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BASIC CONCEPTS

Question 1
Mr. Bhargava, a leading advocate on corporate law, decided to reduce his practice and to
accept briefs only for paying his taxes and making charities with the fees received on such
briefs. In a particular case, he agreed to appear to defend one company in the Supreme Court
on the condition that he would be provided with Rs.5 lacs for a public charitable trust that he
would create. He defended the company and was paid the sum by the company. He created
a trust of that sum by executing a trust deed. Decide whether the amount received by Mr.
Bhargava is assessable in his hands as income from profession. (3 Marks) (June 2009)
Answer
In the instant case, the trust was created by Mr. Bhargava himself out of his professional
income. The client did not create the trust. The client did not impose any obligation in the
nature of a trust binding on Mr. Bhargava. Thus, there is no diversion of the money to the trust
before it became professional income in the hands of Mr. Bhargava. This case is one of
application of professional income and not of diversion of income by overriding title. Therefore,
the amount received by Mr. Bhargava is chargeable to tax under the head “Profits and gains of
business or profession”.
Question 2
What is a zero coupon bond? State briefly the treatment of zero coupon bonds in the hands of
the issuer and the investor under the Income-tax Act, 1961 (8 Marks) (Nov 2006)
Answer
Section 2(48) of the Income-tax Act, 1961 defines a zero coupon bond to mean a bond issued
by any infrastructure capital company or infrastructure capital fund or a public sector company
or scheduled bank on or after 1.6.2005, in respect of which no payment and benefit is received
or receivable before maturity or redemption from such issuing entity.
Discount, which is the difference between the amount received or receivable by the issuer on
issue of the zero coupon bond and the amount payable by the issuer on maturity or
redemption thereof, would be allowed as deduction in the hands of the issuer on a pro rata
basis having regard to the period of life of the bond as provided in section 36(1)(iiia). No tax
is required to be deducted at source under section 194A in respect of income paid or payable
in relation to such bond.
Direct Taxes

Maturity or redemption of a zero coupon bond will be treated as a transfer for purposes of
capital gains in the hands of the investor as provided in section 2(47)(iva). Zero coupon bond
held for not more than 12 months will be treated as a short-term capital asset. Thus, a zero
coupon bond held for more than 12 months will be treated as a long-term capital asset. The
proviso to section 112(1) will be applicable to long-term capital gain arising from the transfer of
zero coupon bonds. Consequently, where the tax payable in respect of long-term capital gain
arising from the transfer of zero coupon bonds exceeds 10% of the amount of capital gains
before indexation, then, such excess shall be ignored while computing the tax payable by the
investor.
Question 3
Explain the incidence of taxation on mutual concerns. (4 marks) (Nov.2004)
Answer
The concept of “mutuality” means that the contributors and beneficiaries are identical. Since
one cannot make profit by dealing with oneself, there is no taxable profit involved wherever
such concept applies. A mutual concern or association stands on the same principle. All the
contributors to the common fund are entitled to participate in the surplus and all the
participants to the surplus are contributors in the case of a mutual concern. The excess of
income over expenditure in a year shall supplement the common fund for future utilization to
the benefit of the contributors and the excess of expenditure over income shall be absorbed by
the common fund.
Generally the surplus derived by a mutual concern is not chargeable to tax. Therefore, a trade,
professional or similar association which functions on the principle of mutuality concept is not
chargeable to tax, if there is any surplus on account of subscriptions, membership fees,
entrance fees etc., exceeding the expenditure.
However, the following additional points need to be taken into consideration-
(i) Where a mutual concern carries on the business of insurance, the profits therefrom are
chargeable to tax. Section 44 provides that the profits for this purpose have to be
computed in accordance with the method prescribed in the Rules contained in the First
Schedule.
(ii) In the case of trade, professional or similar associations, the income derived from
specific services performed for its members is chargeable to tax u/s 28(iii). However, if
there is a loss on account of expenditure exceeding the subscription etc. from members,
such shortfall shall be absorbed by the income chargeable to tax u/s 28(iii). This set off
as per section 44A cannot exceed 50% of the total income of such associations as
computed before allowing the set off.
(iii) In the case of a mutual concern, if income is derived both from mutual activity as well as
from non-mutual activity, the exemption applies only to the income from the mutual
activity. The income attributable to the non-mutual activity will be liable to tax as was held
by the Gujarat High Court in Sports Club of Gujarat Ltd. vs CIT (1987) 171 ITR 504.

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Note : Students may refer to decision such as Canara Bank Golden Jubilee Staff Welfare
Fund v. Dy.CIT (2009) 308 ITR 203 (Karn)
Question 4
Explain with reasons about the taxability of the following transactions for the Assessment year
2003-04:
(i) Raja was declared winner in a lucky dip on 15 th August, 2002. He was paid cash of
Rs.1,00,000 as prize money. (2 Marks) (Nov.2003)
(ii) Mr. Ravi, citizen of India and a non-resident purchased the Savings Certificates issued
by Central Government from out of Dollars remitted from USA on 11-07-02 on which the
interest for the year ended on 31-03-03 was Rs.3 lakhs. (2 Marks) (Nov.2003)
The provisions of the Income-tax Act, 1961 relevant for Assessment Year 2010-11
should be taken into consideration while solving the question. Accordingly, the facts
given above may be taken as relating to financial year 2009-10.
Answer
(i) The prize money of Rs.1 lakh received by Mr. Raja is fully chargeable to tax under the
head ‘Income from other sources’. The amount will be subject to tax at a flat rate of 30%
(plus education cess) as per section 115BB.
(ii) Interest on investment made by a non-resident Indian out of money transferred in foreign
currency for purchase of saving certificates issued before 1.6.2002 is exempt from tax.
However, where the certificates are issued after 01.06.2002, the tax exemption would not
apply. Therefore, assuming that the saving certificates were issued after 1.6.2002, the
interest of Rs.3 lakhs so derived by the non-resident assessee on the saving certificates
purchased on 11.7.2002 is liable to tax and exemption under section 10(4B) will not be
available
Question 5
X Ltd., a domestic company, holds 50% of share capital of Y Ltd. which is another domestic
company. Y Ltd. paid total dividend during the year ended on 31-03-03 of Rs.50 lakhs. Out of
the dividend received from Y Ltd., X Ltd. distributed dividend of Rs.15 lakhs. Explain with
reasons the amount of dividend chargeable to tax in the hands of X Ltd. (3 Marks) (Nov.2003)
The provisions of the Income-tax Act, 1961 relevant for Assessment Year 2010-11
should be taken into consideration while solving the question. Accordingly, the facts
given above may be taken as relating to financial year 2009-10.
Answer
The dividend received by X Ltd from Y Ltd is exempt from tax under section 10(34) if such
dividend is covered by section 115-O. It is pertinent to note that the dividend covered by

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section 115-O is also not liable for ‘ book profit tax ’ under section 115JB in the assessment of
recipient company i.e. X Ltd in this case.
It may be of interest to a note that X Ltd while paying dividend distribution tax under section
115-O is eligible to reduce the dividend received from the dividend paid / declared by it. Since
the dividend paid by X Ltd is less than the dividend received from its subsidiary, the tax
liability under section 115-O would be `nil’.
Assuming X Ltd distributed dividend of Rs.60 lakhs the dividend distribution tax at 16.995% is
payable on the net payout of Rs.35 lakhs only i.e. dividend declared Rs.60 lakhs less Rs.25
lakhs being the dividend received from subsidiary domestic company which has paid DDT on
the dividend declared by it.
Question 6
Does the tax borne by employer on behalf of employee in respect of provision of non-
monetary perquisites constitute an income in the hands of employee? What are the tax
implications of such payment in the hands of employer? (5 Marks) (May 2003)
Answer
Section 10(10CC) provides that in the case of an employee deriving income in the nature of
non-monetary perquisites, the amount of tax on such income paid by his employer, is exempt
from tax in the hands of employee. In view of this, in the instant case, by virtue of exemption
provided in section 10(10CC), the tax borne by the employer on behalf of employees in
respect of provision of non-monetary perquisites is exempt in the hands of the employees.
As regards tax implications of such payment in the hands of employer section 40(a)(v)
provides for disallowance of the tax actually paid by employer under section 10(10CC) while
computing the income chargeable under the head “Profit and gains of business or profession”.
Question 7
An Indian company is engaged in the manufacture and sale of coffee grown by it in its own
estates. Will it liable to tax under the IT Act. If so, how will its income be determined?
(3 Marks) (May 2002)
Answer
As per Rule 7B, income derived from the sale of coffee grown and cured by the seller in India,
shall be computed as if it were income derived from business and 25% of such income shall
be deemed to be income liable to tax. Income derived from the sale of coffee grown, cured,
roasted and grounded by the seller in India with or without mixing chicory or other flavouring
ingredients, shall be computed as if it were income from business and 40% of such income
shall be deemed to be income liable to tax.
In computing such income, an allowance shall be made in respect of the cost of planting
coffee plants in replacement of plants which have died or have become permanently useless
in an area already planted, if such area has not previously been abandoned and for the

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purpose of determining the cost, no deduction shall be made in respect of the amount of any
subsidy which under the provisions of section 10(31), is not includible in the total income.
Question 8
How do you deal with the following situations? Give reasons for your answer (The assessment
year is 2001-2002):
Basu, Managing Director of a company is entitled to commission on sales as per the service
agreement entered into. A part of the commission is converted into purchasing a single
premium deferred annuity policy from Life Insurance Corporation of India. Basu claims that the
commission diverted to secure the deferred annuity cannot be taxed in his personal
assessment . (3 Marks) (May 2001)
Answer
The claim is inadmissible regardless of the assessment year to which the issue relates. The
commission had accrued to the managing director and then it was applied to secure an
annuity contract from LIC. The commission is recognized perquisite under section 17(2) of the
Act. It forms part of the salary structure as per contract of service. It will be includible in the
total income. (CIT v. Navnitlal Shakarlal (2000) 113 Taxman 692 (SC)].
Question 9
How do you deal with the following situation? Give reasons for your answer:
Nija Traders engaged in manufacturing was in receipt of sales-tax subsidy from State
Government as the unit was in backward area. The subsidy is related to the sale of its
products and payable once the production is commenced. Nija Traders claims that the subsidy
is a capital receipt and hence cannot be included as income. (3 Marks) (May 2001)
Answer
The Supreme Court in its judgment in the case of Sahney Steel And Press Works Ltd v. CIT
(1997) 228 ITR 253 (SC) has held that the payments from public funds to assist the assessee
in carrying on trade or business must be treated as revenue receipts. The subsidy granted to
the assessee such as sales tax refund, power concession or refund of bills paid and
exemption from payment of water charges are to be treated as revenue receipts chargeable to
tax. It was held that the character of the subsidy in the hands of the recipient will have to be
determined having regard to the purpose for which the subsidy is given. If the monies are
given for assisting the assessee in carrying out the business operations and the money is
given only after and conditional upon commencement of production, the assistance must be
treated assistance for the purpose of the trade. Therefore on the facts of the case, the sales
tax subsidy was nothing but supplementary trade receipts and therefore is taxable. Also refer
CIT v. Rajaram Maize Products (2001) 251 ITR 427 (SC).
Students may note that the Madras High Court in CIT v. Kanyakumari District Co-operative
Spinning Mills Ltd (2003) 264 ITR 684 (Mad) has held that subsidy received for providing
employment to weaker sections of the society as capital receipt and not chargeable to tax.

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Question 10
Income computed on the accrual basis is no longer relevant for taxation of income. Critically
analyse the validity or otherwise of the same. (3 Marks) (May 2001)
Answer
As per the provisions of section 145, the normal rule is that either cash or mercantile system
of accounting is to be followed. However, even in cases where mercantile system is followed,
certain adjustments have been prescribed in the Act which provide for circumstances in which
the claim for deduction is subject to actual payment. Such provisions are briefly outlined
below:
Section 40 A(7) – Provision for gratuity allowable on payment basis only.
Section 43B – This is one of the most important provisions, which leads to distortion in the
concepts of accrual of income. The items covered by this section are deductible only on
payment basis:
1. Tax, duty, cess or fee.
2. Contribution to any provident fund, superannuation fund, gratuity fund or welfare fund.
3. Payment of bonus or commission.
4. Interest payable to certain financial institutions.
5. Interest payable to scheduled banks.
Section 145A also contributes indirectly to this distortion because adjustments are statutorily
permitted in valuation of inventory for rates, taxes, duties etc.,
Question 11
Anand was the Karta of HUF. He died leaving behind his major son Prem, his widow, his
grandmother and brother’s wife. Can the HUF retain its status as such or the surviving
persons become co-owners. (3Marks) (Nov.2000)
Answer
In the case of Gowli Buddanna v. CIT (1966) 60 ITR 293 (SC) the Supreme court has made it
clear that there need not be more than one male member to form a HUF as a taxable entity
under the Income-tax Act. The expression “Hindu Undivided family” in the Act is used in the
sense in which it is understood under the personal law of the Hindus. Under the Hindu system
of law, a joint family may consist of a single male member and the widows of the deceased
male members and the Income-tax Act does not indicate that it should consist of at least two
male members. Therefore, property of a joint Hindu family does not cease to belong to the
family merely because the family is represented by a single co-parcener who possesses the
right which an owner of property may posses.
It may be noted that the Hindu Succession (Amendment) Act, 2005 w.e.f. 06-09-2005 confers
the same rights in the co-parcenary property on females as that is available to male members

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of the family. A daughter is coparcener of Hindu family property having right to seek partition
of the coparcenary property similar to that of a son.
Question 12
You are consulted on the justifiability of the following claim. Your advice is to be framed based
on the provisions of the Income-tax Act, 1961.
A liability towards expenditure as per agreement was provided in the books. However disputed
for payment before a Court of law on interpretation of clauses of the agreement. Can it be
claimed in the year of provision? (3 Marks) (May 2000)
Answer
The Supreme Court in Kedernath Jute Mills Ltd v. CIT 82 ITR 363 (SC), had held that where
liability exists in presenti, the claim for the same cannot be denied merely because it has been
disputed, where the assessee maintains his book of account on the mercantile system of
accounting.
For the purposes of allowability of a claim or expenditure under the provisions of Income-tax
Act, it is the document that has to be taken into account, based on which the provision has
been made. According to the agreement, there was a liability in presenti. The liability in
presenti is not a contingent liability unlike a future liability. A liability in presenti has to be
provided so that the same cannot be denied at a later date on the premise that it has not been
provided in the year in which the liability really accrued. In the circumstances though the
liability provided in the books was disputed, since it is a liability in presenti as per the
agreement, the same can be claimed in the year of provision.