertainty as to the position of law today, although the Supreme Court in Union of India v. Dharmendra Textile Processors overruled its judgment in Dilip Shroff, since it was not clear to what extent Dilip Shroff has been overruled and in what context the requirement of mens rea had been dispensed with. To briefly summarise, s. 271(1)(c) provides that a penalty may be levied on the assessee if he either conceals the particulars of his income, or has furnished inaccurate particulars of his income. The question that arose was whether s. 271(1)(c) had a mens rea requirement – i.e. was it required to be established that the assessee consciously furnished inaccurate particulars or was the mere fact sufficient? In Dilip Shroff, the Supreme Court answered this question in favour of the assessee, holding that since s. 271(1)(c) is a quasi-criminal provision, this was required to be established and that the burden of proof was on the Revenue. Two months after it was decided, another Division Bench of the Supreme Court expressed reservations over its correctness and referred the matter to a larger Bench. The larger Bench held in Dharmendra Textiles that s. 271(1)(c) was not a penal or quasi-criminal provision, but one that fastened a penalty for the breach of a civil obligation, for which it is not necessary to establish mens rea. To this extent, Dilip Shroff was overruled.

Difficulty arose in the application of the Supreme Court’s judgment in Dharmendra. Complaints from across the country suggested that the Revenue was reading the judgment to suggest that every case where the Assessing Officer differed with the assessee on the returns was one fit for the imposition of penalties, even if the difference pertained to a matter of opinion where it was possible to take two views. The facts of the decision in Kanbay Software illustrate this. Kanbay Software Pvt. Ltd. [“KSPL”] is a company engaged in the business of development and export of software, and maintained two units. KSPL set off the losses of the second unit against the profits of the first and claimed deduction under s. 10A of the Income Tax Act. After the Finance Act, 2003 retrospectively amended portions of this provision, KSPL filed revised returns seeking to carry forward unabsorbed losses and depreciation in respect of the second unit, amounting to a total of about Rs. 5.37 crore. However, the Assessing Officer held that the unabsorbed losses and depreciation of one unit had to be set off against the profits of the other unit before deduction under s. 10A, with the result that no loss could be carried forward. KSPL accepted this finding, filed no appeal, and the order became final. However, the Assessing Officer initiated penalty proceedings under s. 271(1)(c), found that KSPL had “furnished inaccurate particulars”, and levied a penalty of Rs. 2 crore.

In appeal before the ITAT, submissions were invited on the true nature and scope of the decision in Dharmendra Textile Processors. The Revenue argued that the effect of the judgment was that penalty is almost an automatic addition to the income of the assessee, and urged the Tribunal to give effect to this judgment, especially since Dilip Shroff had been widely followed. In rejecting this argument, AM Pramod Kumar has carefully considered and explained the import of the judgments on this point. He noted, correctly, that the primary point on which Dilip Shroff had been overruled was its characterization of s. 271(1)(c) as a “penal” or “quasi-criminal provision”. However, a “civil obligation” is not necessarily one that automatically imposes penalty in the nature of additional income. The Tribunal therefore held that for the “civil obligation” imposed by s. 271(1)(c) to be considered to have been “breached”, it is not sufficient to merely show that there is a disagreement between the returned income and the assessed income. Reference was made to the provisions of s. 139 of the Act. S. 139 specifies the form and procedure of filing returns, and was held to imply that the only civil obligation on the assessee is to furnish returns which are correct and complete “to the best of [his] knowledge and belief”. The following observations are relevant:

“An
 addition 
to
 income
 does 
not 
always 
have 
a
 cause
 and
 effect
 relationship
 with
 the
 discharge
 of
 assessee’s
 obligations
 under
 section 
139(1), 
because
 even 
when
 an
 assessee 
duly 
discharges 
his 
obligations 
under 
section 
139(1), there can still be additions to, 
or 
disallowance
 from, 
 the
 returned
 income
 due
 to
 a
 variety
 of
 reasons, 
viz.
 genuine
 variations
 in
 perceptions
 of
 the
 assessee
 vis‐à‐vis
 the 
Assessing
 Officer
 about
 a
 legal
 interpretation, 
 the
 changes
 in
 judge 
made 
or
 statute
 law 
between
 the 
period 
when
 an
 income
 tax
 return 
is 
filed 
and 
when
 the 
assessment 
is 
framed, extraneous factors affecting ability of the assessee
 to
 establish
 certain
 facts
 based
 on
 which
 deductions
 are
 claimed, 
 and
 even
 plain
 inadvertent
 clerical
 errors.”

The Tribunal went on to hold that Dilip Shroff had been reversed not on the question of whether this additional requirement was part of s. 271(1)(c), but on who the burden of establishing it lies. In sum, the Tribunal held that there are three possible situations where the question of penalty could arise – (a) where the addition to income is clearly because of the assessee’s contumacious conduct; (b) where it is not possible to establish that the addition is on account of the assessee’s contumacious conduct and (c) an addition is made, but the assessee is able to establish his innocence with a bona fide explanation. In the first case, penalty was always leviable, and this has not changed. In the third case, penalty was never leviable and the ITAT held that this continues to be the position. The law has therefore changed only with respect to the second situation – earlier, the Department was required to establish the link between the added income and his contumacious conduct. Now, the onus of proof is on the assessee.

It is unlikely that the last word has been spoken on this subject. Despite the ITAT’s very carefully reasoned and correct judgment, it does not sit entirely comfortably with Dharmendra Textile Processors, and may therefore only be one of the first chapters in this story.