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Taxation and Economic Reforms
by Justice S.H. Kapadia

Cite as : (2004) 6 SCC (Jour) 13

I. Introduction

The main thrust of my speech today is: economic development. This is the main issue which we should all adhere to. India has talent but it is diverted to non-issues. Globalisation has helped India because it has made India one of the fastest-growing knowledge economies. Our younger generation has a potential in the knowledge sector. We have done well in IT sector, financial management, corporate governance and in the business of outsourcing. However, we need foreign direct investment to the extent of $ 8 billion per annum. In this regard, we have to take the following steps like removal of restrictions on entry of capital, ownership and access to industries, entering into investment treaties with developed countries, development of infrastructure, improvement in telecommunications, removal of tariff barriers, etc. At this stage, I would like to mention that with globalisation coming into India, new concept of cross-border acquisition, cross-border takeovers and cross-border mergers have got to be understood. It is for this reason that I would like to emphasise commercial concepts as against juristic concepts. However, globalisation has ill-effects. On one hand it has helped corporate governance; it has increased corporate profits and has increased foreign exchange reserves of India to Rs 106 billion but on the other hand it has also led to bio-piracy of plants, herbs and crops and to exploitation of developing countries. We should, therefore, understand and expand our knowledge of laws dealing with patents, intellectual property rights, transfer-pricing, acquisitions, mergers, etc. Today, we have new laws like the Competition Act, Regulatory Acts, etc. which warrant our knowing new concepts. Once we understand these important new concepts, we can proceed further in every sphere of life and contribute to economic development of India. Therefore, I would like to focus on democratic governance of India which would bring economic development; financial prosperity and ethical morality to this country. However, before going into this concept of democratic governance, we should understand our main economic problems.

II. Economic survey

During the period 1-4-2003 to 31-12-2003, companies have paid taxes exceeding budget target by Rs 20,000 crores. We are expecting this year an annual growth of 7% to 8%. Manufacture recorded growth of 6.2% over the previous year. Service sector has recorded a growth of 10.7% over the last year. Agriculture recorded growth of 7.4% over the last year. India’s foreign exchange reserve as on 20-2-2004 is Rs 106 billion. Household sector has recorded a growth from 17.6% to 22.8% GDP during 1997-98 to 2001-02. One of the major contributories for this achievement apart from good monsoon has been globalisation. I see great hope in future in the service sector to contribute the maximum to our economy.

The only problem which our country is facing today is inflation which is 10% (gross) of GDP. Our fiscal deficits are increasing. On 31-12-2003 fiscal deficit was Rs 93,000 crores which is 67% of the budgeted deficit. Revenue deficits of some of the States have crossed 50% of their respective GDP. Because of inflation, the money supply in economy is growing by leaps and bounds. On account of the huge fiscal deficit, inflation is rampant. The above data shows that government governance is not improving as compared to corporate governance. Our capital output ratio needs to improve. The main problem in poor government governance is poor expenditure management. We need to introduce proper accounting systems as far as public finances are concerned.

III. Democratic governance — meaning of

What we need is democratic governance which is a concept wider than democracy conceived by electoral ballot. Governance includes financial accountability and transparency. It covers performance of democratic duties of open government. Governance is not government. A good governance cannot be at the expense of democracy. It is the duty of the State authorities including judiciary, in a democracy, to stand up and protect fundamental rights, sometimes even against majority opinion. Industrialists and businessmen demand stability before they invest and the key element is stability based on the rule of law. They need an assurance that their investments will be protected. The full inclusive view of democracy will not bring in only material wealth, but also ethical values.

IV. Concepts and their importance


A. Events are facts that happen in the real world. They are not concepts and, therefore, all rights, personal and proprietary, arise from events. Example, a loan is an event. It generates rights. Similarly, mistaken payment is also an event. Law is a response to events. It responds to events by creating rights and obligations. A right in rem is an intellectual construction. It is not empirical. An asset exists in real world, but not a right in rem. A right in rem is a legal concept created and defined by law. Therefore, a response cannot be an event. Law is an interpretation of an event. The right to compensation arises from interference with the property rights of the claimant whereas right to restitution arises from unjust enrichment of the defaulting party on account of receipt of value inherent in the asset in respect of which the claimant has a right in rem. Legal rights and duties do not arise from events, but from interpretation of those events within the intellectual framework of law (concept). Therefore, the fundamental role of a concept like intention, mistake, etc. is to explain the source of rights and duties. To take an example, receipt of money under mistake will not give to the claimant a right of restitution although receipt of money under mistake is an event. In the case of restitution, mere right of payment under mistake is not enough for the claim to succeed. For the claim to succeed, the fact of receipt should be coupled with interpretation of the circumstances which would justify restitution. Therefore, occurrence of an event will not give rise to obligation to pay. It will depend on the interpretation of the occurrence within a framework, namely, obligation to repay what is not due to you.


Therefore, according to Birks legal rights and duties do not arise from bare facts, but from interpretation of those facts. Similarly, rights and duties do not arise from existence of facts like consent/payment, but they arise from legal interpretation of those facts such as mistaken payment or existence of a contract. Hence, contract, mistaken payments, duty to take reasonable care, rights in rem are legal facts.

V. Commercial concepts under the law of taxation

In the words of Holmes, J. “Taxes are what we pay for a civilised society”. I have emphasised the term “concept” because in my view one cannot appreciate laws of taxation, constitution, competition laws, convergence laws, NPA Act, 2002, etc. without understanding the basic concepts of accountancy, economics, finance, statistics, commerce and law.

Tax laws have to apply the concepts contained in the tax laws to the facts created by taxpayer. In the past courts were not required to study and apply principles of accountancy, knowledge of economics and finance in deciding matters under the Income Tax Act or Excise Act. Today, the situation has changed. Every judge sitting in constitutional matters, tax matters, matters relating to economic offences should have basic knowledge of concepts, like economics, finance, accountancy. This is the reason why I have emphasised concepts in my introduction because without clarity and understanding of legal concepts which are legal facts, it would not be possible for a judge to understand the consequences of his orders and he will not be able to appreciate the case before him. Under the Income Tax Act, an assessee is entitled to organise his business. He is entitled to plan his business. Tax planning is one of his tools. On the other hand, the Department will endeavour to increase tax revenue. It is this conflict which has led to the judgment of the Supreme Court in McDowell case1. It is this conflict which started in England prior to 1982 and which ultimately resulted in formulation of a principle called as “Ramsay principle” which has been laid down in the case of W.T. Ramsay v. IRC2. This judgment is important because it lays down for the first time the difference between juristic concept and commercial concept in the matter of interpretation of tax laws. However, Ramsay case2 is an illustration where a scheme formulated by an assessee as a tax-planning measure is termed as tax-avoidance scheme. This conclusion is arrived at by applying strict rule of interpretation i.e. juristic concept which is generally so in all tax laws. In Ramsay case2, therefore, the juristic concept prevailed over the commercial concept. This position has continued up to 2001. However the House of Lords watered down Ramsay’s principle of interpretation in the case of Macniven (Inspector of Taxes) v. Westmoreland Investments Ltd.3 In this case, WIL was a company with huge losses. It had several shareholders. One of the shareholders was a pension fund. WIL owed to the pension fund by way of interest £ 70 million. The liability of WIL exceeded its assets. However, WIL had a potential asset, namely, tax losses in its hands. At this stage, I may clarify that under the Income Tax Act, the concept of asset generally means what is receivable. However, it can include in a given case a loss for which an assessee can make adjustments against his future profits. WIL, therefore, had in its accounts what is called as tax losses. There were several buyers of WIL provided WIL was able to discharge its interest liability to the pension fund amounting to £ 70 million because the buyers had profits in their accounts. They were eager to take advantage of adjustment of tax losses against their profits. The trustees of the pension fund had an idea. They gave a loan to WIL of £ 70 million and WIL used that amount to repay its loan to the tune of 70 million pounds after deducting TDS. Under Section 338 of the Income Tax Act, TDS was payable by the borrowers as and when they paid interest to the creditor. However, Section 338 exempted pension funds from payment of TDS. Therefore, WIL initially paid TDS on the repayment of interest, but the pension fund claimed refund from ITO stating that tax was not payable by the pension fund. This led to dispute. ITO took the view that this was a case of circular trading because there was no real flow of cash between the parties. That the interest liability of WIL was replaced by additional capital liability. That the entire arrangement was to evade tax. ITO relied upon Ramsay principle. However, the House of Lords took the view for the first time that while interpreting the tax law, one has to take into account, the commercial concept and not the juristic concept of income/profits. That the source from which WIL repaid loan/debt was immaterial. That there was nothing in Section 338 of the Income Tax Act of England to suggest that source from which the debt is discharged is relevant. That under Section 338, payment of interest by the borrower had an advantageous tax consequence of constituting a charge on income. That the transaction was circular trading. That WIL had borrowed capital and had paid it back as interest and the only purpose was to produce an allowable deduction under the tax law. In this case, the argument of the Department was that the transaction was real; it was not a sham, but it was not for commercial purpose. This point is very important. There is a difference between a pretence and a transaction which is real. In McDowell case1, the Supreme Court took the view that the transaction was a sham whereas in the case of Westmoreland Investments Ltd.3, the House of Lords took the view that the transaction was real and not a pretence. The Department in WIL case3 stated that although the transaction was not a pretence, it was not for a commercial purpose, but it was for tax avoidance. Therefore, the effect of the transaction was in issue and, therefore, the House of Lords applied the commercial concept and not the legal concept.

To the same effect is the ratio of the judgment of the Supreme Court in the case of: (i) Union of India v. Azadi Bachao Andolan4, and (ii) American Express International Banking Corpn. v. CIT5 — interest for B/P is revenue expenditure and not a part of cost acquisition.

I have given this example to show how commercial concepts can be used simultaneously with legal concepts in deciding cases under the Income Tax Act. Therefore, we are coming to a stage when accounting principles are coming close to legal principles under the Income Tax Act, we have expressions like “profits and gains from business”. Similarly, there are expressions like “taxable profits”. These expressions do not have a fixed statutory definition. These expressions are based on commercial concepts. In the past courts refrained from applying principles of accounting practices in legal disputes under the Income Tax Act. However, at that time, there was no formulation of accounting standards by institutions like ICAI, Cost Accountants Institute, etc. Today, we have accounting standards. Therefore, in appropriate cases, courts can give weightage to commercial concepts over legal concepts unless the Income Tax Act provides to the contrary. (See Taparia Tools Ltd. v. CIT6.)

B. Importance of GAAP — concepts in Accounting

Accounting is a discipline which deals with measurement of economic activity affecting inflow and outflow of economic resources to develop information for decision-making. At Government level, information about inflow from taxes and expenditure on various activities is needed for planning and budgeting. Hence, accounting has universal applicability.

(i) Concepts under GAAP

(a) Cost concept is widely used to value non-monetary fixed assets viz. rights, claims, inventories, prepaid expenses. They are valued at lower of cost or market price.

(b) Revenue recognition (realisation): Business utilises resources to earn revenue by sale of goods. Generally revenue is earned or realised on the date when sale process is complete. Therefore, revenue earning has nothing to do with cash collection or inflow of cash. In the accounting sense, revenue is realised or earned on sale basis i.e. when goods are transferred with title.

(c) Expense recognition: Expense refers to the portion of the cost outlay which is consumed in the process of obtaining revenue in an accounting year. It means that a portion of the revenue earned represents the recovery of cost of resources used and the surplus, if any, is termed as income. Expense is different from expenditure.

(d) Accrual (matching) concept which requires recognition of revenue and expense on a comparable basis i.e. revenue and expense are allocated to a given accounting period on a consistent basis. Revenue received in advance is shown in balance sheet as liability to render services in future. Bills receivable are assets. The whole of revenue is not income. To earn revenue, resources are consumed and cost of resources consumed i.e. expense must be matched with revenue.

(e) Duality: The system of recording based on duality is called double entry system of book-keeping. In Accounting, resources are assets; obligations are liabilities. Introduction of funds by the owner creates corresponding obligation for their repayment.

VI. Conceptual framework of accounting

(A) Conceptual framework is collection of thoughts, comprising of ideals, values, beliefs and suppositions which explain how transactions and events should be measured. The main questions addressed by this conceptual framework of accounting are:

(i) Objectives of financial statements: to provide information.

(ii) The fundamental accounting assumptions for drafting accounts: viz.: (a) going concern (b) accrual (matching) (c) consistency.

(iii) The elements of financial statements viz.: (a) assets, (b) owner’s equities and liabilities for position statement, and (c) incomes and expenses for income statement. These elements are generally recognised on accrual basis. The bases of measurement of these elements are historical cost, replacement cost, sale value and present value. Generally, historical cost is used to measure the above elements. However, in the case of inventory the basis of measurement is different viz. lower of cost or net realisable value whereas in case of pension, the basis of measurement is present value.

(B) Views of accountants vis-à-vis economists

Accountant’s concept of K+Y is different from economist’s concept of K+Y.

Economists’ valuation of K underlying assets is based on the expected future benefits of these assets. However, difficulty arises if the future life of asset is very long. Therefore, accountants have replaced the valuation of K+ underlying assets on the basis of actual cost incurred to bring these assets into business. This actual cost (historical cost) is, however, not the only basis to value assets. Others are: current cost, realisable (sale) value, present value. To the accountant, K is a liability as it is contribution of the owner in the business and it creates obligation on the business to repay. However, economists and accountants agree that K should be maintained in the business and only the surplus (income) should be consumed.

(C) Accounting standards

The professional accounting bodies all over the world have come up with conceptual framework of accounting to satisfy diverse information needs of users. Due to globalisation the need for IAS is there because it reflects investment analysis. Accounting standards are not laws but they are in the nature of laws (Companies Act).

NB: At national level, expert regulatory accounting bodies should be there to control government expenditure. Expert management at national level needs transparency and accountability except in cases of defence/foreign services, etc.

(D) Accounting standards framed by ICAI

Students should know about these. They cover:

  • (i) valuation of inventories. It shows on what basis inventories should be valued i.e. at lower of historical cost or net realisable value.
  • (ii) it deals with cash flow statement.
  • (iii) disclosure of certain items in P&L account.
  • (iv) depreciating accounting.
  • (v) accounting for research and development.
  • (vi) revenue recognition — timing of revenue.
  • (vii) accounting for fixed assets.
  • (viii) accounting for investments.
  • (ix) accounting for amalgamation and treatment of reserves and goodwill.
  • (x) borrowing costs.
  • (xi) accounting for taxes on Y.

Important concepts under the Income Tax Act

(A) Capitalisation

The cost of borrowing for a qualified asset should be capitalised if it results in future economic benefit to company. Qualifying assets are those which take time to get ready for use or sale.

(B) Accounting for taxes on Y

Tax expense has to match the revenue. Tax expense for a specified period consists of current and deferred tax. Tax expense should be included in determination of net profit.

(C) Accounting income and taxable income

Due to timing and permanent differences. Deferred tax is the tax effect of timing differences and it is recognised as an asset only if sufficient future taxable income will be available.

VII. Linkages

(A) Accounting and economics

Accounting has strong linkages with economics, law, management. For example, accounting has acquired important concepts of Y+K from economics. Accountant and economist agree that K should be maintained intact while computing income and Y can be distributed without affecting K. However, for the economist difference between K at the beginning of the year and at the end of the year is Y. However, to the accountant Y is the result of matching of revenue and expenses on different basis viz. accrual, cash, hybrid basis.

(B) Accounting and law

Accounting operates within the legal framework. Many business organisations are governed by enactments which prescribe many aspects of accounting information like the Companies Act prescribe for managerial remuneration, formats of balance sheets, profit-and-loss account. Banking, insurance and electricity companies have their own formats.

VIII. Important terms in taxation

(i) Revenue

Gross inflow of cash, receivables or other consideration arising in the course of ordinary activities of an enterprise from sale of goods, from the rendering of services. It excludes amounts collected on behalf of third parties e.g. taxes.

(ii) Expenditure

Incurring a liability, disbursement of cash or transfer of property (funds) to obtain assets. It is the cost of acquisition of an asset.

(iii) Expense

The cost relating to the operation of an accounting period or for the revenue earned during the period or a benefit which does not extend beyond the specified accounting period.

(iv) Deferred expenditure

Expenditure for which payment has been made or a liability incurred but which is carried forward on the presumption that it will be of benefit over a specific period.

(v) Profit-and-loss account

A financial statement which presents revenue and expenses of an enterprise for an accounting period and shows the excess of revenue over expense.

(vi) Appropriation account

An account sometimes includes a separate section of the profit-and-loss statement indicating application of profits towards dividends, reserves, etc.

(vii) Expense recognition

Expense refers to the portion of the cost outlay (expenditure) which is consumed in the process of obtaining revenue in an accounting period. It means that a portion of the revenue earned represents the recovery of cost of resources used and surplus, if any, termed as Y. This recognition of expenses is important to obtain information about Y. Expense is different from expenditure. An expenditure leads to outflow of resources from the business. Either it gives benefit over the current accounting year, for example, rent for the premises, salaries, etc. (revenue expenditure which are expenses of the current accounting year) or it gives benefit over many accounting periods e.g. cost of acquiring p+m (to expenditures). Since the benefit of expenditure extends over many accounting periods, the portion used or consumed during the current year, called depreciation, is an expense in the current year and the unexpired portion is taken to the balance sheet as an asset of business.

Hence, cost is the total outlay or expenditure on acquiring resources requires for production of goods or to render services. Cost of resources utilised during the current accounting year is expense or utilised cost and is charged to revenue of the period. Costs of resources remaining unutilised at the end of the year is carried forward to the next year and are termed as assets.

Cite: Difference between actual cost against cost of acquisition

CIT v. Rajagopal Rao7

Challapalli Sugar Ltd. v. CIT8

Held: Actual cost under Section 43(1) and Section 145 is different from cost of acquisition under Section 55.

IX. Important citations

(1) Union of India v. Bombay Tyre International Ltd.9 — Measure does not decide nature of levy.

(2) Hingir Rampur Coal Co. Ltd. v. State of Orissa10

(3) District Board of Farrukhabad v. Prag Dutt11 and R.R. Engg. Co. v. Zila Parishad, Bareilly12 tax on circumstances different from tax on Y. If there is no Y no tax can be levied. But in case of tax on circumstances, it can be levied as it is on turnover and status of assessee.

(4) State of W.B. v. Kesoram Industries Ltd.13

(5) CIT v. Vickys Systems14,, Sections 36(1) and 37.


In conclusion I would like to sum up by stating that there are linkages between law, economics, accountancy, management, finance, commerce and statistics. The point to be noted is that something may be real for one purpose, but not for another. When we speak of something being “real”, we mean that it falls within some concepts which we have in mind, by contrast with something else which is in our mind. When an economist says that the real income has fallen, he is not intending to contrast real income with imaginary income. The contrast is between incomes which have been adjusted for inflation and those which are not so adjusted. In order to know what he means by “real”, one must first identify the concept of inflation adjustment by reference to which he is using the word “real”. Therefore, I have given importance to concepts. This approach is not restricted to law or economics or finance. It equally applies to spirituality and philosophy in life.



Speech delivered on 28-2-2004 at Pune in the program — Judicial Colloquia — 2004 — Organised by (New Law College, Pune) Bharati Vidyapeeth Deemed University. Return to Text

Judge, Supreme Court of India Return to Text

1. McDowell & Co. Ltd. v. CTO, (1985) 3 SCC 230 at 253, para 42. Return to Text

2. 1982 AC 300 : (1981) 1 All ER 865 (HL) Return to Text

3. (2001) 2 WLR 377 : (2001) 1 All ER 865 (HL) Return to Text

4. (2003) 263 ITR 706 Return to Text

5. (2002) 258 ITR 601 (Bom) Return to Text

6. (2003) 260 ITR 102 (Bom) Return to Text

7. (2003) 125 Taxman 148 (Mad) Return to Text

8. (1975) 3 SCC 572 Return to Text

9. (1984) 1 SCC 467 Return to Text

10. (1961) 2 SCR 537 Return to Text

11. AIR 1948 All 382 Return to Text

12. (1980) 3 SCC 330 Return to Text

13. (2004) 266 ITR 721 : (2004) 10 SCC 201 Return to Text

14. (2003) 87 ITD 182 Return to Text

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