Merged SMB105!1!6

Business Environment & Law
Block
I
THE SOCIAL AND POLITICAL ENVIRONMENT OF
BUSINESS
UNIT 1
Business Environment: An Introduction
1-27
UNIT 2
Demographic and Social Environment
28-54
UNIT 3
Cultural Environment
55-78
UNIT 4
Political Environment
79-104
Expert Committee
Dr. J. Mahender Reddy
Vice Chancellor
IFHE (Deemed to be University)
Hyderabad
Prof. S. S. George
Director, ICMR
Hyderabad
Prof. Y. K. Bhushan
Vice Chancellor
IU, Meghalaya
Dr. O. P. Gupta
Vice Chancellor
IU, Nagaland
Prof. Loveraj Takru

Director, IBS Dehradun
IU, Dehradun
Prof. D. S. Rao
Director, IBS, Hyderabad
Hyderabad
Course Preparation Team

Prof. Vivek Gupta
Hyderabad
Ms. Hadiya Faheem

Hyderabad
Prof. Debapratim Purkayastha

Hyderabad
Ms. Pushpanjali Mikkilineni

Hyderabad
Prof. Tarak Nath Shah

IU, Dehradun
Ms. Padmaja
IU, Meghalaya
Mr. Mrinmoy Bhattacharjee

IU, Mizoram
Aizawal
Ms. Anurita Jois

IU, Sikkim
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Course Introduction
Business organizations are increasingly exposed to various challenges in the environment
they function. Businesses have come to appreciate the fact that with increasing concentration
of property and people, and increasingly complex servicing, manufacturing, and industrial
processes, they are exposed to greater risk and that they must manage risks more efficiently
and effectively in order to be competitive.
Managers require relevant skills to comprehend the legal risks that are associated with
transactional and functional aspects of business. Awareness of legal and regulatory risks and
their evaluation in taking decisions helps in the proper orientation of business strategies to
meet the competition.
Business Environment & Law examines key issues in the environment and the legal and
regulatory framework that affect organizations and their businesses. The course is divided
into two major parts.
The first part of the course introduces students to the various components of the business
environment. The course enables students to gain an understanding into the social,
demographic, cultural, political, economic, financial, trade, technological, legal, regulatory,
tax, and ethical environments, and how these environments play a vital role in affecting the
business of an organization.
The second part of the course provides the foundation that is essential for managers to take
dynamic decisions within the legal and regulatory framework. The course discusses the legal
issues in substantive business areas such as the law of contracts that deals with the
classification, validity, essential features, parties of the contract, remedies to various parties,
and other miscellaneous aspects. It also provides the provisions pertaining to special contracts
such as contract of agency, indemnity & guarantee, and bailment & pledge. The course also
introduces the current provisions pertaining to the Companies Act, 1956, and the tax laws
such as Direct and Indirect Tax laws.
Block I
The Social and Political Environment of Business

The first block of the course on Business Environment & Law deals with the fundamental
concepts relevant to business environment, and consists of four units. The first unit provides
an introduction to business environment. The second unit discusses the demographic and
social environment, the third unit deals with cultural environment, and the fourth unit
examines the political environment of business.
The first unit, Business Environment: An Introduction, discusses the dimensions and
components of business environment. These include the external and internal environments.
The unit also explains the importance of business environment.
The second unit, Demographic and Social Environment, deals with the demographic
environment and the social environment of business. The unit examines the definition of these
environments and their impact on business.
The third unit, Cultural Environment, describes the cultural environment of business, which is
also another external environment factor. The unit conveys the essence and manifestation of
culture, while explaining its elements such as language, aesthetics, religion, and education.
The unit also examines various concepts related to culture such as culture change, cultural
analysis, cultural adaptation, and the cultural sensitivity of the industrial and consumer
markets.
The fourth unit, Political Environment, gives an overview of the political environment of
business, and how it affects business (domestic or international). The unit examines the
classification of governments based on political systems and economic systems. It discusses
the complexities involved in business due to the political environment. The unit also explains
the factors contributing to political instability, and the concept of political risk.
Unit 1

Structure
1.
Introduction
2.
Objectives
3.
Dimensions of the Business Environment
4.
Importance of the Business Environment
5.
Components of the Business Environment
6.
External and Internal environment
7.
Summary
8.
Glossary
9.
Self-Assessment Test
10. Suggested Readings/Reference Material

11. Answers to Check Your Progress Questions
1. Introduction
In this unit, we introduce you to the business environment. Individuals, businesses,
and the society face possibilities of unprecedented harm, generally called risk, as they
continue to grow economically. Risk is an outcome of the dynamic environment. The
environment comprises external and internal factors. These factors make up the
business environment of an organization, and hence it is required to study it in order
to understand how to manage risk.
This unit will give you an overview of business environment, and explain the
importance of business environment. We shall then move on to discuss the dimensions
and components of business environment. Finally, we would be discussing about
external and internal business environment.
2. Objectives
By the end of this unit, you should be able to:
define the dimensions of the business environment.
recognize the importance of the business environment.
explain the components of the business environment.
identify the external factors and the internal factors in the environment.
3. Dimensions of the Business Environment

The dictionary meaning of the term Environment is: (1) surrounding external objects
and (2) influences of circumstance under which someone or something exists. The
environment of an organization is constituted by an aggregate of all conditions,

events and influences that surround and affect it. Due to its complex, dynamic,
multifaceted nature, and far reaching impact, the business environment exhibits many
characteristics. Consequently, dividing the environment into external and internal
components enables its better understanding. Every business enterprise has to cope
with internal as well as external factors.
Internal factors are generally considered controllable factors as the business enterprise
has control over these factors. The companys personnel, strategy, structure, and its
functional, operations, marketing, and technical capabilities are all internal factors.
These factors can be modified with greater ease to suit the environment. External
factors are beyond the control of a company such as economic, socio-cultural,
regulatory and legal, and demographic factors.
Business environment can also be categorized into economic and non-economic
environment. The economic environment consists of factors such as the fiscal policy,
monetary policy, industrial policy, the physical limits on output, the price and income
equations, nature of the economic system, and the pace of economic development.
The non-economic environment includes social, cultural political, legal, and
technological factors. The economic environment has non-economic implications just
as the non-economic environment has economic implications.
Environmental factors vary from country to country and region to region. The
business environment is a highly complex and dynamic phenomenon. Managers often
take a lifetime to understand the complex nuances of business environment of a
particular country. Considerable skill and dexterity is required in adjusting, coping
with, and managing the business environment. A study of the critical elements of the
business environment is required to facilitate the development of these skills. An
understanding of this turbulent and dynamic environment also helps in effective
decision-making by business managers.
4. Importance of the Business Environment

Organizations are open systems as they are affected by, and in turn affect, their external
environment. External environment refers to all the relevant forces outside the firms
boundaries. The word relevant indicates those factors which managers must pay attention
to help their organizations compete effectively and survive. Irrelevant forces are generally
not of immediate importance, though they might be relevant in future.
As many of these factors are of an uncontrollable nature, companies are often affected
by recession, government interference, competitors actions, etc. Managers cannot
ignore these forces as they are uncontrollable, and use them as excuses for poor
performance. They should instead stay well-informed on the external developments
and react accordingly.
Of late, change is invading all areas of our life at a dramatically accelerating rate. It is
in this ever-changing environment that managers must take decisions. Based on the
impact of the external and the internal environment on the organization, managers
make certain business decisions. These decisions may sometimes, in turn, affect the
external environment.
2

In spite of the uncertainties of the present age, managers must choose investment
programs, organize facilities, set prices for products, and design advertising
campaigns. Also, before making any decision, the business environment must be
taken into consideration.
Check Your Progress

1.
a.
b.
c.
d.
is constituted by an aggregate of all conditions, events, and

influences that surround and affect it.
Risk
Change
Environment
Demography
2.
a.
b.
c.
d.
In which of the following basic categories can business environment be divided?

Local and Regional
Regional and National
External and Internal
Financial and Non-Financial
3.
a.
b.
c.
d.
Which among the following comprises factors such as the fiscal policy, monetary
policy, industrial policy, the physical limits on output, the price and income
equations, nature of the economic system, and the pace of economic
development?
Internal environment
Economic environment
Non-economic environment
Both (b) and (c)
4.
a.
b.
c.
d.
includes social, cultural political, legal, and technological factors.

Non-economic environment
Internal environment
None of the above
5.
By which other term can internal factors affecting a business environment also be
referred to?
Controllable factors
Uncontrollable factors
Relevant factors
Global factors
a.
b.
c.
d.
6.
a.
b.
c.
By which other term can external factors affecting a business environment also be
known?
Controllable factors
Uncontrollable factors
Relevant factors
d.
Global factors
3
5. Components of the Business Environment

Organizations have to classify the relevant environment into components or sectors in
order to cope with its complexity, comprehend the different influences operating on
the organization, and relate the environmental changes to its strategic management
process. To do so, it is necessary to consider a variety of relevant factors in the
environment, such as the size of the organization, level and scope of the organization
to perform a variety of activities, geographical spread of markets, nature of products,
type of technology used, and managerial philosophy. An organizations environment
can be classified into -- demographic, social, cultural, political, economic, financial,
trade, technological, legal, regulatory, tax, and ethical.
As external factors are beyond the control of the firm, the success of the firm will
depend to a large extent on its adaptability to the environment. In other words, the
ability of the firm to properly design and adjust the internal (controllable) variables to
take advantage of the opportunities and to control the threats from the environment
determines the success of the firm.
A firm may achieve external economies of scale if there are changes in the external
environment such as improvements in the transport facilities and communication. A
firm can also achieve internal economies of scale if there are changes in the internal
environment such as introduction of advanced equipment, use of mass production
techniques, etc.
Activity: Karthik owns a small firm in India that conducts training programs for
individuals and companies from time-to-time to introduce them to the current
trends in the field of business. Starting 2009, due to recession, the firm began facing
problems. Karthik couldnt understand the reason why this happened as he
believed that his firm would not be affected by any such happenings. How would
you make Karthik understand the impact of such occurrences on any business
including his own?
Answer:
6. External and Internal Environment

All the factors outside the organization which provide opportunities or pose a threat to
the organization make up the external environment. And all the factors within an
organization which impact strengths or cause weaknesses constitute the internal
environment. Refer to figure 1.1 for a graphic representation of the external and
internal environments of an organization. Understanding the external environment
with regard to the opportunities and threats and the internal environment with regard
4

to the strengths and weaknesses is crucial for the growth and profitability of any
organization. These are described as follows.
Opportunity: A favorable condition in the environment of an organization which
enables the organization to consolidate and strengthen its position.
Threat: An unanticipated condition in the organizations environment which creates a
risk for or causes damage to the organization.
Strength: The inherent capacity which an organization can use to gain strategic
advantages over its competitors.
Weakness: An inherent limitation or constraint which creates a strategic
disadvantages.
Figure 1.1: The Business Environment
Source: ICMR.
Check Your Progress

7.
Which of the following factors may contribute to the external economies of scale
for an organization?
a.
Use of advanced technology in the manufacturing process
b.
Seeking expert advise for re-launching a product
c.
Improvement in the air and road links
d.
Increasing bulk purchases of raw materials and components

5

8.
refers to a favorable condition in the environment of an

organization which enables the organization to consolidate and strengthen its
position.
a.
Strength
b.
Weakness
c.
Opportunity
d.
Threat
9.
What is the inherent capacity of an organization which can be used to gain

strategic advantage over its competitors known as?
a.
Strength
b.
Weakness
c.
Opportunity
d.
Threat
6.1 External Environment

Broadly, the external environment encompasses a variety of factors in the
international, national, and local economy such as social changes, demographic
variables, political system, technology, government, or public attitude toward
business, energy sources, availability of raw materials and other resources, and several
other macro level factors.
The individual factors of the external environment are demographic environment,
social environment, cultural environment, political environment, economic
environment, financial environment, trade environment, technological environment,
legal environment, regulatory environment, tax environment and ethical environment.
These are described below in detail.
Demographic Environment
Demographic environment factors include size, growth rate, age composition, and
gender composition of the population. They also include family size, educational
levels, and economic stratification of the population. All these demographic factors
are relevant to business. The demand for goods and services is affected by
demographic factors such as the size of population, population growth rate, age and
gender composition, life expectancy, family size, spatial dispersal, occupational
status, and employment pattern.
For instance, a rapidly increasing population leads to growing demand for many
products. A high population growth rate also indicates an enormous increase in the
supply of labor. Therefore, population growth rate is an important environmental
factor that affects business. Many multinational corporations have been encouraged to
invest in developing countries like India and China as a result of the cheap labor and
presence of a growing market.
6

The occupational and spatial mobility of the population have their own implications
for business. Easy mobility of labor between different occupations and regions makes
its supply relatively smooth, which in turn affects the wage rate.
Heterogeneity of labor in terms of language, caste, religion, and ethnicity makes
personnel management a complex task. Also, heterogeneity of population in terms of
varied tastes, preferences, beliefs, and temperaments results in differing demand
patterns and calls for different marketing strategies.
Social Environment
Social environment factors include human relationships and the developments. The
form and function of such relationships have a bearing on the organizations business.
Buying and consumption habits of people, their languages, beliefs, values, customs,
tradition, tastes, and preferences are some vital factors and influences operating in the
social environment.
Primarily, social environment affects the strategic management process within the
organization in the areas of mission, setting of objectives, and decision-making related
to products and markets. Some of these factors that affect business are given below.
Social concerns such as the role of business in society.
Social attitudes and values such as the societys expectations from business.
Family structures and changes in them such as the increase in the number of nuclear
families.
Role of women in society, and their status in it.
Educational levels and gender inequality in the levels.
Awareness and work ethics.
Knowledge of the cultural environment is important to understand the business
environment in its totality as cultural norms largely drive consumer needs and buyer
behavior. Cultural elements such as language, education, and religion play a vital role
in shaping a companys marketing mix program. Analysis of these elements helps in
finding out market opportunities. Companies often gain a competitive edge by
meeting cultural needs that have been so far ignored by their competitors.
Cultural blunders may prove expensive for multinational companies. Such blunders
may lead to embarrassment, lost customers, legal consequences, missed opportunities,
expensive damage control, and tarnished reputation. Thus, it is imperative to gather a
deep understanding of cultural differences and grasp the intricacies of foreign markets
in this era of globalization.
Exa mple: McDona lds Strategies in
India
In 2004, Businessworld selected McDonalds India Private Ltd (McDonalds), as
the most respected company in the food service sector in India. Many factors can
be attributed to the success of McDonalds Indian operations.
Contd
Contd
McDonalds focused on products and changed its menu to suit the tastes of Indian
consumers. It launched India specific items including McVeggie burger, McAloo
Tikki burger, Veg. Pizza McPuff, and Chicken McGrill burger. Considering the
Indian preferences and sensibilities, the company excluded pork and beef items in
its menu. It offered eggless sandwich sauces for vegetarian customers and
vegetarian items were prepared at a separate counter at the outlets.
On the pricing front, McDonalds adopted customized pricing for each of the cities
depending upon the tax structure, demand, and purchasing power of the population.
To attract mass-market customers, it launched a new menu called Happy Price
Menu in which select items are priced at Rs. 20 across all the outlets in the country.
McDonalds also focused on creating a right ambience in its outlets. The company
positioned its outlets as a restaurant that catered to the typical Indian family, and the
physical environment reflected that image with the atmosphere being informal and bright.
The outlets were spacious for kids to play around and families had the facility to conduct
events like birthday parties. In addition, the outlets were made non-smoking zones to
reflect the sensibilities of Indian families. McDonalds also laid special emphasis on kids.
The outlets had low counters for easy accessibility to the kids. Besides, vibrant colors and
theme-based paintings that were pleasing to the kids were used.
McDonalds developed localized ads in line with the advertising strategy of the
parent company. Localized ads with the punch line Im lovin it were created.
Humorous ads with the theme What Your Bahana is were developed to put the
message across to the consumers. The protagonists in the ads cite weird reasons for
eating out at McDonalds. In addition, McDonalds also ran various sales
promotion activities to keep up the interest in the brand like offering toys and other
accessories, and conducting contests.
Adapted from Case Study McDonalds in India. The ICMR Center for
Management Research, 2005. www.icmrindia.org.
Check Your Progress

10. Which among the following is studied with reference to the size, growth rate, age
composition, gender composition, life expectancy, etc., of the population?
a. Social environment
b. Cultural environment
c. Ethical environment
d. Demographic environment
11. The study of factors such as family structures and changes in them, role and
status of women in society, and educational levels and gender inequality in
educational levels which affect a business organization is part of
a. Demographic environment
b. Social environment
c. Cultural environment
d. Internal environment
8

12. In Japan, a company began selling its golf balls in packs of four. The company
felt that these convenient packs would help in increasing its sales. However, the
sales failed to do well. It was later found that the word four when pronounced in
Japanese sounded like the word death. These kinds of cultural blunders may
prove expensive for multinational organizations, and may lead to
_.
i. Missed opportunities
ii. Lost customers
iii. Legal problems
iv. Costly damage control
a. Only i, ii, and iii
b. Only i, iii, and iv
c. Only ii, iii, and iv
d. i, ii, iii, and iv
The term political environment refers to factors related to the management of public
affairs and their impact on an organizations business. The political environment is
closely related to the economic system and the economic policy.
In most countries, a number of laws regulate business conduct apart from those that
control investment and related matters. These laws cover issues like standard of
product, packaging, and promotion. Some governments specify certain standards for
the products, including packaging, while others prohibit the marketing of certain
products. Promotional activities are subject to various types of controls in most
nations.
For instance, India is a democratic country with a stable political system. The
government plays an active role as a planner, promoter, and regulator of economic
activity. The Indian government has considerable influence over the various business
aspects in the country.
The Indian government also framed a number of regulations to restrict the
concentration of economic power, monopolistic undertakings, and large industrial
houses in the country. For instance, the Competition Act was passed in 2002 to ensure
economic development of the country. The act was framed to protect consumers
interests, ensure freedom of trade carried on by others, promote and ensure
competition in market, and prevent practices having adverse effect on competition.
Economic Environment
Economic environment factors include macro level factors related to the areas of
production and distribution of wealth that affect an organizations business. A few
important factors and influences operating in the economic environment are given
below.
Economic stages that exist at a given time in a country.
The economic structure that is adopted by a country, i.e., capitalistic, socialistic, or
mixed economy.
9

Economic planning such as 5-year plans and budgets.
Economic policies, i.e., monetary, industrial, and fiscal policies.
Economic indices such as national income, per capita income, disposable personal
income, GDP (gross domestic product), distribution of income, rates of savings and
investment, value of imports and exports, and balance of payments.
Infrastructural factors such as financial institutions, banks, communication facilities,
modes of transport, and energy sources.
Business managers are aware of the importance and impact of the economic
environment on their organizations. In the annual reports of most companies,
information is provided on the prevailing economic environment and the specific
aspects of the environment that have an impact on their organization and the business
they are in.
The economic policy of the government also has a great impact on business (adverse,
favorable, or neutral). The incentives and disincentives offered in the government
policies affect businesses. The government may provide concessions and other forms
of support to an industry belonging to the priority sectors (in terms of the government
policy). On the other hand, the government policy may not support industries that are
regarded as non-essential. Thus, economic system is a very important determinant of
the scope of private business and is therefore a very important external factor
influencing business.
Financial Environment
The international financial environment is constantly changing with growth in income,
balance of payments position, inflation, fluctuations in exchange rate, and
unpredictable political events in various countries. Business enterprises are closely
linked with the financial markets and institutions. The financial system constitutes an
integral part of the economic system. It consists of the flow of savings, financial
intermediaries, financial instruments, and securities that facilitate the transfer of funds.
Reforms and regulations in the money and capital markets have contributed greatly to
the changing business environment. Professional financial managers are trying to
tackle these factors, and reduce the uncertainty arising out of the dynamic nature of
the financial environment.
Trade Environment
Due to globalization, businesses are now compelled to look beyond the physical
boundaries of their home countries. The need to think and act from a global
perspective has become a universal rule of business. Globalization refers to the
process of integration of the world into one huge market. The aim today is to reduce
the gap between domestic prices and world prices, and to lower the trade barriers,
tariff and non-tariff, and liberalize the trade regime. A tariff is a tax levied by the
government on the exports and imports in a country. Non-tariff barriers are trade
barriers that are used to control imports. These include import bans, export subsidies,
countervailing duties, and anti-dumping measures (Countervailing duties and antidumping measures are actually non-tariff barriers. However, they take the form of
tariffs once they are enacted).
10

Technological Environment
The technological environment factors are related to applied knowledge and the
materials and machines used in the production of goods and services. Given below are
some factors and influences operating in the technological environment.
Sources of technology (company, external, and foreign sources), cost of acquisition of
technology, and collaboration in and transfer of technology.
Technological development, stages of development change, rate of change of
technology, and research and development.
Impact of technology on human beings, the main-machine system, and the effects of
technology on environment.
Communication and infrastructural technology and technology in management.
In the Indian context, there is variation in the state of technological development
among various industry sectors. Generally, the technological aspect of competition is
considered to vary with customer needs and government policy.
Foreign technical collaborations at the macro level are popular in India. This is because
companies operating in a highly competitive environment often use technology as a
weapon to compete. The development of technology in a particular company, and also in
the industry as a whole, is affected by collaboration in and transfer of technology.
Activity: Mobi International is a US-based mobile phone supplier. The company is
planning to set up a manufacturing facility in India. Before doing this, the company
wants to analyze the external business environment in India. How should the company
go about it, and what factors of the external environment should the company consider?
Answer:
Check Your Progress

13. Which of the following factors given below is (are) not part of the economic
environment?
i. Monetary, industrial, and fiscal policies
ii. Capitalist, socialistic, or mixed economy
iii. Factors related to the management of public affairs and their impact on an
organizations business
iv. Infrastructural factors such as financial institutions, banks, communication
facilities, modes of transport, and energy sources.
a. Only ii and iv
b. Only iii
c. Only i, ii, and iii
d. Only iv
11

14. Which of the following environments includes macro level factors such as
national income, per capita income, and balance of payments that affect an
organizations business?
a. Trade environment
b.
c.
Financial environment
d.
Political environment
15.
refers factors related to the management of public affairs and

their impact on an organizations business.
a.
Political environment
b.
c.
Trade environment
d.
16. What is the process of integration of the world into one huge market referred to
as?
a.
Liberalization
b. Privatization c.
Globalization
d.
Capitalization
17.
factors are related to applied knowledge and the materials and

machines used in the production of goods and services.
a.
Trade environment
b.
Technological environment
c.
d.
Legal Environment
Organizations being corporate entities have to abide by the law of the land. Legal
systems with varied complexity and dimension differ from country to country, thus
making it essential for the multinational companies to cope with the widely differing
laws in the countries where they are operating. In some countries, the laws specify
virtually every detail, while in others, they serve only as a broad guideline and their
interpretation is left to the courts. Therefore, a foreign enterprise has to be
scrupulously careful to abide by the local laws and regulation.
While businesses have crossed national boundaries, there is no international body to
make rules and oversee their fulfillment by different parties. The jurisdiction of laws
gains importance when a conflict occurs between contracting parties and the question
arises as to which nations laws be applied to resolve the problem. In order to control
foreign businesses in their economies, host countries enact laws, which take several
forms such as tariffs, antidumping laws, export/import licensing investment
regulations, legal incentives, and restrictive trading laws.
12

Regulatory Environment
The regulatory environment factors are related to the planning, promotion, and regulation
by the government, of those economic activities that affect an organizations business.
Given below are some of the important factors and influences operating in the
regulatory environment.
The constitutional framework, directive principles of state policy, fundamental rights,
and division of legislative power between central and state governments.
Policies related to distribution and pricing, and their control.
Policies related to imports and exports.
Policies related to the public sector, small-scale industries, sick industries, development
of backward areas, control of environmental pollution, and customer protection.
The economic activities of a country are regulated by public authorities in the larger
interests. Business and industry operate within a regulatory environment. A two-way
relationship exists between industry and the regulatory environment. The industry
functions according to the policies, procedures, and rules laid down by the
government. However, the industry tries to influence the government through
lobbying, creation of public awareness, press advertisements, and the parliamentary
process. Thus, the regulatory environment is one of the most important components
that the strategic managers of any organization have to consider.
The exercise of the regulatory mechanism takes place through various administrative
controls over business. Some of these controls include industrial policy and licensing;
capital issues control and control over stock exchanges; control over foreign exchange
and import and export control; control over foreign investment and foreign
collaboration; control over commodities pricing and distribution; control over
development and regulation of industries; control through consumer protection; and
control of environmental pollution.
The government is often blamed by the industry for exercising excessive control
through a plethora of rules and regulations. On the other hand, companies are
sometimes accused of failing to work within the framework of national priorities, and
failing to live up to the expectations of society in general.
Tax Environment
Governments design tax systems in order to raise revenue and to promote economic
and social goals. At times, governments try to stimulate overall national economic
activity through tax reduction, while at other times, they try to increase tax revenues
through tax hikes. The government may extend tax concessions to certain industries to
stimulate productive activity. Similarly, tariffs maybe imposed by the government on
imported manufactured goods to discourage the outflow of foreign exchange reserves
or to shelter a domestic industry from the onslaught of foreign competition.
The tax system may be so designed as to discourage or encourage certain social
behavior. The heavy taxation imposed on tobacco and alcohol, and fines on pollution
help in not only raising revenue, but also discourage use of such products. They are also
imposed as a type of social levy for the perceived harm that their use causes society.
13

Ethical Environment
There are certain dos and donts in every society. The principles of morality or rules
of conduct are referred to as ethics. Ethics aims to identify the rules that should
govern the behavior of people as well as goods that are worth seeking. An ethical
issue is a situation, problem, or opportunity in which an individual must choose
among several actions that must be evaluated as right or wrong. Similarly, the moral
principles and standards that guide behavior in the world of business comprise
business ethics and corporate governance. The demand for ethical behavior in
business has increased due to the unethical activities of various organizations.
Decisions made on the basis of what is right and what is wrong constitute an
organizations ethical environment. Managers are realizing the importance of
separating management from ownership of a company to ensure the observance of a
code of conduct.
Example: Google in China
In September 2000, Google began operating a search engine in China by offering 24
million web pages in Chinese language. It had gained lot of popularity in China owing
to its simplicity and ability to carry out searches effectively. During that time, the
Chinese government was blocking several websites through IP filters intermittently.
Users trying to search using Google were redirected to other local search engines.
In early September 2002, a new filtering system based on keywords was introduced
by the Chinese government. Filtering software containing specified words was
installed in four public access networks that blocked access to websites including
Google. When these words were searched for on Google, the browsers indicated
Page cannot be displayed. Access to Googles search services was fully restored
by September 12, 2002. After restoration of services, some search terms that were
banned by the authorities returned a standard results page. When users clicked on
the page, they were directed to websites approved by the Chinese government and
on some occasions access to Google was blocked for sometime.
By 2003, Google was ranked #1 in Chinas search engine market with a share of
34.8%. But in the next two years, its market share started dropping. Google was
unable to maintain its lead as it did not have a local presence and its services
became slow and unreliable. Google soon realized that some of the queries that
were politically sensitive were not reaching the companys servers. It was not
prepared to host its search engine on servers inside China as that would require self
censorship of the content.
In September 2004, on the launch of Chinese version of Google News, the
company announced that news sources that were banned by the Chinese
government would not be included in Google News. By November 2004, the
Chinese authorities blocked Google news in English, forcing users to switch to the
censored Chinese version of the news.
Contd
14
Contd
Google users in China continued to face many problems with the search engine.
Many services like Google images were not available. Google was unreachable 10
percent of the time. This was due to extensive filtering carried out by the ISPs in
China. ISPs used their own filtering methods resulting in inconsistent results. By
early 2004, users in China had thought that Google was unreliable and started
using alternative search engines. Google was seven times slower than its rival
Baidu and the company itself was not happy with the way its services were being
operated in the country.
Google felt that only a local presence could help it to provide better and more
reliable services to customers. To operate in China, Google needed an Internet
Content Provider license, which required it to filter its content. In April 2005, after
obtaining permission from the Ministry of Information Industry in China, Google
announced the opening of a representative office in Shanghai (Mainland China),
and registered the URL www.google.com.cn. Google also announced that its
China R&D Center would be opened by the third quarter of 2005. These steps by
Google were aimed at localizing its operations and expanding the companys
presence in the online search market in China. Earlier, Google had operated its
office from Hong Kong, which limited its ability to provide advertising services to
companies located in Mainland China. Googles business was therefore limited to
the revenues earned from AdWords and AdSense.
Filtering search results was against Googles policy; but, in order to reach Chinese
users effectively, the company said it had decided to agree to Chinese Governments
terms and conditions, which included Chinas local content restrictions.
Google agreed to remove some sensitive information and content that
was objectionable to the ruling Chinese Communist Party from its search results.
The company agreed to the censorship because even if it had provided uncensored
content, the content was filtered at the ISP level and users could only access that
content which was approved by the Government.
In January 2006, google.cn was officially launched. Google announced that it
would place disclosure on all the pages from where the search results were filtered
out. Google maintained its stand on protecting user privacy. User generated content
including e-mail, chat, and blogs were not made available on google.cn, to avoid
disclosing user information to the authorities. Google decided to store the search
records from google.cn, outside the country. In this way, Google wanted to prevent
the Chinese government from accessing the data without its consent. Google would
get better access to the market as it would be able to place its servers in China.
With the Chinese government not blocking the search, the site would speed up.
Adapted from Case Study Googles Problems in China. The ICMR Center for
15
Check Your Progress

18. Which of the following statements is false regarding legal environment?
a.
Organizations being corporate entities have to abide by the law of the land.
b.
Legal systems are broadly the same and do not differ from country to country,
thus making it easy for the multinational companies to cope with the laws in the
countries where they are operating.
c.
In some countries, the laws specify virtually every detail, while in others, they
serve only as a broad guideline and their interpretation is left to the courts.
d.
Host countries enact various laws in order to control foreign businesses in their
economies.
19. Identify from the following the factors that operate in the regulatory environment.
i.
The constitutional framework, directive principles of state policy and the

fundamental rights.
ii.
Policies related to distribution and pricing, and their control.
iii. Policies related to imports and exports.

iv. Policies related to small-scale industries, sick industries, development of
backward areas, control of environmental pollution, and customer protection.
a. Only i, ii, and iii b.
Only i, iii, and iv
c.
Only ii, iii, and iv
d.
i, ii, iii, and iv
20. The exercise of the regulatory mechanism takes place through various
administrative controls over business. Which of the following controls are used as
part of the regulatory mechanisms?
i.
Industrial policy and licensing
ii.
Capital issues control and control over stock exchanges
iii. Control over foreign investment and foreign collaboration

iv. Control over commodities pricing and distribution
v. Control through consumer protection
a.
Only i, ii, and iii
b.
Only i, iii, iv, and v
c.
Only ii, iv, and iv
d.
i, ii, iii, iv, and v
21.
a.
refers to the principles of morality or rules of conduct.

Change
b. Ethics c.
Culture
d.
16
Politics

22. Tariffs are imposed by the government to
i. to discourage the use of certain products as their use is perceived to harm the society.
ii. to raise revenue and to promote economic and social goals.
iii. to discourage the outflow of foreign exchange reserves in case of imports.
iv. to shelter a domestic industry from the onslaught of foreign competition.
Only i, iii, and iv
c. Only ii, iii, and iv
d. i, ii, iii, and iv
23. Decisions made on the basis of what is right and what is wrong constitute an
organizations
environment.
a. Political
b. Trade
c. Ethical
d.
Economic
6.2 Internal Environment

The internal environment comprises resources, synergy, and distinctive competencies
of a firm. These factors together determine its organizational capability in terms of its
strengths and weaknesses existing in the different functional areas of marketing,
operations, personnel, financial, and technical. Thus the firms capabilities in the
above mentioned functional areas in addition to the firms strategy and structure make
up the dynamics of its internal environment.
Strategy
The word strategy is derived from the Greek work strategia, which connotes the art
and science of directing military forces. Thus, strategy constitutes a well thought out
systematic plan of action to defend oneself or to defeat rivals. Glueck defined strategy
as a unified, comprehensive, and integrated plan relating the strategic advantages of
the firm to the challenges of the environment. It is designed to ensure that the basic
objective of the enterprise is achieved.
Strategy involves establishing the proper organization-environment fit or matching the
organizational factors with the environmental factors. It involves an analysis of the
organizational factors (strengths and weaknesses) and the environmental factors
(opportunities and threats) in the business environment. Thus strategy serves as a
blueprint indicating the courses of action to achieve the desired objectives. Strategy
influences an organizations internal environment in the following ways.
It determines organizational tasks.
It influences the choice of technology in the organization as well as the people
responsible for accomplishment of tasks.
It determines the specific environment within the organization as well as that within
which the organization operates. In other words, strategy defines a business
environment and gets defined by the latter.
17

Structure
Some of the important factors influencing business decisions are the organization
structure, composition of the Board of Directors, the extent of professionalization of
management, etc. The structure of an organization is affected by a number of factors
like the size of the business, the nature of the business, the diversity of the business,
the characteristics of the market, the characteristics of the strategy, and the future
plans of the organization.
Changes in the strategy of an organization may necessitate changes in the structure.
Organization structures need to be flexible so as to enable the organization to quickly
and effectively respond to market changes. A hierarchical and rigid system leads to
slower decision making, thus affecting the companys position in the highly competitive
business environment where decisions and actions have to be taken quickly.
Marketing Capability
These factors are related to pricing, promotion, and distribution of products or services,
and all related aspects that have an impact on the organizations capacity and ability to
implement strategies to market its products or services. The factors that
influence the marketing capability of an organization are given below.
Product-related factors such as variety, differentiation, positioning, and packaging.
Price-related factors like pricing objective, policies, changes, and protection.
Promotion-related factors such as promotional tools, sales promotion, advertising, and
public relations.
Integrative and systematic factors like marketing mix, distribution systems, company
image, marketing organization, marketing system, marketing management, and
information system.
Operation Capability
These factors are related to the production of products or services, use of material
resources, and all related aspects that have a bearing on the organizations capacity
and ability to implement strategies to produce its products or services. The factors that
influence the operations capability of an organization are given below.
Factors related to the production system such as capacity, location, layout, product or
service design, degree of automation, and extent of vertical integration.
Factors related to the operation and control system such as aggregate production
planning, material supply, inventory, cost and quality control, and maintenance
system and procedure.
Factors related to R&D such as product development, patent right, level of technology
used, and technical collaboration and support.
Personnel Capability
These factors are related to the existence and use of human resources and skills, and
all related aspects that have a bearing on the organizations capacity and ability to
implement strategies to attract and retain its human resources. The factors that
influence the personnel capability of an organization are given below.
Factors related to the personnel system such as manpower planning system, selection,
development compensation, communication and appraisal, and the personnel
departments position within the organization procedures and standards.
18

Factors related to organizational and employees characteristics such as corporate
image, quality of managers, staff and workers, employers perception about and
image of the organization, availability of development opportunities for employees,
and working conditions.
Factors related to industrial relations such as the relationship between union and
management, collective bargaining, safety, welfare and security, employee
satisfaction, and employee morale.
Financial Capability
These factors relate to the availability, usage, and management of funds and all related
aspects that have a bearing on the organizations capacity and ability to implement its
strategies towards procurement and disbursement of funds. The factors that influence
the financial capability of an organization are given below.
Factors related to the sources of funds such as the capital structure, procurement of
capital, financing pattern, availability of working capital, borrowings, capital and
credit availability, reserves and surplus, and relationship with banks, lenders, and
financial institutions.
Factors related to the use of funds, capital investment, fixed assets acquisition, current
assets, loans and advances, dividend distribution, and relationship with shareholders.
Factors related to management of funds such as financial accounting and budgeting,
management control system, state of financial health, cash, inflation, credit, return and
risk management, cost reduction and control, and tax planning and control.
Technical Capability
Organizations cannot face challenges of the 21st century by replacing existing work
structures, procedures, and technologies. They need a strategy for organizational
fitness including leveraging on limited resources to achieve dramatic, rapid, and
continuous improvement. Most product development organizations recognize that the
capability of their technical staff is critical to improving their productivity and quality
in achieving their business goals.
Activity: TPL, a tyre manufacturing company has been facing problems with regard to
its products. The company was receiving several complaints regarding the poor quality
of its tyres from its customers. Upon investigation, the companys top Management
found that the problems occurred due to a poor quality control system. It also found out
that the machinery at the manufacturing facility was poorly maintained. What is this
area of internal environment that has been looked into by the management? What
are the other areas that make up the dynamics of the companys internal
environment?
Answer:
19
Check Your Progress

24.
a.
can be defined as a unified, comprehensive, and integrated plan

relating the strategic advantages of the firm to the challenges of the environment.
Strategy
b.
c.
Structure
Ethics
d.
None of the above
25. Which among the following involves an analysis of the organizational factors,
that is, strengths and weaknesses, and the environmental factors, that is,
opportunities and threats, in the business environment?
a. External environment analysis
b.
Strategic analysis
c.
d.
Economic environment analysis

Structural analysis
26. In which of the following ways does strategy influence an organizations internal
environment?
i. It determines organizational tasks.
ii.
It influences the choice of technology in the organization as well as the people

responsible for accomplishment of tasks.
iii. It determines the specific environment within the organization as well as that
within which the organization operates. In other words, strategy defines a
business environment and gets defined by the latter.
a. Only i and ii b.
Only i and iii
c.
Only ii and iii
d.
i, ii, and iii
27. The
is affected by a number of factors like the size of the
business, the nature of the business, the diversity of the business, the
characteristics of the market, the characteristics of the strategy, and the future
plans of the organization.
a.
organizational personnel
b.
c.
organizational structure
organizational size
d.
organizational strategy
28.
type of organization structures lead to slower decision making,

affecting the organizations position in the highly competitive business
environment where decisions and actions have to be taken quickly.
a.
Rigid
b.
Flexible
c.
Hierarchical
d.
Both (a) and (c)
20

29. Which among the following is not a factor that influences the marketing
capability of an organization?
a. Positioning
b.
Pricing objective
c.
Distribution system
d.
Return and risk management
30.
a.
factors are related to the production of products or services, use of

material resources, and all related aspects that have a bearing on the organizations
capacity and ability to implement strategies to produce its products or services.
Marketing capability
b.
c.
Financial capability
Operations capability
d.
Personnel capability
31. Identify the factors that influence the operations capability of an organization.
i. Extent of vertical integration
ii.
Risk management
iii. Cost and quality control

iv. Manpower planning system
a.
Only i and ii
b.
c.
Only i and iii

Only ii and iv
d.
Only i, ii, and iii
32.
factors are related to the existence and use of human resources and
skills, and all related aspects that have a bearing on the organizations capacity
and ability to implement strategies to attract and retain its human resources.
a. Technical capability
b. Personnel capability c.
Marketing capability
d.
Operations capability
33. Which of the following statements is false regarding financial capability factors?
a. These factors relate to the availability, usage, and management of funds and all
related aspects that have a bearing on the organizations capacity and ability to
implement its strategies towards procurement and disbursement of funds.
b.
c.
d.
It includes factors related to the sources of funds such as capital structure,

procurement of capital, financing pattern, availability of working capital,
borrowings, and capital and credit availability.
It includes integrative and systematic factors like marketing mix, distribution
systems, company image, marketing organization, marketing system, marketing
management, and information system.
It includes factors related to the use of funds, capital investment, fixed assets
acquisition, current assets, loans and advances, dividend distribution, and
relationship with shareholders.
21
7. Summary
Environment can be defined as surrounding external objects or influences of
circumstance under which someone or something exists. The environment of an
organization is constituted by an aggregate of all conditions, events, and influences
that surround and affect it.
Every business enterprise has to cope with internal as well as external factors.
Business environment is complex and dynamic. Managers have to consider the
impact of the external and the internal environment on the organization while making
decisions.
All the factors outside the organization which provide opportunities or pose a threat to
the organization make up the external environment.
All the factors within an organization which impact strengths or cause weaknesses
constitute the internal environment.
The individual factors of the external environment are demographic environment,
social environment, cultural environment, political environment, economic
environment, financial environment, trade environment, technological environment,
legal environment, regulatory environment, tax environment and ethical environment.
The individual factors of the internal environment exist in the functional areas of
marketing, operations, personnel, financial, and technical, in addition to the firms
strategy and structure.
8. Glossary
Economic environment: It comprises factors such as the fiscal policy, monetary
policy, industrial policy, the physical limits on output, the price and income equations,
nature of the economic system, and the pace of economic development.
Environment: Surrounding external objects or influences of circumstance under
which someone or something exists. The environment of an organization is
constituted by an aggregate of all conditions, events and influences that surround and
affect it.
External environment: All the factors outside the organization which provide
opportunities or pose a threat to the organization.
Internal environment: All the factors within an organization which impact strengths
or cause weaknesses.
Non-economic environment: It includes social, cultural political, legal, and
technological factors.
Opportunity: A favorable condition in the environment of an organization which
enables the organization to consolidate and strengthen its position.
Strategy: It can be defined as a unified, comprehensive, and integrated plan relating
the strategic advantages of the firm to the challenges of the environment.
Strength: The inherent capacity which an organization can use to gain strategic
advantages over its competitors.
Threat: An unanticipated condition in the organizations environment which creates a
risk for or causes damage to the organization.
Weakness: An inherent limitation or constraint which creates a strategic
disadvantages.
22
9. Self-Assessment Test
1.
Before making any decision, managers have to take into consideration the
business environment. Explain the importance of business environment in
managerial decision-making.
2.
An organizations growth and profitability depends on its understanding of the

external and the internal environment. Explain the external environment factors
and the internal environment factors that affect an organization.

1.
Anant K. Sundaram and J. Stewart Black, The International Business

Environment: Text and Cases, Prentice-hall Of India Pvt Ltd, 2007.
2.
Francis Cherunilam, Global Economy and Business Environment, Himalaya

Publishing House, 2004.
3.
Raj Agrawal and Parag Diwani, Business Environment, Excel Books, Second
Edition, 2002.
4.
S.K. Misra and V.K. Puri, Economic Environment of Business, Himalaya

5.
Namita Gopal, Business Environment, Tata McGraw-Hill, Second Edition, 2009.
6.
Business Environment
<http://www.1000ventures.com/business_guide/business_environment.html>
7.
External Business Environment

<http://tutor2u.net/business/gcse/external_environment_introduction.htm>
8.
<http://www.fao.org/docrep/W5973E/w5973e03.htm>

Following are the answers to the Check Your Progress questions given in the Unit.
1.
(c) Environment
Environment can be defined as surrounding external objects and influences of
circumstance under which someone or something exists. The environment is
constituted by an aggregate of all conditions, events, and influences that surround
and affect it.
2.
(c) External and Internal

Business environment can be divided into external and internal environment.
Internal factors are generally considered controllable factors as the business
enterprise has control over these factors. External factors are beyond the control
of a company.
23

3.
(b) Economic environment

Business environment can be categorized into economic and non-economic
environment. Economic environment comprises factors such as the fiscal policy,
monetary policy, industrial policy, the physical limits on output, the price and
income equations, nature of the economic system, and the pace of economic
development.
4.
(b) Non-economic environment

Business environment can be categorized into economic and non-economic
environment. The non-economic environment includes social, cultural political,
legal, and technological factors.
5.
(a) Controllable factors

Internal factors are generally considered controllable factors as the business
enterprise has control over these factors. The companys personnel, strategy,
structure, and its functional, operations, marketing, and technical capabilities are
all internal factors.
6.
(b) Uncontrollable factors

External factors are beyond the control of a company such as economic, sociocultural, regulatory and legal, and demographic factors. Therefore, they are called
as uncontrollable factors.
7.
(c) Improvement in the air and road links

A firm may achieve external economies of scale if there are changes in the
external environment such as improvements in the transport facilities and
communication. The other three options help a firm in achieving internal
economies of scale.
8.
(c) Opportunity
All the factors outside the organization which provide opportunities or pose a
threat to the organization make up the external environment. Opportunity refers to
a favorable condition in the environment of an organization which enables the
organization to consolidate and strengthen its position.
9.
(a) Strength
All the factors within an organization which impact strengths or cause
weaknesses constitute the internal environment. Strength is the inherent capacity
of an organization which can be used to gain strategic advantage over its
competitors.
10. (d) Demographic environment

Demographic environment is studied with reference to the size, growth rate, age
composition, gender composition, life expectancy, etc., of the population.
Demographic environment factors affect the demand for goods and services.
24

11. (b) Social environment
Social environment factors include human relationships and the developments. The
form and function of such relationships have a bearing on the organizations business.
The study of factors such as family structures and changes in them, role and status of
women in society, and educational levels and gender inequality in educational levels
which affect a business organization is part of social environment.
12. (d) i, ii, iii, and iv
Cultural blunders may prove expensive for multinational companies. Such
blunders may lead to embarrassment, lost customers, legal consequences, missed
opportunities, expensive damage control, and tarnished reputation. Thus, it is
imperative to gather a deep understanding of cultural differences and grasp the
intricacies of foreign markets in this era of globalization.
13. (b) Only iii
All the given options are part of the economic environment, except option iii.
Option iii is part of the political environment.
14. (b) Economic environment
The economic environment factors include macro level factors such as national income,
per capita income, and balance of payments that affect an organizations business.
15. (a) Political environment
Political environment refers factors related to the management of public affairs
and their impact on an organizations business. It is closely related to the
economic system and the economic policy.
16. (c) Globalization
Economic reforms worldwide have compelled businesses to come out of their domains
and see beyond the physical boundaries of the country, thus leading to globalization.
Globalization is the process of integration of the world into one huge market.
17. (b) Technological environment
Technological environment factors are related to applied knowledge and the
materials and machines used in the production of goods and services. Some of the
factors and influences operating in the technological environment include sources
of technology, cost of acquisition of technology, technological development,
effects of technology on environment, and technology in management.
18. (a) Legal systems are broadly the same and do not differ from country to
country, thus making it easy for the multinational companies to cope with
the laws in the countries where they are operating.
All the statements are true regarding legal environment, except statement (b). The
correct statement is legal systems with varied complexity and dimension differ
from country to country, thus making it essential for the multinational companies
to cope with the widely differing laws in the countries where they are operating.
25

All the statements given are factors that operate in the regulatory environment.
20. (d) i, ii, iii, iv, and v
All the statements given are controls used as part of the regulatory environment.
21. (b) Ethics
The principles of morality or rules of conduct are referred to as ethics. Ethics
aims to identify the rules that should govern the behavior of people as well as
goods that are worth seeking.
Tariffs are imposed by the government to discourage the use of certain products
as their use is perceived to harm the society; to raise revenue and to promote
economic and social goals; to discourage the outflow of foreign exchange
reserves in case of imports; and to shelter a domestic industry from the onslaught
of foreign competition.
23. (c) Ethical
Decisions made on the basis of what is right and what is wrong constitute an
organizations ethical environment. An ethical issue is a situation, problem, or
opportunity in which an individual must choose among several actions that must
be evaluated as right or wrong.
24. (a) Strategy
Strategy can be defined as a unified, comprehensive, and integrated plan relating
the strategic advantages of the firm to the challenges of the environment. It
involves establishing the proper organization-environment fit or matching the
organizational factors with the environmental factors.
25. (b) Strategic analysis
Strategy involves an analysis of the organizational factors, that is, strengths and
weaknesses, and the environmental factors, that is, opportunities and threats, in
the business environment. Strategy serves as a blueprint indicating the courses of
action to achieve the desired objectives.
26. (d) i, ii, and iii
Strategy influences an organizations internal environment in the following ways
-- it determines organizational tasks; it influences the choice of technology in the
organization as well as the people responsible for accomplishment of tasks; and it
determines the specific environment within the organization as well as that within
which the organization operates. In other words, strategy defines a business
environment and gets defined by the latter.
27. (b) organizational structure
The organizational structure is affected by a number of factors like the size of the
business, the nature of the business, the diversity of the business, the
characteristics of the market, the characteristics of the strategy, and the future
plans of the organization. Organization structures need to be flexible so as to
enable the organization to quickly and effectively respond to market changes.
26

28. (d) Both (a) and (c)
Organizational structures which are rigid and hierarchical lead to slower decision
making, affecting the organizations position in the highly competitive business
environment where decisions and actions have to be taken quickly. They need to
be flexible to enable the organization to quickly and effectively respond to market
changes.
29. (d) Return and risk management
Positioning, pricing objective, and distribution system are all factors that
influence the marketing capability of an organization. Return and risk
management is a factor that influences the financial capability of an organization.
30. (c) Operations capability
Operations capability factors are related to the production of products or services,
use of material resources, and all related aspects that have a bearing on the
organizations capacity and ability to implement strategies to produce its products
or services. Some of the factors and influences affecting operations capability of
an organization are capacity, location, layout, aggregate production planning,
patent right, level of technology used, etc.
31. (b) Only i and iii
Extent of vertical integration, and cost and quality control are the factors that
influence the operations capability of an organization. Risk management is a
factor that influences the financial capability of an organization, while manpower
planning system is a factor that influences the personnel capability of an
organization.
32. (b) Personnel capability
Personnel capability factors are related to the existence and use of human
resources and skills, and all related aspects that have a bearing on the
organizations capacity and ability to implement strategies to attract and retain its
human resources. Some of the factors and influences affecting personnel
capability are manpower planning system, corporate image, quality of managers,
working conditions, collective bargaining, safety, employee morale, etc.
33. (c) It includes integrative and systematic factors like marketing mix,
distribution systems, company image, marketing organization, marketing
system, marketing management, and information system.
All the statements are true regarding financial capability factors except statement
(c). Integrative and systematic factors like marketing mix, distribution systems,
company image, marketing organization, marketing system, marketing
management, and information system are part of the marketing capability.
27
Unit 2

Structure
1.
Introduction
2.
Objectives
3.
Understanding Demographics
4.
Demographic Classification
5.
Society
6.
Social Class
7.
Group
8.
Family
9.
Summary
10. Glossary
1. Introduction
In the last section of the previous unit, we have discussed about the external and
internal environments of a business organization. We have learnt that the external
environment is constituted by several individual factors. In this unit, we will discuss
two of the external environment factors demographic environment and social
environment and understand their importance in the study of business environment.
An understanding of the demographic environment is important for a business as it
involves people for whose consumption goods and services are produced.
Demographics influence consumption behaviors directly and indirectly by influencing
other attributes of individuals such as their personal values and decision styles (which
in turn influence consumption).
Social stratification has always existed in one form or the other in all societies. A
study of social class differences helps marketers understand consumer behavior,
segment markets appropriately, and subsequently, develop marketing strategies.
Man, being a social animal, interacts with others regularly. Most times, our social
behavior and relationships are motivated by the desire to satisfy our needs. Thus, the
impact of social groups affects many buying decisions. The family provides an
opportunity to jointly examine demographic, economic, sociological, and biological
variables. Family demography is concerned with the factors that determine the
number, size, composition and change in families.

This unit will give you an overview of the demographic environment, and discuss the
classification of demographics. We shall then move on to discuss aspects of the social
environment. We will discuss social class and social status, and then study how social
classes are determined. Finally, we would discuss the importance of analyzing the
family life cycle in business.
2. Objectives
define the demographic environment.
identify the various demographic variables such as income, lifestyle, education,
gender, social class, occupation, and age.
explain the social environment by understanding the concepts of social class, group,
and family.
3. Understanding Demographics
Demographics describe a population in terms of its size, structure, and distribution.
Size means the number of individuals in a population; structure describes the
population in terms of age, income, education, and occupation among other things;
and distribution of the population describes the location of individuals in terms of
geographic region and rural, urban, or suburban location.
A sound knowledge of different demographic variables such as age, income, lifestyle,
and education is essential for designing and marketing products and services.
Demographic variables are the most popular bases for distinguishing consumer
groups. Consumer wants, preferences, and usage rates are often associated with
demographic variables. They influence consumer behavior and contribute to the
overall demand for various products and services.
4. Demographic Classification
Markets comprise innumerable buyers. Buyers differ in their wants, purchasing
power, buying attitudes, and buying habits. So, it may not be practically feasible to
develop a single product or service that would appeal to all consumers. The concept of
market segmentation proves helpful in this situation. Market segmentation aims at
dividing the market into distinct subset of consumers with homogeneous needs or
characteristics and selecting one or more segments to target them. Income, lifestyle,
education, gender, social class, occupation, and age are the demographic variables.
These have been traditionally used by marketers to segment the market.
4.1 Income
Income determines both purchasing power and status. Higher the income, greater the
purchasing power. However, income per se generally does not cause or direct
consumption to nearly the extent that education and occupation do. Occupation and
education influence preferences for products and services; income only provides the
means to acquire these products and services. Income is generally more effective as a
segmentation variable, when used along with other demographic variables.
29

4.2 Lifestyle
The lifestyle of an individual is the pattern of living expressed through his/her
activities, interests, and opinions. Lifestyle patterns include the ways people spend
time, the extent of their interaction with others, and their general outlook on life and
living. People determine their own lifestyles, but the pattern is also affected by
demographic factors such as age, education, income, and social class. Lifestyles
impact the consumer buying decision process in many ways. They also influence the
consumers product needs and brand preferences.
4.3 Gender
Gender has always been a distinguishing segmentation variable. Firms design
products that are specifically meant for either men or women. Of late, gender roles
have changed in many ways; it is no longer an accurate way to distinguish consumers
in some product categories. Demographic classification on the basis of gender has also
changed with time in the case of many products. Many product categories have been
affected by the increased number of women in the workforce. For product
manufacturers or service providers, study of this classification is very important to
help them position the product properly.
4.4 Education
Education has traditionally been highly valued in many cultures, and is a direct
measure of status. The higher ones educational level, the more status one has in the
society. Education has a strong influence on ones tastes and preferences. It also
influences how one thinks, makes decisions, and relates to others. It also influences
what one can purchase by partially determining ones income and occupation.
4.5 Social Class
A social class is a hierarchical division of a society into relatively distinct and
homogeneous groups whose members have similar attitudes, values, and lifestyles. An
individuals education, occupation, ownership of property, income level, and heritage
(racial/ethnic background, parents status) influence his/her social standing. Social
standing ranges from the lower class (those with few or none of the socioeconomic
factors desired by society) to the upper class (those with many of the socioeconomic
characteristics considered desirable by society). Individuals with different social
standings tend to have different needs and consumption patterns. Many companies
design products and services for specific social classes.
4.6 Occupation
Occupation provides status and is linked to education and income. The type of
work one does and the types of individuals one works with over time also directly
influence ones values, lifestyles, and all aspects of the consumption process.
Media preferences, hobbies, and shopping patterns are also influenced by
occupational class.
30

4.7 Age
Age is used as a basis for understanding and segmenting a market as the product and
service needs vary with consumer age. It is also the most frequently used demographic
variable in market segmentation. This is because the life cycle has been divided up by
society into easily recognizable groups that are clearly differentiated from each other
infants, children, teenagers, young adults, and so on. Also, knowing someones age
can often tell you a lot about them. Disposable income generally increases with age (at
least until retirement).
Exa mple: Dominos Pizza i n
Japan
Dominos Pizza was established in 1960, when two brothers purchased DomiNicks,
a pizza store in Ypsilanti, Michigan. The company was renamed as Dominos Pizza
in 1965. In order to expand globally, franchisers were invited to open their own stores
and this paved the way for Dominos Pizza to mark its presence in various countries
across the world. However, the companys operations in various countries outside the
US were a failure. Many analysts opined that the failure was mainly due to the
companys failure to comply with the requirements of local customers. The company
started carefully analyzing the local environment and adapting its practices to suit the
needs of customers. Further, it also trained its franchisees to meet the companys
standards. This was evident in the case of its franchisees in Japan who won the hearts
of Japanese consumers by meeting their demands.
The dramatic changes in the demographics of the Japanese market in the 1980s
gave scope for a lot of business opportunities. The emergence of the working
woman who found little time for cooking gave rise to the need for ready to eat
food. Further, the teen population in Japan had developed an interest in western
habits and styles. These demographical changes in Japan encouraged Dominos
Pizza to open its first pizza store in Japan in 1985. It proved to be a success.
Dominos Pizza did a lot of groundwork before it entered the Japanese market. It
conducted extensive market research, which revealed that the food habits and tastes
of the Japanese were quite different from that of the US consumers. The research
found that the Japanese preferred raw fish, rice, and seaweed in their diets to pizza
with common ingredients like tomato and cheese. It was also found that among the
various segments of the Japanese market, the teen segment was the one that liked
pizza the most. But the segment couldnt afford to consume the product in huge
quantities as it had the least disposable income. Another potential segment was the
premium segment, but the problem was that the people of this segment preferred to
go out to expensive restaurants rather than having a pizza at home. Thus, the
Japanese market threw many challenges in Dominos way.
Dominos tried many strategies to win the patronage of the Japanese consumers.
The first among these was changing the size of the pizza. It made the pizzas smaller
into 10 and 14 inch pies from the 12 and 16 inch versions, along with toppings
preferred by the Japanese. Dominos introduced toppings such as squid, shimeji
mushrooms, pineapple and corn, catering to the tastes of the Japanese consumers.
Contd
31
Contd
One major hurdle for the company in reaching its customers was the heavy traffic
in Japan that made it impossible to deliver the product in time. However, the
company was able to overcome the problem of by using three-wheeled scooters
with a pizza-warming container on the rear of the vehicle. These vehicles were able
to zip past the traffic on Japans congested roads, allowing the delivery boys to
rush even during the heavy traffic hours to keep to their delivery times. Another
difficulty Dominos faced in Japan was locating addresses as the houses in Japan
were not numbered according to location, but according to when they had been
constructed. Therefore, the franchisee outlets in Japan were provided with the area
maps to easily locate the customers and deliver the pizzas in time. Also, the
employees of the stores were given intensive training on behavioral aspects. The
training programs taught the staff about the Japanese standards of politeness by
providing samples of polite phrases. The staff was also supposed to use polite
phrases when they answered phone calls from customers.
Adapted from Case Study Dominos Pizza: Challenges Faced in Japan. The
ICMR Center for Management Research, 2005. www.icmrindia.org.
Activity: A consumer appliances company was planning to bring out microwaves,
air conditioners, and washing machines for the low-end consumer market in
Andhra Pradesh. The marketing research department of the company was assigned
the task of finding out the potential markets where the company can sell its
products. The market research team selected few places, and teams were sent to
collect the demographic information about the places. In this regard, what kind of
information should the team look out for? Why?
Answer:
Check Your Progress

1.
Demographics describe a population in terms of its size, structure, and

distribution. In this regard, which of the following statements is correct?
a.
Size describes the population in terms of age, income, education, and occupation
among others.
b.
Structure means the number of individuals in a population.
c.
Distribution of the population describes the location of individuals in terms of

geographic region and rural, urban, or suburban location.
d.
All of the above
32

2.
Identify the statements that hold true regarding the study of demographics in the
environment.
i.

distribution.
ii.
A sound knowledge of different demographic variables such as age, income,

lifestyle, and education is essential for designing and marketing products and
services.
iii. Demographic variables are the most popular bases for distinguishing consumer
groups.
iv. Consumer wants, preferences, and usage rates are often associated with
demographic variables.
Only i, iii, and iv
c.
d.
i, ii, iii, and iv
3.
Which of the following aims to divide the market into distinct subsets of
consumers with homogeneous needs or characteristics?
a.
Socialization
b.
Segmentation
c.
Stereotyping
d.
None of the above
4.
is a hierarchical division of a society into relatively distinct and

homogeneous groups whose members have similar attitudes, values, and
lifestyles.
a. Social class b.
Socialization
c.
Social standing
d.
Social mobility
5. Society
Society is composed of a group of people who share institutions which we classify as
political, economic, religious, etc. A society is the largest membership group.
Typically, it has territorial boundaries, but these may not be precise. Societal
boundaries are often marked by language and religion, which are important features
by which societies are identified. Members belonging to a society must coordinate their
actions with each other. No individual can do his/her own thing with no
concern for others.
6. Social Class
Social class can be defined as the classification of members of a society into a
hierarchy of distinct classes, so that a member of each class has approximately equal
position in society with other members of the same class. Though all people in this
33

world may be created equal, society gives different status to different people. Some
people have a high status in society, while others are given a lower status. These
statuses are referred to as social strata or classes. Social stratification is the ranking of
people by the other members of a society into higher and lower positions. The status
and respect given to the people in the society depends on this ranking.
6.1 Characteristics of Social Class
Social classes have the following characteristics.
Social Classes are Multidimensional
Social classes are based on various components, and are therefore, multidimensional.
They are not determined by a single parameter such as occupation and income.
Certain parameters are more reliable than others. For instance, although money is
often a misleading indicator of social class or position, in the US, it is largely
associated with the idea of social class. Occupation is one of the best indicators of
social class. In every society, some jobs are given higher status than others. Housing is
another important variable that helps determine a persons social class.
Social Classes are Hierarchical
Social class categories are ranked vertically ranging from higher status to lower status.
Members of a particular social class may perceive the members of other social classes
as either equal or as of higher or lower status. This aspect is very important for
marketers. Consumers prefer to buy the product which they think is being used by
their equals or higher classes. They usually avoid products that are perceived to be
lower class products.
Social Classes are Restrictive
Members of a social class interact with each other as their values, behavior, activities,
and interests match. They interact less with members of other social classes because
of differences in educational background, lifestyle, and income level. People also
think that it is below their dignity to interact with persons of lower status. This kind of
restricted behavior makes it difficult for marketers to communicate their message
across different social classes.
Social Classes are Homogeneous
People within a social class are homogeneous as they have similar interests, attitudes,
and purchasing behavior patterns. They are exposed to similar media, and buy similar
products and services. This homogeneity helps marketers in segmenting the market
effectively.
Social Classes are Dynamic
The social stratification system can be divided into open and closed systems. In an open
system, people have the opportunity to move vertically in the society, i.e., they can
move from a lower status to a higher one or vice-versa. In a closed system, the status of
a person is determined by their birth. That is, status is inherited and social mobility is
restricted. Changes in social status, however, take place over a long period of time.
34
Check Your Progress

5.
Which of the following statements is not true regarding society?
i.
Society is composed of a group of people who share institutions which we

classify as political, economic, religious, etc.
ii.
Society has very precise territorial boundaries marked by language and religion,
which are the important features by which societies are identified.
iii. Members belonging to a society may or may not coordinate their actions with
each other.
a.
Only i and ii b.
Only i and iii c.
Only ii and iii
d.
Only iii and iv
6.
All the statements given below are true regarding social classes, except:
a.
Social classes are multidimensional.
b.
Social classes are heterogeneous.
c.
Some people have a high status in society, while others are given a lower status.
d.
Social classes are restrictive.
7.
The social stratification system can be divided into:
a.
open and closed system
b.
formal and informal system
c.
primary and secondary system
d.
economic and non-economic system
8.
In which of the following systems do people have the opportunity to move

vertically in the society, i.e., they can move from a lower status to a higher one or
vice-versa?
a.
Formal system
b.
Open system
c.
Closed system
d.
Informal system
7. Group
A group can be defined as, two or more individuals who share a set of norms values
or beliefs and have certain implicitly defined relationships to one another such that
their behaviors are interdependent. A group consists of two or more people who
interact to accomplish either individual or mutual goals.
35

7.1 Group Properties
In order to understand the concept of group, one has to be aware of the concepts of
status, norms, role, socialization, and power.
Status
Status is the achieved or recognized position of an individual in a group. This can be
attained through aspects like education, income level, occupation, or family
background. It is ones rank in the social system, as perceived by the other members
of the society. Status goes with certain rights and duties associated with that position.
Sometimes, few members who have similar status in the society may come together to
form a group.
Norms
Norms are the rules and standards of conduct set by a group. Group members are
expected to abide by these norms. In informal groups, norms are generally unwritten,
but are well understood.
Role
The term role is usually designated to the behavioral patterns associated with a
particular status. Role is the dynamic aspect of status, and includes the attitude,
values, and behavior ascribed by society to people having a particular status. The
structure existing in the society decides what sort of role behavior is acceptable. The
behavior expected of an individual depends on the position held by him/her, rather
than on the individual himself.
For instance, generally all students are expected to attend classes and study. However,
the levels to which these expectations are fulfilled vary dramatically. While some
students come into the class early, take notes, and ask several questions, there are
others who come late to class and never ask questions. All of us perform several roles.
The roles may change over time, sometimes even within a day. A student may be
playing the role of a son in the house, a part-time employee in a restaurant, and a
basketball team player. His behavior in each role will be different.
Roles in groups are learned, but each individual does not learn in the same way.
Society allows some variation in role performance. Role parameters represent the
range of behavior acceptable within a given role. If the behavior varies too much,
sanctions are imposed. Sanctions are punishments imposed on an individual for
violating role parameters. That is, individuals are rewarded for conformity and
punished for non-conformity. Role overload occurs when an individual tries to
perform too many roles in the limited available time, energy, or money. Individuals
who try to do this may also face role conflict, that is, two or more of their roles are
incompatible with each other. For example, working women who are married often
have to face conflict between their roles as a home-maker and as an employee.
A role stereotype is a shared visualization of the ideal performer of a given role. We
share a common view about the behavioral characteristics of doctors, lawyers, and
teachers. Managers can use these stereotypes in their promotional messages.
36

Socialization
Socialization is a process by which new members learn the values, norms, and
expected behavior patterns of the group they are becoming a part of. Socialization is
an ongoing process. It is intense in childhood, but people go through the process
whenever they meet new groups that impact their lives. Consumer socialization is a
process by which individuals acquire the skills, knowledge, and attitudes required to
function as consumers.
Power
Power can be defined as a force that results in behavior that would not have occurred
in the absence of the force. It also refers to the degree of personal choice a person
enjoys or his/her influence over others. Various social powers may be operative in
different social groups. Some of these are reward power, coercive power, legitimate
power, expert power and referent power.
Reward power
It is based on the perception one has about anothers ability to reward him/her. The
strength of reward power increases as the one perceives the size of reward another can
assess. Rewards may either be tangible (money, gifts) or intangible (recognition,
praise). Social groups have a great deal of reward power, which they dispense to their
members. This motivates members to exhibit the desired behavior. Marketers use
reward power, directly (by providing quality products and services) or indirectly (by
promising the reward of group acceptance through the use of a particular product), to
influence consumers.
Coercive power
It is the power to influence behavior through punishment or by withholding rewards.
Punishment may not be physical punishment, but subtle psychological sanction.
Coercive power is used by marketers to show the unfortunate consequences that a
consumer may face if he/she doesnt own the product or service (life insurance,
deodorants, mouthwash, etc.), thus coercing them to buy the product or service.
Legitimate power
It stems from a members perception that the group has the legitimate right to
influence him/her. Some of these feelings are internalized by parents, teachers, and
religious institutions. An individual accepts some sort of code, and the group he/she
belongs to can assert its power to see that he/she abides by the code. Family is a small
group in which we can see legitimate power operating. Each member performs some
role that is legitimized by other members. Marketers use this power by appealing to
consumer values. Words like should, ought to, are used to express such behavior.
Expert power
It power results from the expertise gained in due course of time, either by an
individual or a group. Consumers are always influenced by those whom they perceive
having superior knowledge, better skills, and more experience. Many advertisements
37

rely on expert opinion about the product. Information power, which is often related to
expert power, comes from logic, reasoning, and importance of communication.
Advertisements which use information power, explain why their product is good by
providing evidence on aspects like price, quality, features, and performance.
Referent power
It is based on a persons, a firms, or a products attractiveness or appeal. It flows
from the feeling of belongingness of an individual to a group. As a result of the
feeling, one develops a desire to gain closer association with the group. The
individuals identity with the group can be established or maintained only if the
individual behaves in the way a group does. The more this identification will be, the
more will be its referent power.
Advertisers use referent power in promotions to encourage consumers to be like, or do
the same thing as, the individual advertising the brand. Using celebrities in
advertisements is especially popular. Marketers also use testimonials from ordinary
consumers to show that they experienced same problems and have found satisfaction
with the recommended brand.
7.2 Classification of Groups
Groups can be classified based on the dimensions of function, degree of personal
involvement, and degree of organization.
Function
These groups are classified in terms of their functions such as students and workers.
Each major group has subcategories that could generally be categorized into family,
age, gender, education, and religion.
Degree of Personal Involvement
Based on the degree of personal involvement, we can identify two different groups -primary and secondary. In the primary group, interpersonal relationships are based on
frequent face-to-face interaction. These groups have shared norms and interlocking
roles. Families and work groups are examples of such groups. Secondary groups are
those in which the members have relatively impersonal and formalized relationships.
This is a residual category that includes all groups that are not primary such as
political parties and trade unions. Even in secondary groups, there may be face-to-face
interaction. The distinction lies in the lack of intimacy or personal involvement.
Degree of organization
Groups range from unorganized to highly structured groups. Depending on where they
fall in the range, groups are classified as formal and informal groups. Formal groups
have definite structure such as they have president, vice-president, general manager,
and secretary in an organization. These groups are typically secondary groups, and are
developed to accomplish specific goals, whether economic, political, or social.
Informal groups are typically primary groups. They have a relatively loose structure
and lack clearly defined goals and objectives. These groups influence an individuals
values and attitudes.
38

Primary groups greatly impact the customers, and therefore are important to
marketers. It is from such groups that consumers develop their consumption patterns
and media preferences. Hence, advertisers present their products within a primary
group setting, such as among family members or friends. Secondary groups also
influence consumers, and they are also used in advertising.
Activity: HealthFoods Incorporated is a company providing health drinks, healthy
snacks, and nutritious supplements to school and college going students. To market
its products to the group, the company rolled out certain ads. The ads featured wellknown nutritionists and doctors talking about the companys products and
comparing them with similar products from other companies. What kind of an
advertising strategy did the company adopt? Explain the probable reasons for the
company to use this strategy.
Answer:
Check Your Progress

9.
can be defined as two or more individuals who share a set of norms

values or beliefs and have certain implicitly defined relationships to one another
such that their behaviors are interdependent.
a.
Group
b.
Role
c.
Power
d.
Status
10. Which among the following terms can be defined as the achieved or recognized
position of an individual in a group?
a. Role b.
Status
c.
Power
d.
Norm
11. Norms can be defined as:

a.
the behavioral patterns associated with a particular status.
b.
the degree of personal choice a person enjoys or his/her influence over others
c.
the rules and standards of conduct set by a group.
d.
a process by which new members learn the values, norms, and expected behavior
patterns of the group they are becoming a part of.
39

12. Identify the statements which are false regarding role.
i. It is the degree of personal choice a person enjoys.
ii.
It is the dynamic aspect of status, and includes the attitude, values, and behavior
ascribed by society to people having a particular status.
iii. It is usually designated to the behavioral patterns associated with a particular

status.
a. Only i b.
Only ii
c.
Only iii
d.
Only i and iii
13. Match the following terms with their respective definitions.

Term
Defintion
i. Role parameter
p.
A shared visualization
performer of a given role.
ii. Role overload
q.
It represents the range of behavior

acceptable within a given role.
iii. Role stereotype
r.
It occurs when an individual tries to

perform too many roles in the limited
available time, energy, or money.
a.
i/p, ii/q, iii/r
b.
i/q, ii/r, iii/p
c.
i/r, ii/p, iii/q
d.
i/q, ii/p, iii/p
of
the
ideal
14. Identify the statements that are true regarding socialization.

i.
It is the process by which new members learn the values, norms, and expected
behavior patterns of the group they are becoming a part of.
ii.
It is an ongoing process.
iii. It is intense in childhood, but people go through the process whenever they meet
new groups that impact their lives.
a. Only i and ii b.
Only i and iii
c.
Only ii and iii
d.
i, ii, and iii
15. Which among the following terms can be defined as a force that results in
behavior that would not have occurred in the absence of the force?
a.
Group
b.
Norm
c.
Power
d.
Role
40

16. Which of the following is referred to as the power to influence behavior through
punishment or by withholding of rewards?
a.
Coercive power
b.
Legitimate power
c.
Reward power
d.
Expert power
17. Their power flows from the feeling of belongingness of an individual or group.
Which power is being referred here?
a.
Legitimate power
b.
Expert power
c.
Referent power
d.
Reward power
18. Which of the following statements is false regarding legitimate power?

a.
The power flows from the feeling of belongingness of an individual or group.
b.
It stems from a members perception that the group has the legitimate right to
influence him/her.
c.
Some of these feelings are internalized by parents, teachers, and religious

institutions.
d.
An individual accepts some sort of code, and the group he/she belongs to can
assert its power to see that he/she abides by the code.
19. Advertisements which use information power, explain why their product is good
by providing evidence on aspects like price, quality, features, and performance.
Information power is related to
_.
a.
legitimate power
b.
referent power
c.
coercive power
d.
expert power
20. Which of the following statements is true regarding the classification of groups
based on the degree of organization?
i.
Groups range from unorganized to highly structured groups.
ii.
Each major group has subcategories that could generally be categorized into
family, age, gender, education, and religion.
iii. Formal groups have definite structure, while informal groups have relatively
loose structure and lack clearly defined goals and objectives.
a. Only i and ii b.
Only i and iii
c.
Only ii and iii
d.
i, ii, and iii
41
8. Family
The term family has been defined by different authors in different ways. Given
below are some of the well-known definitions of the term.
A social unit living together.
Two or more persons related by blood, marriage, or adoption who reside together.
A household of people related by blood or marriage. More especially, we can define a
family as husband and wife (or one parent), with or without never-married children,
living together in the same dwelling.
A household may contain more than two generations of people. A nuclear family is
made up of husband and wife together with their children, born or adopted. A kinship
group is an extension of the parent-child relationship through three or more
generations, including grandparents, grandchildren, cousins, uncles, and aunts. Sib is a
group of individuals unilaterally descended from a single (real or postulated) common
ancestor. It is sometimes called a consanguineous group.
8.1 Functions of Family
A family has the responsibility to ensure the economic well being of its members, to
provide emotional support, to establish suitable family lifestyles, and to ensure the
socialization of members. These four functions are of relevance to business.
Economic Well-being
In an affluent country, family is no longer formed primarily for economic security.
Giving some kind of financial support to the members is a basic family function. In
the last few decades, division of responsibilities in the family for ensuring economic
well-being has changed significantly. The traditional roles of husband as provider and
wife as homemaker have changed with an increase in the number of working women.
The role of children has also changed with more number of teenagers working parttime to earn their pocket money. They rarely support the family financially, while
their education costs are met by the other family members.
Emotional Support
Providing emotional support (love, affection, and intimacy) and encouragement to the
members is an important function of the family that helps the members cope with
personal and social problems. If the family does not provide this kind of support when
it is required, individuals may end up taking the help of professional counselors or
psychologists.
Suitable Family Lifestyle
Establishing a suitable lifestyle is another important function of the family.
Upbringing, experience, and the personal and jointly held goals of the spouses
determine how much importance they give to education, career, reading, and
television viewing; how frequently they dine out; and what recreational and
entertainment activities they choose. Family lifestyle commitments that include the
allocation of time influence the consumption pattern to a great extent.
42

Socialization of Children and Other Family Members
Socialization of family members, especially young children, is an important family
function. This process involves teaching children the basic values and modes of
behavior that are consistent with the prevailing culture. These usually include moral
and religious principles, interpersonal skills, dress and grooming standards,
appropriate manners and speech, and the selection of suitable educational and
occupational goals.
Socialization skills can be imparted. Children are socialized directly through
instructions, and indirectly through observing the behavior of their parents and other
siblings. Marketers usually target parents looking for assistance in the task of
socializing pre-adolescent and post-adolescent children. Socialization of young
children is important because it provides a foundation for their behavior in the future.
Consumer socialization of children
Consumer socialization refers to the process by which an individual acquires the skills
necessary to function in the marketplace as a consumer. It has two different
components -- socialization directly related to consumption, and socialization
indirectly related to consumption. An example of socialization directly related to
consumption is the acquisition of skills and knowledge related to budgeting, pricing,
and brand attitudes. An example of socialization indirectly related to consumption is
the motivation that spurs a young man to purchase his first razor. The indirect
component of consumer socialization is of great interest to marketers as it helps them
to understand why people buy specific products.
Consumer socialization of children is a process by which children acquire the skills,
knowledge, and attitudes necessary to function in the marketplace as consumers.
Studies have shown that children develop consumption skills by observing their
parents who function as role models. Children usually rely on their parents and older
siblings for basic consumption learning, while adolescents and teenagers look to their
friends for acceptable behavior. Children get opportunities to learn in-store shopping
skills through shared shopping experiences. Working mothers usually opt for
coshopping with their children. Coshopping is a means of spending time with ones
children, and accomplishing an important task at the same time.
8.2 Family Life Cycle
The concept of the family life cycle (FLC) facilitates the classification of family units
into distinct segments. FLC analysis helps marketers to segment families in terms of a
series of stages spanning the life course of a family unit. FLC studies demographic
variables such as marital status, the size of family, the age of family members, the
employment status of the members, and the disposable incomes of the members. The
family-life-cycle concept is broadly categorized into two sections. The first section
studies the traditional family-life-cycle. As the first failed to analyze important family
living arrangement, the second emerged to focus on alternative stages, including the
non-traditional family.
43

Traditional Nuclear Family Life Cycle
The traditional family life cycle has been divided into the following five different
segments on the basis of various stages in the family.
i.
Bachelorhood: The major task during this period is to disconnect and reconnect
with ones family on a different level while simultaneously establishing oneself
as a person. During this stage, individuals strike out on their own taking full
responsibility for their actions and choices. Meeting, dating, and mating are
prominent concerns during this period.
ii.
Honeymooners: During this stage, newly married couples learn to adjust, adopt,
or share space, meals, work, leisure, and other activities. This process takes time,
energy, good will, and the ability to compromise. During this stage, couples opt
for a pleasure seeking lifestyle.
iii. Parenthood: Parenthood can be divided into two distinct parts. They are:
Families with young children: When a newborn enters a family, the family
becomes temporarily unbalanced. Couples have to adjust the time they spend
working outside the house, socializing with friends, and engaging in recreational
activities. They also have to decide between activities, and between themselves
who will take the responsibility of the child. A rebalancing and renegotiation
occurs between husband and wife concerning their investment of energy, time,
and focus. Couples at this stage are the best targets for companies that serve the
baby market.
Families with adolescents: Couples who take care of adolescents must take care
of themselves, the relationships, their teenagers, and often their aging parents.
This time can be turbulent if parents have difficulty setting limits and defining
relationships. This stress is usually marked by increased number of arguments
and disagreements between parents, and difference in terms due to an
inconsistency between what the parents want for their children and what the
children want for themselves.
iv. Postparenthood (an older married couple with no children living at home):
As children leave home for college, careers, or marriage, parents experience an
ideal time to rediscover each other and have fun together. Many women are likely
to be attending to their own interests and thankful for the freedom to pursue them
at last. For those women who have primarily defined themselves as mothers and
invested heavily in their children, this time can be marked by sadness and
depression.
v.
Dissolution: Couples in this stage are either in the final years of employment or
in retirement. Finances are the major concern for this population. Health and loss
of spouse are major concerns.
Modern Family Life Cycle

In the last few decades, the structure of families has changed. They have become
smaller in size. People have started postponing their marriages and divorce rates have
44

risen. So, it has become necessary to include divorced single parents, and middle-aged
married couples without children in the family lifecycle. The various stages in this
modern cycle are given in below.
Bachelor I: Age of head is between 18 and 34; single (never married, divorced,
separated, or widowed); no dependent children
Young Couple: Female head is aged between 18 and 34; couple (married or
unmarried); no children
Full Nest I: Female head is aged between 18 and 34; couple (married or unmarried);
youngest child is under 6
Full Nest II: Female head is aged between 18 and 34; couple (married or unmarried);
youngest child is 6 or over
Single Parent I: Age of head is between 18 and 34; single (never married, divorced,
separated, or widowed); youngest child is under 6.
Single Parent II: Age of head is between 18 and 34; single (never married, divorced,
separated, and widowed); youngest child is 6 or over.
Bachelor II: Age of head is between 35 and 64; single (never married, divorced,
separated, or widowed); no dependent children.
Childless Couple: Female head is aged between 35 and 64; couple (married or
unmarried); no dependent children.
Delayed Full Nest: Female head is aged between 35 and 64; couple (married or
unmarried); youngest child is under 6.
Full Nest III: Female head is aged between 35 and 64; couple (married and
unmarried); youngest child is 6 or over.
Single Parent III: Age of head is between 35 and 64; youngest child is 6 or over.
Bachelor III: Age of head is 65 or over; single (never married, divorced, separated, or
widowed); no dependent children.
Older Couple (Empty Nest): Female head is aged 65 or over; couple (married or
unmarried); no dependent children.
Activity: Anvitha is a 32 year old woman working with Nike as a quality control
manager. She has two kids -- one aged 8 and the other aged 6. She is the sole earner
in the family. Anvitha belongs to which stage in the modern family life cycle?
Name the other stages in the life cycle. Also, compare the modern family life cycle
with the traditional one.
Answer:
45
Check Your Progress

21. Which of the following statements are false regarding family?
i.
It is a social unit living together.
ii.
It is a household of people who are related only by blood, and not by adoption or
marriage.
iii. It contains only two generations of people comprising of father, mother, and
children.
iv. It has to ensure the economic well being of its members by providing emotional
support, establishing suitable family lifestyles, and socializing members.
a. Only i and ii b.
Only i and iv
c.
Only ii and iii
d.
Only iii and iv
22.
can be defined as an extension of the parent-child relationship

through three or more generations, including grandparents, grandchildren,
cousins, uncle, and aunts.
a.
Sib
b. Kinship group c.
Nuclear group d.
Postparenthood
23. Which of the following given below are the functions of a family?
i.
Provide emotional support
ii.
Ensure economic well-being
iii. Establish suitable lifestyles

iv. Socialize children and other family members
a.
Only i, ii, and iii
b.
Only i, ii, and iv
c.
d.
i, ii, iii, and iv
24. All the statements given below are true regarding socialization of children,
except:
a.
It involves teaching children the basic values and modes of behavior that are
consistent with the prevailing culture.
b.
These skills cannot be imparted through instructions or observation.
c.
It provides a foundation for the behavior of children in the future.
d.
It usually includes moral and religious principles, interpersonal skills, dress and
grooming standards, appropriate manners and speech, and the selection of
suitable educational and occupational goals.
46

25. Which of the statements given below is true regarding consumer socialization of
children?
a.
It refers to the process by which an individual acquires the skills necessary to

function in the marketplace as a consumer.
b.
An example of socialization indirectly related to consumption is the acquisition of

skills and knowledge related to budgeting, pricing, and brand attitudes.
c.
The direct component of consumer socialization is of great interest to marketers

as it helps them to understand why people buy specific products.
d.
All of the above
26. From the following, identify the statement that is not true regarding family life
cycle analysis.
a.
It helps marketers to segment families in terms of a series of stages spanning the

life course of a family unit.
b.
It does not study aspects like the income, expenditure, or disposable income of
family members.
c.
It studies demographic variables such as marital status, the size of family, the age
of family members, and the employment status of the members.
d.
It facilitates the classification of family units into distinct segments.
27. The traditional family life cycle has been divided into five different segments on
the basis of various stages in the family. All the segments given below are part of
the traditional nuclear family life cycle, except:
a.
Bachelorhood
b.
Families with adolescents
c.
Dissolution
d.
Single Parent I
28. Mr. Singh is 57 years old and is about to retire in another 3 years. He stays along
with his wife. His children are married and well-settled. Mr. and Mrs. Singh are
in which stage of the traditional family life cycle?
a.
Bachelorhood
b.
Dissolution
c.
Parenthood
d.
Delayed full nest
29. Yogita is a 32 year old mother of two daughters, one aged 9 and the other aged 5.
Her husband, an army officer, died two years back while on duty. Yogita had to
take care of the kids by herself. Considering her husbands sacrifice to the
country, the Indian army gave her a job at the Army Dental Hospital. Yogita is
going through which stage in the modern family life cycle?
a.
Full Nest I
b.
Empty Nest
c.
Single Parent I
d.
Single Parent III

47
9. Summary
Demographics describe a population in terms of its size, structure, and distribution.
Income, lifestyle, education, gender, social class, occupation, and age are
demographic variables.
Society is composed of a group of people who share institutions which we classify as
political, economic, religious, etc.
Social class can be defined as the classification of members of a society into a
hierarchy of distinct classes, so that a member of each class has approximately equal
position in society with other members of the same class.
Social classes are multidimensional, restrictive, homogeneous, and dynamic.
A group can be defined as two or more individuals who share a set of norms values or
beliefs and have certain implicitly defined relationships to one another such that their
behaviors are interdependent.
Groups can be classified based on the dimensions of function, degree of personal
involvement, and degree of organization.
A family is a social unit living together. It comprises two or more persons related by
blood, marriage, or adoption who reside together.
A family ensures the economic well being of its members, provides emotional
support, establishes suitable family lifestyles, and socializes members.
The concept of the family life cycle facilitates the classification of family units into
distinct segments. Family life cycle analysis helps marketers to segment families in
terms of a series of stages spanning the life course of a family unit.
10. Glossary
Coercive power (classification of power): The power to influence behavior through
punishment or by withholding rewards.
Demographics: Description of a population in terms of its size, structure, and
distribution. The demographic variables are income, lifestyle, education, gender,
social class, occupation, and age.
Distribution (in demographics): Description of the location of individuals in terms
of geographic region and rural, urban, or suburban location.
Expert power (classification of power): The power that results from the expertise
gained in due course of time, either by an individual or a group.
Family: A social unit living together. It comprises two or more persons related by
blood, marriage, or adoption who reside together.
Group: Two or more individuals who share a set of norms values or beliefs and have
certain implicitly defined relationships to one another such that their behaviors are
interdependent.
Legitimate power (classification of power): The power that stems from a members
perception that the group has the legitimate right to influence him/her.
Lifestyle: The pattern of living expressed by an individual through his/her activities,
interests, and opinions.
Market segmentation: Dividing the market into distinct subset of consumers with
homogeneous needs or characteristics and selecting one or more segments to target
them.
48

Norms: The rules and standards of conduct set by a group. Group members are
expected to abide by these norms.
Power: A force that results in behavior that would not have occurred in the absence of
the force. It also refers to the degree of personal choice a person enjoys or his/her
influence over others.
Reward power (classification of power): The power based on the perception one
has about anothers ability to reward him/her.
Role: The dynamic aspect of status, and includes the attitude, values, and behavior
ascribed by society to persons having a particular status.
Size (in demographics): Number of individuals in a population.
Social class: A hierarchical division of a society into relatively distinct and
homogeneous groups whose members have similar attitudes, values, and lifestyles.
Social class: The classification of members of a society into a hierarchy of distinct
classes, so that a member of each class has approximately equal position in society
with other members of the same class.
Socialization: A process by which new members learn the values, norms, and
expected behavior patterns of the group they are becoming a part of.
Society: A group of people who share institutions which we classify as political,
economic, religious, etc. People identify a particular society by determining what
identifies themselves as members and generally by others as members.
Status: The achieved or recognized position of an individual in a group. It is ones
rank in the social system, as perceived by the other members of the society.
Structure (in demographics): Description of the population in terms of age, income,
education, and occupation among others.

1.
An understanding of the demographic environment is important for a business as

it involves people for whose consumption goods and services are produced.
Explain this statement.
2.
Demographic variables are used by marketers to segment a market. What are

these variables? Describe in detail.
3.
Though, people may be created equal, society gives different status to different
people. Some people have a high status in society, while others are given a lower
status. What is a social class? Explain its characteristics.
4.
In order to understand the concept of group, one has to be aware of the concepts
of status, norms, role, socialization, and power. Explain the concept of group in
this regard.
5. Describe the following in detail.

Society
Classification of groups
Family and its functions
49

1.
Raj Agrawal and Parag Diwani, Business Environment, Excel Books, Second
Edition, 2002.
2.
Namita Gopal, Business Environment, Tata Mcgraw Hill, Second Edition, 2009.
3.
Demographics
<http://en.wikipedia.org/wiki/Demographics>
4.
Society
<http://en.wikipedia.org/wiki/Society>
5.
Types of Society
<http://www.sociologyguide.com/types-of-society/index.php>
6.
Types of Society
<http://en.wikipedia.org/wiki/Types_of_societies>
7.
Social Class
<http://en.wikipedia.org/wiki/Social_class>
8.
Social Class
<http://www.victorianweb.org/history/Class.html>
9.
Social Group
<http://en.wikipedia.org/wiki/Social_group>
10. Family
<http://en.wikipedia.org/wiki/Family>
11. Consumer Socialization of Children
<http://www.aeforum.org/aeforum.nsf/b6f532dc08e2a32e80256c5100355eab/745
1ba8d0d2d883880256d6600531043/$FILE/EB2003.pdf>
12. Family Life Cycle
<http://faculty.stonehill.edu/glantos/Lantos1/PDF_Folder/BA342_PDF/PowerPoi
nts/11.%20Family%20Influences.pdf>
13. Family Life Cycle
<https://www.csupomona.edu/~sdpeters/docs/GBA%20517/SN%20Topic%202%
20Buying%20Behavior%20PP.ppt>

1.
(c) Distribution of the population describes the location of individuals in

terms of geographic region and rural, urban, or suburban location.
distribution. Size means the number of individuals in a population; structure
describes the population in terms of age, income, education, and occupation
among others; and distribution of the population describes the location of
individuals in terms of geographic region and rural, urban, or suburban
location.
50

2.
(d) i, ii, iii, and iv

All the statements are true regarding the study of demographics in the
environment. Demographics influence consumption behaviors directly and
indirectly by influencing other attributes of individuals such as their personal
values and decision styles (which in turn influence consumption).
3.
(b) Market segmentation

Market segmentation aims at dividing the market into distinct subset of
consumers with homogeneous needs or characteristics and selecting one or more
segments to target them. Demographic variables like income, lifestyle, education,
gender, social class, occupation, and age have been traditionally used by
marketers to segment the market.
4.
(a) Social class

A social class is a hierarchical division of a society into relatively distinct and
homogeneous groups whose members have similar attitudes, values, and lifestyles.
An individuals education, occupation, ownership of property, income level, and
heritage (racial/ethnic background, parents status) influence his/her social
standing.
5.
(c) Only ii and iii

Society is composed of a group of people who share institutions which we
classify as political, economic, religious, etc. Typically, it has territorial
boundaries, but these may not be precise. Members belonging to a society must
coordinate their actions with each other. No individual can do his/her own thing
with no concern for others.
6.
(b) Social classes are heterogeneous.

All the statements are true except statement (b). Social classes are
multidimensional, homogeneous, and restrictive. People within a social class are
homogeneous as they have similar interests, attitudes, and purchasing behavior
patterns. They are exposed to similar media, and buy similar products and
services. This homogeneity helps marketers in segmenting the market effectively.
7.
(a) open and closed system

The social stratification system can be divided into open and closed system. In an
open system, people have the opportunity to move vertically in the society, i.e.,
they can move from a lower status to a higher one or vice-versa. In a closed
system, the status of a person is determined by their birth. That is, status is
inherited and social mobility is restricted.
8.
(b) Open system

The social stratification system can be divided into open and closed system. In an
open system, people have the opportunity to move vertically in the society, i.e.,
they can move from a lower status to a higher one or vice-versa. In a closed
system, the status of a person is determined by their birth. That is, status is
inherited and social mobility is restricted.
51

9.
(a) Group
A group can be defined as two or more individuals who share a set of norms
values or beliefs and have certain implicitly defined relationships to one another
such that their behaviors are interdependent. It comprises two or more people
who interact to accomplish either individual or mutual goals.
10. (b) Status

Status is the achieved or recognized position of an individual in a group. It is
ones rank in the social system, as perceived by the other members of the society.
11. (c) the rules and standards of conduct set by a group.
Norms are the rules and standards of conduct set by a group. Group members are
expected to abide by these norms. In informal groups, norms are generally
unwritten, but are well understood.
12. (a) Only i
The term role is usually designated to the behavioral patterns associated with a
particular status. Role is the dynamic aspect of status, and includes the attitude,
values, and behavior ascribed by society to people having a particular status. Power
is the degree of personal choice a person enjoys or his/her influence over others.
13. (b) i/q, ii/r, iii/p
Role parameters represent the range of behavior acceptable within a given role.
Role overload occurs when an individual tries to perform too many roles in the
limited available time, energy, or money. A role stereotype is a shared
visualization of the ideal performer of a given role.
Socialization is a process by which new members learn the values, norms, and
expected behavior patterns of the group they are becoming a part of. Socialization
is an ongoing process. It is intense in childhood, but people go through the
process whenever they meet new groups that impact their lives.
15. (c) Power
Power can be defined as a force that results in behavior that would not have
occurred in the absence of the force. It also refers to the degree of personal choice
a person enjoys or his/her influence over others.
16. (a) Coercive power
Coercive power is the power to influence behavior through punishment or by
withholding rewards. Punishment may not be physical punishment, but subtle
psychological sanction.
17. (c) Referent power
Referent power is based on a persons, a firms, or a products attractiveness or
appeal. It flows from the feeling of belongingness of an individual to a group. As a
result of the feeling, one develops a desire to gain closer association with the group.
52

18. (a) The power flows from the feeling of belongingness of an individual or
group.
Legitimate power stems from a members perception that the group has the
legitimate right to influence him/her. Referent power flows from the feeling of
belongingness of an individual to a group.
19. (d) expert power
Expert power results from the expertise gained in due course of time, either by an
individual or a group. Consumers are always influenced by those whom they
perceive having superior knowledge, better skills, and more experience. Many
advertisements rely on expert opinion about the product.
Statement ii is false as it is related to the classification of groups based on
function. In this, groups are classified in terms of their functions such as students
and workers. Each major group has subcategories that could generally be
categorized into family, age, gender, education, and religion.
21. (c) Only ii and iii
Statements i and iv are true regarding family, while statements ii and iii are false.
In a family, two or more persons related by blood, marriage, or adoption reside
together. A household may contain more than two generations of people.
22. (b) Kinship group
A kinship group is an extension of the parent-child relationship through three or
more generations, including grandparents, grandchildren, cousins, uncles, and
aunts. Sib is a group of individuals unilaterally descended from a single (real or
postulated) common ancestor. A nuclear family is made up of husband and wife
together with their children, born or adopted. Postparenthood is a stage in the
traditional family cycle that comprises an older married couple with no children
living at home.
A family has the responsibility of ensuring the economic well being of its
members by providing emotional support, establishing suitable family lifestyles,
and socializing members.
24. (b) These skills cannot be imparted through instructions or observation.
The process of socialization of family members, especially young children, is an
important family function. It involves teaching children the basic values and
modes of behavior that are consistent with the prevailing culture. Socialization
skills can be imparted. Children are socialized directly through instructions, and
indirectly through observing the behavior of their parents and other siblings.
53

25. (a) It refers to the process by which an individual acquires the skills
necessary to function in the marketplace as a consumer.
Consumer socialization refers to the process by which an individual acquires the
skills necessary to function in the marketplace as a consumer. It has two different
components -- socialization directly related to consumption, and socialization
indirectly related to consumption. An example of socialization directly related to
consumption is the acquisition of skills and knowledge related to budgeting,
pricing, and brand attitudes. An example of socialization indirectly related to
consumption is the motivation that spurs a young man to purchase his first razor.
The indirect component of consumer socialization is of great interest to marketers
as it helps them to understand why people buy their products.
26. (b) It does not study aspects like the income, expenditure, or disposable
income of family members.
The concept of the family life cycle (FLC) facilitates the classification of family
units into distinct segments. FLC studies demographic variables such as marital
status, the size of family, the age of family members, the employment status of
the members, and the disposable incomes of the members.
27. (d) Single Parent I
The traditional family life cycle has been divided into the following five different
segments on the basis of various stages in the family. These are bachelorhood,
honeymooners, parenthood, postparenthood, and dissolution. Single Parent I is a
stage in the modern family life cycle.
28. (b) Dissolution
Mr. and Mrs. Singh are going through dissolution, a stage in the traditional family
life cycle in which the couples are either in the final years of employment or in
retirement. Finances and health are the major concerns in this stage.
29. (c) Single Parent I
Yogita is a single parent. She is 32 years old and her youngest child is 5 years
old. Therefore, she belongs to the Single Parent I stage in the modern family life
cycle.
54
Unit 3
Structure
1.
Introduction
2.
Objectives
3.
Understanding Culture
4.
Essence of Culture
5.
Elements of Culture
6.
Manifestation of Culture
7.
Culture Change
8.
Cultural Analysis
9.
Cultural Adaptation
10. Cultural Sensitivity of Markets

11. Summary
12. Glossary
1. Introduction
In the previous unit, we discussed the importance of the demographic and the social
environments in the study of business environment. In this unit, we will discuss the
cultural environment, an external environment factor.
In todays business environment, companies do business both within a country
and across national boundaries, interacting with people, institutions, and
organizations nurtured in different cultural environments. Different nations have
striking and significant differences of attitude, belief, ritual, motivation,
perception, morality, truth, superstition and an almost endless list of other cultural
characteristics. Values that are important to one group of people may mean little
to another. These cultural differences deeply affect market behavior. Todays
organizations need to be as familiar as possible with the cultural traits of the
countries they want to do business with.
This unit will help you understand culture and its essence. We will then move on to
discuss the elements of culture and the manifestation of culture. We will also discuss
aspects like culture change, cultural analysis, and cultural adaptation. Finally, we will
discuss how the markets are sensitive to the various cultures.
2. Objectives
define culture, and explain the essence of culture.
identify the elements of culture.
recognize the influence of culture on consumption, thinking process, and
communication processes.
explain the concepts of culture change, cultural analysis, and cultural adaptation.
determine the cultural sensitivity of markets.
3. Understanding Culture
E. Adamson Hoebel defined culture as, the integrated sum total of learned behavioral
traits that are shared by members of a society. Sir Edward Tylor defined culture as,
that complex whole which includes knowledge, belief, art, morals, law, customs, and
any other capabilities and habits acquired by individuals as members of society.
Other definitions of culture are given below.
Culture is a total pattern of behavior that is consistent and compatible in its
components. It is not a collection of integrated random behaviors, but behaviors that
are internally related and integrated.
Culture is a learned behavior, it is not biologically transmitted. It depends on
environment, not heredity. Thus it can be called the man-made part of our
environment.
Culture is behavior that is shared by a group of people, a society. It can be considered
as the distinctive way of life of people.
Culture thus includes all learned behavior and values that are transmitted to an
individual living within a society, through shared experiences.
4. Essence of Culture
Different people have varied views on culture. Many regard it as something a
country, a region, or firm has, or as something that you can see, hear, touch,
smell, or taste. This approach to culture identifies the ceremonies, clothi ng,
historical landmarks, art, and food as examples of a countrys culture. Irrespective
of the various views, it is a commonly accepted fact that culture develops through
recurrent social relationships that form patterns that are eventually internalized b y
members of the entire group.
Three vital characteristics are integral to the definition of culture.
1.
It is learned: It is acquired by people over time through their membership in a

group that transmits culture from generation to generation.
2.
It is interrelated: One part of the culture is deeply connected with another part
such as religion and marriage, and business and social status.
3.
It is shared: The tenets of a culture extend to other members of the group.
56
Culture as a concept encompasses every part of a persons life. It meets virtually all
human needs, both physical and psychological. Its evolution is not complete. Through
constant embellishment and adaptation, culture continues to evolve, partly in response
to environment needs and partly through the influence of outside forces. However,
cultural differences are not clearly visible in the first instance; the differences can be
subtle and can surface in situations where one would never notice them.
Check Your Progress

1.
can be defined as the integrated sum total of learned behavioral traits

that are shared by members of a society.
a. Ethics b.
Culture
c.
Business
d.
Politics
2.
Identify the statement that does not hold true regarding culture.
i.
It is the integrated sum total of learned behavioral traits that are shared by
members of a society.
ii.
It is a collection of integrated random behaviors which are not related in any way.
iii. It is a learned behavior and it is biologically transmitted.

iv. It can be considered as the distinctive way of life of people, which is dependent
on the environment.
a. Only i and ii b.
Only i and iv
c.
Only ii and iii
d.
Only iii and iv
3.
All the statements given below are the characteristics of culture, except:
a.
It is acquired by people over time through their membership in a group that

transmits culture from generation to generation.
b.
Cultures are rarely connected with each other as each culture is very different
from others.
c.
Culture can be shared, i.e., the tenets of a culture can extend to other members of
the group.
d.
Culture develops through recurrent social relationships that form patterns that are
eventually internalized by members of the entire group.
57
5. Elements of Culture
Culture can be understood by examining the cultural elements within a country. Given
below are four cultural elements that are vital to any country.
5.1 Language
Language differentiates human beings from animals. Human beings speak in so many
languages that it becomes a part of the cultural environment of the region to which they
belong. Language is used to communicate and to interpret the environment. There are
two facets of language which have a bearing on business organizations. These are -- the
use of language as communication across, and often within, national boundaries, and the
huge diversity of languages across, and often within, national boundaries.
Most languages do not literally translate from one to another. Added to this, it is
extremely difficult to understand the symbolic and physical aspects of the
communication of different cultures. The language used for communication has two
parts -- the spoken part and the silent part. Communication through vocal sounds or
written symbols forms the spoken part, while silent language refers to the numerous
non-verbal communication mechanisms such as gestures, grimaces, body language,
eye contact, and conversation distance that people use to get a message.
Different gestures convey different meanings across cultures. Thus managers should
familiarize themselves with the various aspects of foreign cultures. Language is often
described as the mirror of a culture. The diversity of languages across the globe poses
a serious problem for multinationals. In countries such as India, there are many
languages. The problem is further aggravated when the meanings and expressions
vary a great deal between countries that share the same language.
5.2 Aesthetics
Aesthetics includes aspects like art, drama, color, music, folklore, and architecture present
in a society. This aspect usually captures the ideas and expressions that are inherent in a
culture. For example, colors carry different meanings across the globe. Aesthetics could
mean a lot to a business manager designing a product to suit the local cultural setup.
5.3 Religion
Managers should understand and appreciate buying motives, customs, practices, and
religious beliefs of people. According to Terpstra and David, religion refers to a
communitys set of beliefs that relate to a reality that cannot be verified empirically.
These beliefs usually involve reflection about after-life, but not always. An MNC has
to adapt itself to the local religious taboos and sentiments. The location and design of
stores and office buildings are also influenced by religious beliefs.
5.4 Education
Education can be considered as a vehicle to channel culture from one generation to
another. There are two facets of education that impact multinationals -- the level and
quality of education, and the level of education in comparison with other countries. In
most developed countries, education up to a certain age is compulsory. The illiteracy
58
rate is a powerful tool for assessing the education level of a country. In countries
having a very low to moderate literacy rate, managers have to be careful in matters
pertaining to product labeling, print ads, and survey research. Even simple labels can
be misunderstood in such countries.
Companies are also concerned about the quality of education in the country. They
need to know whether the education level of a country meets their business needs and
whether the labor force within a country possesses the necessary skills to make the
transition from labor-intensive to capital-intensive industries. Even within countries
having similar levels of economic development, there are huge differences in the
blend of skills the labor forces possesses. Shortage in certain fields might force the
companies to employ expatriates or bid against one another for the scarce talent
available.
Example: Differing Elements of Culture US vs. India
Karine Schomer identified five challenges that offshore teams in India face while
working with Americans. These are given below.
i. Management hierarchy and issues like rank and title are given a lot of
importance in India. According to the culture in the US, authority is delegated,
and members in the team are expected to take responsibility and are
accountable for the results. American managers expect that the team members
open up, offer suggestions, and take initiative rather than listen to and do what
theyre told.
ii. Americans strictly adhere to time related commitments such as appointments,
meetings, and deadlines. They schedule everything in such a way that a delay in
a particular thing would have a serious ripple effect on the other things. Indians
are more flexible and follow an open-ended approach. This attitude sometimes
creates tension at the last moment especially regarding project deadlines.
iii. Americans prefer clear, detailed agreements. They are uncomfortable with
vague expressions. Commitments are taken literally and seriously adhered to. If
a person fails to follow them, he/she is considered as unreliable. Indians usually
have a flexible attitude toward agreements. They consider them as guidelines
for acting in the future.
iv. Indians give importance to following the rules and implementing correct
processes. Americans, on the other hand, are highly result-oriented. They dont
prefer to be told about why certain things (while following the processes) are not
possible or cant happen.
v. Americans are direct, candid, and not worried about conflict, while
communicating. They have an open and straightforward way of agreeing and
disagreeing. Indians usually try to avoid conflict. It is very difficult for them to
say no or disagree effectively as they fear loss of face.
Adapted from Karine Schomer, Culture Matters: 5 Challenges India Offshore Teams Face
in Working with Americans, <http://www.sourcingmag.com/content/c060814a.asp>.
59
Activity: The cultures in India, US, and UK differ in many ways. Take at least two
cultural elements and explain the differences between these three cultures.
Answer:
6. Manifestation of Culture
The diffusion theory of innovation refers to an acceptance of a product or idea by
consumers over time, linked to a given social structure and a given system of values
or culture. The diffusion process varies from culture to culture. While some cultures
are very conservative, others demand innovativeness from the employees in every
aspect of their business.
Culture not only affects the diffusion process in general, but also exerts a great deal of
influence on the adoption of a product in particular. A product that is suitable for one
culture may be totally inappropriate elsewhere. Therefore, marketers should avoid
using a global standardized campaign to introduce new products in foreign markets.
The innovators, who are usually the opinion leaders, prompt the adoption of a product.
Hence, international marketers should identify them in the given market.
6.1 Influence of Culture on Consumption
Culture refers to the set of values, ideas, and attitudes that are accepted by a homogeneous
group of people and transmitted to the next generation. The priority of needs, consumption
patterns, and consumption habits and lifestyles are all dictated by culture. Culture
influences what is to be purchased; it also affects what should not be purchased.
Understanding the influence of culture is very important for conducting business
effectively in various countries of the world. Because of the enduring aspect of culture, it is
easier and profitable for marketers to make products consistent with the culture in which
products are marketed than to try to change the culture to fit the product.
6.2 Influence of Culture on Thinking Process
Culture affects the thinking processes of individuals, groups, and organizations due to
the self-reference criteria (SRC) that binds an individual to his/her cultural
assumptions. It becomes important for the manager/researcher to make objective
evaluations about such assumptions. Managers have to examine the applicability of
these initial assumptions in terms of another culture. This makes them think in
international terms and not in terms of his/her native culture. An awareness of the
influence of culture on thinking processes is valuable as it helps a manager prevent a
transfer of personal cultural norms on a wholesale basis to an overseas market. This
awareness should make a manager more consumer-oriented, and the marketing
strategy developed will more likely reflect true market needs.
60
6.3 Influence of Culture on Communication Processes
Edward T. Hall, an anthropologist made a vital distinction between high and lowcontext cultures and how it impacted communication. A high-context culture uses
high-context communication, i.e., information that is either in the physical context or
internalized in the person, with little being communicated in the explicit words or
message. The context of communication is high as it includes a great deal of
additional information such as message senders values, positions, background, and
associations in society. A low context culture employs low-context communication, in
which most information is contained in explicit codes, such as words. Unless global
leaders are aware of the subtle differences, communication misunderstandings might
occur between low- and high-context communicators.
Hall also distinguished between monochronic and polychronic cultures. Some cultures
handle information in a direct, linear fashion and are thus monochronic in nature.
Other cultures are relatively polychronic as people work on several fronts
simultaneously instead of pursuing a single task. The cultural context and the manner
in which information is processed can be combined to describe the communication
process of a particular country.
Check Your Progress

4.
Which of the following statements is not true regarding language, as an element

of culture?
a.
It is used to communicate and to interpret the environment.
b.
It is described as a mirror of culture.
c.
Most languages do not literally translate from one to another.
d.
The language used in communication has only the spoken part, which involves
communication through vocal sounds and/or written symbols.
5.
Which among the following is not a form of communication used in silent

language?
a.
Gestures
b.
Body language
c.
Written symbols
d.
Eye contact
6.
Which of the following elements of culture usually captures the ideas and
expressions that are inherent in a culture, and includes aspects like art, drama,
color, music, and architecture?
a.
Language
b.
Religion
c.
Education
d.
Aesthetics
61

7.
is an element of culture that refers to a communitys set of beliefs

that relate to a realty that cannot be verified empirically.
a.
Language
b.
Religion
c.
Education
d.
Aesthetics
8.
Which of the following facets of education (as an element of culture) has a vital
bearing on a multinational business organization?
i.
Blending of skills of the labor in the country.
ii.
The level and quality of education.
iii. The level of education in comparison with other countries.

a.
Only i and ii
b.
Only i and iii
c.
Only ii and iii
d.
i, ii, and iii
9.
Which type of culture handles information in a direct, linear fashion, according to

Edward Halls theory?
a. Polychronic b.
Monochronic
c.
High-context
d.
Both (a) and (b)
10. The
refers to an acceptance of a product or idea by consumers over
time, linked to a given social structure and a given system of values or culture.
a.
self-reference criterion
b.
cultural adaptation
c.
cross-cultural analysis
d.
diffusion theory of innovation
11. Identify the statement that does not hold true regarding high-context cultures.
a.
Information used is in the physical context
b.
Information contained is mostly in explicit codes, such as words
c.
Information used is internalized in the person, with little being communicated in

the explicit words or messages
d.
Includes a great deal of additional information such as message senders values,

positions, background, and associations in society
7. Culture Change
Companies should be aware of culture change. This characteristic of culture brings in
a variety of possibilities. Products and services, which might not have been accepted
at one point of time due to a particular culture, may become acceptable at a later time
due to a change in the culture.
62
7.1 Basics of Cultural Change
Many theories have been propounded on the basis on which cultural transition takes
place. One such proposition is based on Maslows hierarchy of needs theory. Refer to
figure 3.1 for the Maslows Hierarchy of Needs. In this theory, Maslow ranked five
human needs in ascending order. Starting with the lowest, these needs are -physiological needs (food, water, shelter); safety needs (protection, security, stability);
social need (affection, friendship, acceptance); ego needs (prestige, success, selfesteem); and finally the need for self-actualization (self-fulfillment). As a country
moves from a subsistence level economy, where the major goal has been the basic
fulfillment of physiological needs, to a stage where basic needs are achievable easily,
new needs take precedence. Thus, when an economy satisfies one level of needs, it
automatically gives rise to new needs, whose satisfaction requires cultural change.
Figure 3.1: Maslows Hierarchy of Needs
Adapted from <http://www.tutor2u.net/business/people/motivation_theory_maslow.asp>.

Another proposition, based on Halls classification of culture, examines the formal,
informal, and technical aspects of cultural change. According to Halls classification,
the formal aspects are the core cultural aspects of an economy. These core aspects are
very deeply rooted and are totally resistant to change. They are considered absolute
rights and wrongs in a society. But informal aspects refer to traits that the members of
the society learn over time. These are also common norms that everyone is supposed to
be aware of. If an informal aspect is not adhered to, an expression of disapproval or
concern is shown. Technical aspects are transmitted in the form of instruction and have
valid reasons underlying them. As there is little emotional bondage to this aspect, it is
easily prone to change. All the three cultural aspects vary from country to country.
63

7.2 MNCs as Agents of Change
In todays globalized era, MNCs contribute considerably to industrialization in various
economies. As a result, MNCs are effective in rapidly transferring features of one society
to another, perhaps a very different society. They are uniquely capable of forcing cultural
change. MNCs transmit their home country values in two different ways:
Through the vast network of affiliates, which introduces, demonstrates, and
disseminates new behaviors while increasing and shaping the manufacturing sector of
host countries, and
Through the business services structure, including advertising and business education.
Activity: According to the Maslows hierarchy of needs theory, suggest the
appropriate level for the following needs.
At the New Years party, Jonathan drove in a brand new hybrid car, imported from
the US.
Having gained enough experience working in the cities, Vaishnavi, a doctor, now
wants to work in the villages to help the people over there.
As soon as he shifted to a new house, Karthik joined the local sports and cultural
clubs.
Answer:
8. Culture Analysis
In order to understand the cultural environment in the international business scenario,
it is vital to analyze the various cultural setups in different countries. Cultural analysis
can be based upon any of these three approaches.
Ethnocentrism approach: Companies following this approach adopt a strategy
which is more appropriate to the domestic market. They assume that what is good at
home would also work the same way in foreign markets.
Assimilation approach: This approach is similar to the ethnocentrism approach.
Most companies consider that the US market is a cultural melting pot. They assume
that the cultural traits demonstrated in the US market should work everywhere in the
world. They believe that if the product or the service clicks in the US market, the
same will click in any other part of the world.
Primacy of host country approach: Companies following this approach consider the
market composition and base decisions on the cultural traits of the host country. This
approach is based on the assumption that the home countrys cultural traits are
inappropriate for successful operation in markets outside the home country.
The Halls map of culture teaches us how to understand the different aspects of
foreign culture.
64
8.1 Halls Map of Culture
Hall has devised a two-dimensional matrix containing different human activities, which
he calls primary message systems. Ten activities fall under this category. These are -Interaction: Interaction with the environment through various modes like speech and
writing.
Association: Structure and organization of the society and its various components
Subsistence: Activities through which the society satisfies the basic needs of people
such as food and water, and the attitude toward such needs.
Bisexuality: Differences between the roles and functions of men and women.
Territoriality: Ownership, use, and protection of land territory.
Temporality: Division and allocation of time and its use for various activities.
Learning: Pattern of transmitting knowledge.
Play: Process of enjoying through relaxation and recreation.
Defense: Protection against natural and human forces in the environment
Exploitation: Using skills and technology to turn natural resources to peoples needs.
According to him, a person interested in the cultural analysis of a particular region
need not necessarily study all the ten aspects, but can study any one of them and grasp
adequate understanding of the culture. Based on Halls framework, Robock and
Simmond have analyzed the play activities of a toys and games company. The analysis
showed that perspectives of play vary from one culture to another. Halls
framework created 18 categories of questions in this case. Some of the questions are -How do people interact during play as regards competitiveness, instigation, or
leadership? (Interaction/Play) What games are played involving acting, role playing,
or other aspects of real-world interaction? (Play/Interaction) Who organizes play and
how do the organization patterns differ? (Association/Play), etc.
Thus through Halls map of culture, one can understand the overall nature of a culture
by studying one or two primary message systems. Such an analysis works very well in
the context of international business because only a particular element of culture
related to an international business decision needs to be analyzed.
Check Your Progress

12. A company following this approach concerns itself with market composition and
bases decisions on host country cultural habits.
a.
Cross-cultural
b.
Assimilation
c.
Primacy of host country
d.
Self-reference criteria
65

13. What is the philosophy that assumes that what works in the domestic country
would also work equally in a foreign market?
a.
Assimilation approach
b.
Ethnocentrism approach
c.
Primacy of host country approach
d.
None of the above
14. Identify the proper sequence of needs in Maslows hierarchy of needs theory from
lowest to highest.
a.
Physiological Social Security Esteem Self-actualization
b.
Physiological Security Esteem Social Self-actualization
c.
Physiological Security Social Esteem Self-actualization
d.
Physiological Social Esteem Security Self-actualization
15. The major goal of a subsistence level economy is to meet the

its people.
a.
needs of
social b.
esteem
c.
security
d.
physiological
16. Many theories have been propounded on the basis on which cultural transition
takes place. One of these propositions is based on Edward Halls classification of
culture that examines all the following aspects of cultural change, except the
aspects.
a.
formal
b. security c.
informal
d.
technical
17. Match the following aspects of cultural change proposed by Hall with their
respective description.
Aspect
i.
Formal
p.
These are transmitted in the form of instruction and

have valid reasons underlying them.
ii.
Informal
q.
These are absolute rights and wrongs in the society.
r.
These are traits that members of the society learn over

time.
iii. Technical
a.
i/p, ii/q, iii/r
b.
i/r, ii/p, iii/q
c.
i/q, ii/r, iii/p
d.
i/r, ii/q, iii/p
66
Description
18. Identify the statement that does not hold true regarding the formal aspects of
cultural change according to the Halls classification of culture.
i.
These are traits that the members learn over time.
ii.
They are considered absolute rights and wrongs in a society.
iii. These are easily prone to change as there is little emotional bondage.
iv. These core aspects are very deeply rooted and are totally resistant to change.
i.
ii.
Only i and ii
Only i and iii
iii. Only ii and iv

iv. Only iii and iv
19. Match the following human activities defined according to Hall with their
respective descriptions.
Activity
Description
i.
Subsistence
p.
Division and allocation of time and its use for

various activities
ii.
Exploitation
q.
Perspectives of activities of individuals and groups

that deal with livelihood and living
iii. Temporality
r.
Using skills and technology to turn natural

resources to peoples needs.
iv. Defense
s.
Structure and organization of the society and its

various components
v.
t.
Protection against natural and human forces in the

environment
Association
a.
i/r, ii/s, iii/q, iv/p, v/t
b.
i/q, ii/r, iii/p, iv/t, v/s
c.
i/p, ii/t, iii/r, iv/s, v/q
d.
i/t, ii/q, iii/s, iv/r, v/p
9. Cultural Adaptation
Cultural adaptation refers to business decision making appropriate to the cultural traits
of a society. It involves adapting ones decisions to the local cultural sentiments of the
society and ensuring that the native customs, traditions, and taboos offer no
constraints to their implementation.
The concept of cultural adaptation is difficult to practice. One major constraint in the
process is the tendency to use the self-reference criteria (SRC), which means,
whenever people are faced with unique situations, their own values take precedence
for their understanding of the circumstances. Cultural analysis of global markets is
vital, whether a firm is pursuing a business locally or globally. Companies should be
capable of conducting cross-cultural analysis. Such a capability will help companies
position themselves in the best competitive place in the marketplace.
67

9.1 Cross-cultural Analysis
Cross-cultural analysis is the symbolic comparison of similarities and differences in
the material and behavioral aspects of different cultures. It is used by managers to
understand the different market segments within and across national boundaries. It
helps in determining whether a marketing program can be used in more than one
foreign market or must be modified to suit local conditions. This analysis uses
methods and approaches used in social sciences such as anthropology, linguistics, and
sociology, and other standard marketing research techniques like multi-attribute and
psychographic techniques.
9.2 Misinterpreting Cross-Cultural Assessments
While conducting cross-cultural assessments, one serious issue confronting business
decisions is reduction, if not elimination of cultural bias. Managers should be aware of
the influence of their own culture on the interpretation of given events, behaviors, and
information. While our past experiences and the way we interpret them are culturally
defined, it is still possible to be aware of the influences culture has had in our lives, on
our behavior, and on the decisions we make.
9.3 Sources of Cultural Misinterpretation
According to Adler, there are three sources of cross-cultural misinterpretation -subconscious cultural blinders, lack of cultural self-awareness, and projected
similarity and parochialism.
Subconscious Cultural Blinders
These refer to the tendency to subconsciously draw assumptions about events, people,
and behavior. It is important to consider this type of misinterpretation while
developing advertising material, whether visual or verbal, for example.
Lack of Cultural Self-awareness
These refer to the awareness of ones own cultural characteristics. Usually, we tend to
interpret the actions of others in terms of our own cultural framework.
Misunderstandings can arise if we fail to see how others see us, and lack
understanding as to how our culture influences our behavior and decisions.
Projected Similarity and Parochialism
It refers to our tendency to assume that people from other cultures (or situations in
other cultures) are similar to people belonging to our own culture.
9.4 Self-Reference Criteria
Self-reference Criteria (SRC) is an unconscious tendency to refer to ones own cultural
values when evaluating situations in other cultural environments. According to Lee, it
is the root cause of most international business problems. In order to remove errors in
judgment or interpretation, a conscious effort has to be made by the managers. Lee
proposed four steps for identifying and correcting SRC.
i.
Define the business problem or goal in terms of your own cultural traits, habits, or
norms.
ii.
Define the business problem or goal in terms of the foreign cultural traits, habits,
or norms. Make no value judgments.
68
iii. Isolate the SRC influence in the problem, and examine it carefully to see how it
complicates the problem.
iv. Redefine the problem without the SRC influence, and solve for the optimum
business goal situation.
To use this framework to ones advantage, one should have an intimate knowledge of
other cultures as well as ones own culture. This cross-cultural analysis of markets
requires cultural empathy or an ability to understand the inner logical buyer behavior
in other cultures, and an ability to be non-judgmental about the values underlying
buyer behavior in other cultures. The former goal is achievable only as a result of
exposure to other cultures, sensitivity training, and a conscious effort to see the world
as other see it. The latter goal is achievable after a conscious effort is made to
understand ones own culture and to overcome the natural tendency to make
judgments based on this culture.
Example: Cultural Adaptation at Coca-Cola Company
Coca-Cola Company (Coca-Cola) was established in 1892. Since its inception, CocaCola had traveled a long way and today the name Coca-Cola is a familiar one in
more than 200 countries around the world. Coca Colas customized marketing and
promotional strategies have enabled the company to overcome cultural and language
differences it encountered and to succeed in the global market.
Coca-Cola depended heavily on marketing research to develop products and plan
promotional campaigns that catered to the needs of consumers in the target market.
Though Coca-Cola was a global brand, it approached various markets around the
world in different ways without relying on a standardized strategy. It identified the
regional and cultural differences in various countries and tailored the marketing
strategies accordingly. While developing various promotional strategies for the
new markets, the company took utmost care not to hurt the sentiments and
emotions of local consumers. The differentiated strategy of the company was
reflected in the fact that its products contained different flavors, packaging, prices,
and advertising. Thus, Coca-Cola successfully applied its principle think locally
and act locally in its operations.
The company used the Always Coca-Cola campaign theme worldwide to restore
the universality of the brand. But at the same time, it analyzed the differences in
culture and preferences of various countries and adapted its ad campaigns for each
specific market. For instance, the Eat Football, Sleep Football, Drink Coca-Cola
campaign in Great Britain attracted the consumers. This campaign was based on
the British consumers strong inclination to the football game, reinforcing the link
between Coca-Cola and football while continuing the brands support for the game
and the fans. Another instance of adapting its ad campaigns was its Mean Joe
Green TV ad campaign in the US which was introduced in other countries where
the ad contained the same theme but the athletes who acted in the ad were from the
respective countries where the ad campaign was launched.
Contd
69
Contd
The regional managers of Coca Cola in various countries were responsible for
adapting the product and other elements of marketing to meet the demands of the
local people. In China, the taste of Coca-Cola was developed and modified to suit
the Chinese palates. The company tried to associate its brand with the traditional
Chinese art by participating in the China International Beverage Festival that took
place in September 1982. The regional managers in different countries were also
responsible for the sales and distribution program of Coke. This program aimed at
reflecting the differences in the tastes and preferences of consumers in various
countries. In Spain, Coke was taken along with wine; whereas in Italy, it was
served with meals. In China, Coke was served at special government occasions.
Adapted from Case Study Differentiation Strategies of Coca-Cola, The ICMR
Center for Management Research, 2005. www.icmrindia.org.
Activity: Chips International is a US-based potato chips making company. The
company was well-known for its good quality, crispy, and flavored chips. In 2005,
the top management of the company decided to foray into India and Japan. The
company entered into these markets in 2007. The company felt that using the same
flavors used in the US would attract the Indian and the Japanese consumers, and
therefore, did not make any change to the products. What do you call this approach
of cultural analysis by the company? How is it different from the other approaches
of cultural analysis?
Answer:
10. Cultural Sensitivity of Markets

Markets can be broadly classified into consumer markets and industrial markets.
Consumer markets can be further classified into durable goods market and nondurable goods market. Durable goods can be further divided into technological
products and non-technological products.
10.1 Industrial Markets
Industrial markets consist of industrial buyers. These buyers are generally interested
in solving problems that are related to reducing costs, increasing production and
administrative efficiency, producing a particular type of product, or achieving a
combination of these goals. As most industrial buyers tend to emphasize economic
goals, cultural and social considerations play a relatively less significant role in a
purchase decision. In terms of a global perspective, there are differences that need to
70
be considered when selecting the products to be marketed and the marketing program
to be used. Other variables that might come into the picture are government
regulations, the size and sophistication of the potential buyers operations, and the
context within which the product or service is to be used. All these variables have an
impact on the marketing effort of the company.
10.2 Consumer Markets
Consumer markets comprise individual buyers who are interested in satisfying a
persons need or want. These are more susceptible to cultural and social forces than
industrial markets; the purchase of non-durable products such as clothing, food, and
cosmetics is driven by numerous socio-cultural factors. But these factors have little
effect on the purchase of durable goods such as television sets, radios, and small and
large household appliances.
There are exceptions, however, that make the job of an international business manager
more interesting and challenging. The purchase of refrigerators, for example, is
sensitive to both spatial and social factors such as room size and shopping habits.
Europeans tend to live in smaller rooms and hence purchase smaller refrigerators in
contrast to Americans. Not only this, they also shop for food more frequently and in
smaller amounts than most Americans do. Such differences occur due to the social
functions of meetings friends, non-ownership of automobiles, and inadequate parking
facilities. Mexicans, on the other hand, purchase large refrigerators as status symbols
and to meet the needs of their large families. It is important for managers to
understand the influence of social and cultural factors on buyer behavior.
Check Your Progress

20. Jiten is a quality control specialist working at AG Motors. He was sent to Japan to
attend a training program at the companys headquarters. Jiten has never been to
Japan. He had several views about the country and its people. He thought that the
food over there was weird and expensive, there would be Japanese signboards
everywhere, and people did not know how to speak English. What is the tendency
to assume certain things known as?
a.
Conscious cultural blinders
b.
Subconscious cultural blinders
c.
Parochialism
d.
21. Which of the following refers to an act of making decisions based on the cultural
traits of the society?
a.
Cross-cultural analysis
b.
Cultural adaptation
c.
d.
None of the above
71

22. What is the tendency that assumes that people from other cultures (or situations in
other cultures) are similar to people belonging to our own culture?
a.
Parochialism
b.
Comparative similarity
c.
Maslows hierarchy of needs
d.
None of the above
23. What is the unconscious tendency to refer to ones own cultural values when
evaluating situation in other cultural environments known as?
a.
Parochialism
b.
Cultural adaptation
c.
d.
24. What do you call a systematic comparison of similarities and differences in the
material and behavioral aspects of different cultures?
a.
Parochialism
b.
c.
Halls map of culture
d.
Maslows hierarchy of needs
25. Identify the statements that hold true regarding cross-cultural analysis.
i.
It is used by managers to understand the different market segments within and

across national boundaries.
ii.
It helps in determining whether the marketing program can be used in more than
one foreign market or must be modified to suit local conditions.
iii. It binds an entity (individuals, groups, and organizations) to its cultural

assumptions, thus affecting the thinking process of the entity.
iv. It gives rise to the tendency to assume that people from other cultures (or
situations in other cultures) are similar to people belonging to ones own culture.
a.
Only i and ii
b.
Only i and iv
c.
d.
Only iii and iv
26. Which among the following is not a source of cross-cultural misinterpretation as

given by Adler?
a.
b.
Lack of cultural self-awareness
c.
Projected similarity
d.
Needs hierarchy
72
27. All the statements given below are true regarding cultural adaptation, except:
a.
It involves business decision making appropriate to the cultural traits of the society.
b.
The use of self-reference criteria helps in the process of cultural adaptation.
c.
It is very difficult to practice.
d.
It involves adapting ones decisions to the local cultural sentiments of a society

and ensuring that the native customs, traditions, and taboos offer no constraints to
their implementation.
11. Summary
Culture refers to the set of values, ideas, and attitudes that are accepted by a
homogeneous group of people and transmitted to the next generation.
Three vital characteristics of culture are -- it is learned, it is interrelated, and it is
shared.
The elements of culture are language, aesthetics, religion, and education.
Culture influences consumption, thinking processes, and communication processes.
Many theories have come up on the basis on which cultural transition takes place.
One theory has used the Maslows hierarchy of needs theory as the basis. Another
theory is based on Halls classification of culture. MNCs also act as agents of change.
Cultural analysis can be based upon any of these three approaches -- ethnocentrism
approach, assimilation approach, and primacy of host country approach.
Cultural adaptation refers to business decision making appropriate to the cultural traits
of a society.
As most industrial buyers tend to emphasize economic goals, cultural and social
considerations play a relatively less significant role in purchase decisions. Consumer
markets are more susceptible to cultural and social forces than industrial markets.
12. Glossary
Cross-cultural analysis: It is the symbolic comparison of similarities and differences
in the material and behavioral aspects of different cultures.
Cultural adaptation: It refers to business decision making appropriate to the cultural
traits of the society.
Culture: The set of values, ideas, and attitudes that are accepted by a homogeneous
group of people and transmitted to the next generation
Diffusion theory of innovation: An acceptance of a product or idea by consumers
over time, linked to a given social structure and a given system of values or culture.
Maslows Hierarchy of Needs theory: In this theory, Maslow ranked five human
needs in increasing order. Starting with the lowest, these needs are -- physiological
needs (food, water, shelter); safety needs (protection, security, stability); social need
(affection, friendship, acceptance); ego needs (prestige, success, self-esteem); and
finally the need for self-actualization (self-fulfillment).
73

Monochronic and polychronic cultures: Monochronic cultures handle information
in a direct, linear fashion. People belonging to polychromic cultures work on several
fronts simultaneously instead of pursuing a single task.
Self-reference Criteria (SRC): An unconscious tendency to refer to ones own
cultural values when evaluating situations in other cultural environments.
Subconscious cultural blinders (source of cultural misinterpretation): These refer
to the tendency to subconsciously draw assumptions about events, people, and
behavior.

1.
Organizations need to be familiar with the cultural traits of the countries they
want to do business with. Define culture. Explain its characteristics.
2.
Culture can be understood by examining the cultural elements within the country.
What are these elements?
3.
Culture not only affects the diffusion process in general, but also exerts a great
deal of influence on other aspects. Explain this statement.
4.
Companies should be aware of culture change as it brings in a variety of

possibilities. What factors contribute to changes in culture?
5.
To understand the cultural environment in the international business scenario, it is

vital to analyze the cultural setups in different countries. How can one analyze the
cultures of different countries?
6.
Organizations should ensure that their decisions adapt to the cultural sentiments
of the societies in which they are operating. Explain the importance of crosscultural analysis. What are the major constraints in the process?
7.
Culture affects purchase decisions in the consumer and industrial markets.

Explain this statement.

1.
Gary Ferraro, Cultural Dimension of International Business, Dorling

Kindersley (india) Pvt Ltd, Fifth Edition, 2008.
2.
Culture
<http://humanresources.about.com/od/organizationalculture/a/culture.htm>
3.
Culture and Halls Map of Culture

<http://www.it.murdoch.edu.au/~sudweeks/catac98/pdf/27_lee.pdf>
4.
5.
Cross-cultural Analysis
<http://www.as.ua.edu/ant/Faculty/murphy/crosscut.htm>
6.
<http://www.dot-connect.com/How_to_understand_cross-cultural_analysis.html>
7.
Cultural Issues in International Marketing

<http://www.dot-connect.com/How_to_understand_cross-cultural_analysis.html>
74

1.
(b) Culture
E. Adamson Hoebel defined culture as, the integrated sum total of learned
behavioral traits that are shared by members of a society.
2.
(c) Only ii and iii

Culture is not a collection of integrated random behaviors, but behaviors that are
internally related and integrated. It is a learned behavior, and it is not biologically
transmitted. It depends on the environment, and not heredity.
3.
(b) Cultures are rarely connected with each other as each culture is very
different from other.
All the statements are true about the characteristics of culture, except (b). Culture
is interrelated. One part of the culture is deeply connected with another part such
as religion and marriage, and business and social status.
4.
(d) The language used in communication has only the spoken part, which
involves communication through vocal sounds and/or written symbols.
All the statements are true regarding language, except statement (d). The
languages used for communication has two parts -- the spoken part and the silent
part. Communication through vocal sounds or written symbols forms the spoken
part, while silent language refers to the numerous non-verbal communication
mechanisms such as gestures, grimaces, body language, eye contact, and
conversation distance that people use to get a message.
5.
(c) Written symbols

The languages used for communication has two parts -- the spoken part and the
silent part. Communication through vocal sounds or written symbols forms the
spoken part.
6.
(d) Aesthetics
Aesthetics includes aspects like art, drama, color, music, folklore, and
architecture present in a society. This aspect usually captures the ideas and
expressions that are inherent in a culture.
7.
(b) Religion
Language, aesthetics, religion, and education are the elements of a culture.
Terpstra and David defined religion as a communitys set of beliefs that relate to
a reality that cannot be verified empirically.
8.
(d) i, ii, and iii

Education can be considered as a vehicle to channel culture from one generation
to another. There are two facets of education that impact multinationals -- the
level and quality of education, and the level of education in comparison with
other countries.
75

9.
(b) Monochronic
Edward Hall, an anthropologist, identified cultures to be monochronic or
polychromic. Some cultures handle information in a direct, linear fashion and are
thus monochronic in nature. Other cultures are relatively polychronic as people
work on several fronts simultaneously instead of pursuing a single task.
10. (d) diffusion theory of innovation

The diffusion theory of innovation refers to an acceptance of a product or idea by
consumers over time, linked to a given social structure and a given system of
values or culture. The diffusion process varies from culture to culture. While
some cultures are very conservative, others demand innovativeness from the
employees in every aspect of their business.
11. (b) Information contained is mostly in explicit codes, such as words
A high-context culture uses high-context communication, i.e., information that is
either in the physical context or internalized in the person, with little being
communicated in the explicit words or message. A low context culture employs
low-context communication, in which most information is contained in explicit
codes, such as words.
12. (c) Primacy of host country
Companies following the primacy of host country approach consider the market
composition and base decisions on the cultural traits of the host country. This
approach is based on the assumption that the home countrys cultural traits are
inappropriate for successful operation in markets outside the home country.
13. (b) Ethnocentrism approach
Companies following the ethnocentrism approach adopt a strategy which is more
appropriate to the domestic market. They assume that what is good at home
would also work the same way in foreign markets.
14. (c) Physiological Security Social Esteem Self-actualization
Maslow in his theory of hierarchy of needs ranked five human needs in increasing
order. Starting with the lowest, these needs are -- physiological needs (food,
water, shelter); safety needs (protection, security, stability); social need (affection,
friendship, acceptance); ego needs (prestige, success, self-esteem); and the need
for self-actualization (self-fulfillment).
15. (d) physiological
A subsistence level economys major goal is to fulfill the basic physiological
needs of its people. As it grows by achieving its basic needs, new needs take
precedence.
16. (b) security
The Halls classification of culture examines the formal, informal, and technical
aspects of cultural change.
76
17. (c) i/q, ii/r, iii/p
The formal aspects are the core cultural aspects of an economy. They are
considered absolute right and wrongs in a society. Informal aspects refer to traits
that the members of the society learn over time. These are also common norms
that everyone is supposed to be aware of. Technical aspects are transmitted in the
form of instruction and have valid reasons underlying them. As there is little
emotional bondage to this aspect, it is easily prone to change.
Statements ii and iv are true regarding the formal aspects of cultural change based
on the Halls classification of culture. Statements i and iii are false. Statement i
refers to informal aspects, while statement iii refers to technical aspects.
19. (b) i/q, ii/r, iii/p, iv/t, v/s
Hall has devised a two-dimensional matrix containing 10 different human
activities, which he calls primary message systems. The other five activities are -learning (pattern of transmitting knowledge); play (process of enjoying through
relaxation and recreation); interaction (interaction with the environment through
various modes like speech and writing); bisexuality (differences between the roles
and functions of men and women), and territoriality (ownership, use, and
protection of land territory).
20. (b) Subconscious cultural blinders
Subconscious cultural blinders refer to the tendency to subconsciously draw
assumptions about events, people, and behavior. It is important to consider this
type of misinterpretation while developing advertising material, whether visual or
verbal. In the given situation, Jiten has certain misconceptions about Japan and its
people. These are in reality not true.
21. (b) Cultural adaptation
Cultural adaptation refers to business decision making appropriate to the cultural
traits of the society. It involves adapting ones decisions to the local cultural
sentiments of the society and to ensure that the native customs, traditions, and
taboos offer no constraints to their implementation.
22. (a) Parochialism
Projected similarity or parochialism refers to the tendency to assume that people
from other cultures (or situations in other cultures) are similar to people belonging
to ones own culture.
23. (c) Self-reference criteria
Self-reference criteria (SRC) refers to an unconscious tendency to refer to ones
own cultural values when evaluating situations in other cultural environments.
Culture affects the thinking processes of individuals, groups, and organizations
due to the self-reference criteria (SRC) that binds an individual to his/her cultural
assumptions.
77

24. (b) Cross-cultural analysis
Cross-cultural analysis is the symbolic comparison of similarities and differences
in the material and behavioral aspects of different cultures. It is used by managers
to understand the different market segments within and across national
boundaries.
25. (a) Only i and ii
Statements i and ii are true, while statements iii and iv are false. Statement iii
refers to self-reference criteria, while statement iv refers to projected similarity
and parochialism.
26. (d) Needs hierarchy
According to Adler, there are three sources of cross-cultural misinterpretation -subconscious cultural blinders, lack of cultural self-awareness, and projected
similarity and parochialism. The hierarchy of needs theory was proposed by
Maslow. It is one of the theories on the basis of which cultural transition takes
place. One such proposition is based on Maslows hierarchy of needs theory.
27. (b) The use of self-reference criteria helps in the process of cultural
adaptation.
All the statements given above are true regarding cultural adaptation, except
statement (b). The concept of cultural adaptation is difficult to practice. One
major constraint in the process is the tendency to use the self-reference criteria
(SRC), which means, whenever people are faced with unique situations, their own
values take precedence for their understanding of the circumstances.
78
Unit 4
Structure
1.
Introduction
2.
Objectives
3.
Types of Government
4.
Multiplicity of Political Environments
5.
Factors Contributing to Political Instability
6.
Political Risk
7.
Interface of Politics with Business
8.
Impact of International Political Environment on Domestic Business
9.
Summary
10. Glossary
1. Introduction
In the previous unit, we discussed the cultural environment of business. In this unit,
we will cover the political environment of business. The term political environment
includes diverse happenings such as civil difficulties, acts of terrorism against
businesses, and conflicts between countries in a particular region, which may be onetime occurrences like the war between India and China or perennial problems like the
enmity between Israel and its Arab neighbors.
The political environment forms one of the most important facets of the business
environment for any business today, since business is influenced by the political
happenings within the country and internationally. A significantly rich foreign market
may not warrant entry if the political environment is characterized by instability and
uncertainty. Therefore, todays organizations rely on a thorough review of the political
environment before committing themselves to a new market in a foreign country. The
political environment of a country does not remain static; political changes and
upheavals may occur at any point of time after an international marketer has made a
commitment and has established his/her business.
Political stability has been found to be one of the most crucial variables that
companies consider when planning overseas ventures. Unstable political activity
subjects foreign businesses to risks such as violence, expropriation, restriction of
operations, and restrictions on repatriation of capital and remittances of profits.

This unit will discuss the types of governments, the multiplicity of political
environment, and the factors contributing to political instability. We will then move
on to discuss political risk and the political risk considerations in emerging markets.
Finally, we will discuss the interface of politics with business, and the impact of the
international political environment on domestic business.
2. Objectives
classify the various types of government.
recognize the multiplicity of political environments.
identify the factors contributing to political instability.
define political risk.
assess the political risk considerations in emerging markets.
explain the interface of politics with business.
recognize the impact of the international political environment on domestic business.
3. Types of Government
Governments are generally classified on the basis of political systems or economic
systems. Refer to Figure 4.1 for the classification of governments.
3.1 Political Systems
Knowledge of the different forms of government can help one appraise political
climates. The different forms of government can be classified as either parliamentary
(open) or absolutist (closed). Parliamentary governments consult citizens from time to
time to learn their opinions and preferences. The policies of such governments reflect
the desires of the majority of members of the society. Absolutist governments include
monarchies and dictatorships, where the ruling regime dictates government policies
without considering the needs or opinions of the citizens. These are found in newly
formed nations or those undergoing some kind of political transition. Such
governments are relatively rare now.
The political systems of different countries do not fall neatly into one of these two
categories. The UK is a good example of a constitutional hereditary monarchy; despite
the monarch, the government is classified as parliamentary. Some monarchies and
dictatorships have parliamentary elections. The former Soviet Union for example was
not classified as parliamentary voting, because the ruling party never allowed an
alternative on the ballot.
Governments can also be classified on the basis of the number of political parties that are
represented in it, as two-party, multiparty, single-party, and one party dominant systems.
Two-party system: In this, there are typically two strong parties that take turns
controlling the government, though there may be several other parties. The two parties
are generally governed by different philosophies, which results in a change in the
government policy when one party succeeds the other. The US, Japan, and Sri Lanka
have a two-party system of government.
80
Multiparty system: In this form of government, there are some large parties, but
these are unable to form the government because they fall short of the required
majority. In such cases, the government is formed through coalitions between the
various parties, each one of which wants to protect its own interests. The longevity of
the coalition depends largely on the cooperation of the party partners. A change in a
few votes may bring down the coalition government. If the government does not
survive a vote of no confidence (i.e., does not have the support of the majority of the
representatives), the government is disbanded and a new election is called. India,
Germany, France, and Israel have a multiparty system of government.
Single-party system: In this system, only one political party is legally allowed to
form the government. Opposition to the ruling party in any form is banned by law.
Countries like Cuba and Vietnam have single-party systems.
Dominant-party system (or one party dominant system): In this, only one political
party can become the ruling government. This is because the party is so strong that it
becomes dominant within the political structure of the country. The other parties are
allowed to operate freely, but are weak or ineffective to challenge the power of the
dominant party. In Britain, the Conservative party was the dominant party for a period
of 18 years (1979-1997) under the leadership of Margaret Thatcher and John Major.
Countries like Egypt, Malaysia, Singapore, and Zimbabwe have a dominant-party
system of government.
Figure 4.1: Classification of Governments
Source: ICMR.
3.2 Economic Systems
This system of classification is concerned with business ownership -- whether
businesses are privately owned, or government owned, or whether there is a
combination of private and government ownership. The economic system can be
further subdivided into three types communism, socialism, and capitalism. Based on
the governments control over business activity, the various economic systems can be
placed along a continuum, with communism at one extreme and capitalism at the
other. The transition from communism to capitalism is accompanied by a decrease in
government interference and lower control over the factors of production. No nation
operates under pure communism or pure capitalism. Most countries find it necessary
to make some compromise between the two extremes.
81

The communist philosophy holds that all resources should be owned and shared by all
people (i.e., not for profit seeking enterprises) for the benefit of society. The degree of
government control that occurs under socialism is somewhat less than under
communism. A socialist government owns and operates the basic, major industries,
but allows private ownership of small businesses. The degree of control exercised by a
socialist government can vary. The philosophy of capitalism provides for a freemarket system that allows business competition and freedom of choice for both
consumers and companies. It is a market-oriented system in which individuals,
motivated by private gains, are allowed to produce goods or services for public
consumption under competitive conditions. The results include diverse products,
product quality, efficiency, and relatively lower product prices.
Activity: Identify the types of governments in the following countries both in terms
of the political systems as well as in terms of the economic systems.
a.
India
b.
c.
Peoples Republic of China

United States of America
d.
United Kingdom
Answer:
Check Your Progress

1.
The single-party system of government is classified based on which form of

government classification?
a.
Political system
b.
Economic system
c.
Parliamentary system
d.
All the above
2.
In which of the following types of political systems, only one political party is
legally allowed to form the government, and opposition to the ruling party in any
form is banned by law?
a.
Two-party system
b.
Multiparty system
c.
Single-party system
d.
Dominant-party system
82
3.
All the statements given below are true regarding the dominant-party political
system, except:
a.
Only one political party can become the ruling government.
b.
Opposition to the ruling party in any form by the other parties is banned by law.
c.
The ruling party is very strong that it becomes dominant within the political
structure of the country.
d.
There are other parties, which are allowed to operate freely, but are weak or
ineffective to challenge the power of the dominant party.
4.
What form of government includes monarchies and dictatorships, where the

ruling regime dictates government policies without considering needs or opinions
of the citizens?
a.
Single-party
b.
Absolutist
c.
Communist
d.
Capitalist
5.
The
government philosophy holds that all resources should be
owned and shared by all people for the benefit of society.
a.
Absolutist
b.
Capitalist
c.
Socialist
d.
Communist
6.
What form of government consults citizens from time to time for the purpose of
learning their opinions and preference?
a.
Capitalist
b.
Communist
c.
Socialist
d.
Parliamentary
7.
Identify the statement that holds true regarding the socialist form of government.
a.
The government form of government owns and operates the basic, major
industries but allows private ownership of small business.
b.
The degree of government control that occurs under communism is comparatively

less than the same under socialism.
c.
The resources are owned and shared by all people (i.e., not for profit seeking
enterprises) for the benefit of society.
d.
In this, the individuals, motivated by private gains, are allowed to produce goods
or services for public consumption under competitive conditions.
8.
Which government philosophy provides for a free market system that allows
business competition and freedom of choice for both consumers and companies?
a.
Parliamentary
b.
Communist
c.
Absolutist
d.
Capitalist
83
4. Multiplicity of Political Environments

Today, businesses have to face a complex political environment, mainly because they
have to cope with the political situation in more than one nation. This complexity has
forced MNCs to consider the political environment from these different angles -foreign politics, domestic politics, and international politics.
4.1 Foreign Politics
Foreign politics refers to the politics that are associated with the local or host country.
The association in this form of politics might range from being favorable and friendly
to being hostile and dangerous. The political and economic circumstances in the host
country will determine the kind of political climate a company may face when doing
business in that country.
A government supports or discourages foreign investment, considering the balance of
payments (BOP), economic development, and political realities. The host government
may view imports negatively because they adversely affect the host countrys balance
of payments. This is generally true in the case of import of luxury and nonessential
products, especially when those items can be or are already produced locally. The
government may also favor policies that improve the countrys exports and encourage
investment in industries that stimulate employment. Similarly, foreign ownership of
vital or sensitive businesses may be prohibited considering national interests.
The host country may be for or against foreign firms. To win foreign capital and new
technology, the host country may promise cooperation, and provide various tax and
financial incentives. On the other hand, it may criticize the foreign firms for making
excessive profits and draining the nation of its wealth. Further, it may also restrict the
repatriation of profits to corporate headquarters abroad.
4.2 Domestic Politics
Domestic politics refers to the politics that exist in the companys home country, also
known as the parent or source country. These politics are usually thought as causing
minimal problems. This is not true. Apart from dealing with political problems
overseas, companies should pay close attention to political developments at home.
Labor and political organizations criticize a local companys international activities by
accusing it of exporting capital and jobs. At times, this opposition is based on moral
principles. The government, instead of providing support, can become a hindrance in
international trade. For instance, it may impose regulations that interfere with the free
flow of trade. This action may be motivated more by political considerations rather
than by sound economic reasoning. Also, when national interests are at stake, a
government may use certain companies as instruments to achieve its political goals.
4.3 International Politics
International politics refers to the interaction of the overall political environment
factors of two or more countries. The environment becomes highly complex when the
interest of the company, host country, and the home country do not coincide. And,
sometimes, the problems cannot be solved.
84
Exa mple: HMs Prob lems due to Domestic Po

litics
In April 1998, Hindustan Motors (HM) announced a Voluntary Retirement Scheme
(VRS) as part of cost-cutting exercise. Again, in November 1998, it offered a Rs.
0.1 million package. Employee unions, which were backed up by Center of Indian
Trade Union (CITU) and the Indian National Trade Union Congress (INTUC)
resisted the scheme. Unions demanded VRS package at par with VRS offered by
the Fiat management at its Kurla, plant.
The political patronage that the employee unions enjoyed worsened the situation. The
unions were pretty sure of the support from the West Bengal State Government, led
by a communist party. With employee protests getting intensified, HM approached
the state government with a proposal to run the plant for only three days in a week, so
that it could save Rs. 0.32 million every week. The company also promised that it
would continue to pay the workforce full wages for an entire week.
The state government rejected this proposal, and this led to more problems for the
company. In January 1999, HM filed a writ petition in the Calcutta High Court,
claiming that its decision was not prompted by industrial relations, but by the
companys poor financial position. In a counter move, the state government filed an
appeal before the division bench of the Calcutta High Court, claiming that HM had
suppressed facts and figures during its meeting with them to settle the issue. The
division bench directed that the matter be referred to the Industrial Tribunal. In July
1999, the Industrial Tribunal dismissed the companys proposal. HM again filed a
writ petition against the Tribunals order in the division bench of Calcutta High Court
and the division bench upheld the Tribunals order. In response to the division
benchs order, HM moved the Supreme Court in July 1999. During all this time,
productivity at the plant suffered considerably, which added to the companys woes.
Adapted from Case Study Hindustan Motors Struggle for Survival, The ICMR
5. Factors Contributing to Political Instability

It is vital to identify and evaluate the relevant factors contributing to political
instability in order to assess a companys potential political environment. Potential
sources of political complication include social unrest, the attitudes of nationals, and
the policies of the host government.
5.1 Social Unrest
Social disorder is caused by underlying conditions as economic hardship, internal
discord and revolt, and ideological, religious, racial, and cultural differences. These
cause social unrest, adversely affecting the companies which get involved in the process.
5.2 Attitude of Nationals
The government and the attitudes of the citizens of the host country should be
investigated to assess how hospitable they can be to foreign enterprises and citizens.
Citizens of the host country are often concerned about the intentions of the foreign
85

enterprises and citizens with regard to exploitation and colonialism. These concerns are
often linked to the foreign governments actions in the past that may be seen as being
improper. Such inherent hostility will lead to major problems because of their relative
permanence. Governments may change, but citizens hostility may remain the same.
5.3 Policies of the Host Government
The host governments attitude toward foreigners may be short lived. This attitude
may change with time or change in leadership, and this change cou ld be either for
better or worse. Government policy formulation can affect business operations in
two ways -- internally and externally. The effect is internal when the policy regulates
the firms operations within the home country. It is external when the policy
regulates the firms activities in another country. The external government policy
does not affect those firms doing business only in one country, but such a policy can
create complex problems for firms doing business in countries that are in conflict
with each other.
Check Your Progress

9.
Identify the factor(s) which can contribute to political instability in a country

where a foreign company is operating.
i.
Social unrest
ii.
Policies of the host government
iii. Attitudes of the nationals

a.
Only i
b.
Only i and ii
c.
Only ii and iii
d.
i, ii, and iii
10. Which of the following statements is true regarding domestic politics?

a.
b.
It refers to the politics that exist in the companys home country.

These politics do not cause any trouble to the local companies.
c.
Governments of home countries always lend complete support to local

companies.
d.
Governments of home countries never use local companies to achieve their

political goals.
11. Which of the following parties are involved or get affected due to international
politics?
a.
Company
b.
Host country governments
c.
Home country governments
d.
All of the above
86
6. Political Risk
Political risk refers to any government action that diminishes the value of a firms
operations within the political boundaries or influence of that government. It also
includes any action by the government that differentiates between foreign and
domestic firms. Political risk is distinct from terrorism and credit risks arising from
international operations. However, risk that arises due to restrictions on currency
convertibility is classified as political risk.
6.1 Elements of Political Risk
Political risk may arise due to one or more of the following elements. Firms should
look for ways to manage their political risk.
Confiscation, Expropriation and Nationalization
These are the most severe government actions against foreign firms. Confiscation
occurs when a government takes ownership of a property without providing
compensation. Expropriation is a similar to confiscation but differs with regard to
compensation. In expropriation, there will be some compensation, though not
necessarily adequate. Usually a company whose property is being expropriated agrees
to sell its operations not because it has a choice, but because of some coercion. This
sale is made to the government or a nominee of the government, by order. Under
nationalization, an entire industry within a country is transferred from public to
private ownership, with no discrimination as to foreign or local ownership. When
firms are nationalized, the compensation provided by the government does not
adequately reflect the going-concern value of the firm. After a property has been
confiscated or expropriated, it can either be nationalized or domesticated.
Contract Repudiation and Frustration
Firms engaged in building infrastructure projects (turnkey facilities) and those which
are in joint ventures with a government sometimes enter into disputes with the host
country government, often on matters of payment. The government may repudiate a
contract because of financial reasons; real or imagined non-performance; or failure to
fulfill the contract due to conditions beyond the firms control. Most times, payment
will be made up to the point of the dispute.
Unfair Regulatory Environment
Foreign firms are discriminated against in many ways such as discriminatory capital
requirements; differing tax structures; and limitations on access to necessary
materials, components, or distribution systems. An advantage for foreign firms in
recent years has been the right to bid on host government contracts. However this
again can be a reason for discomfort for the firm within the host country.
Restrictions on Currency Convertibility
Currency convertibility has grown with a growth in the world trade. Some governments
believe that convertibility regulation and the rate at which currency is converted are
important economic tools. In order to preserve foreign exchange reserves, some
governments either do not allow foreign firms to repatriate profits to their home
countries or force them to convert currency at rates less than the market rate.
87

War risk
A foreign firms assets are potentially at risk at the advent of war, either civil or against
another country. War refers to hostile contention by means of armed forces carried out
between nations or factions. It includes civil war and armed insurrection. The question
here is, when does civil commotion become civil war? In most countries, unions are
political parties, or at least they are politically active in some way or the other. Though
violent strikes may occur, injuries and damages that result from them are generally not
thought of as political risk. The term insurrection, commonly referred to an uprising,
may also refer to any resistance to the lawful authority of the state.
6.2 Analysis of Political or Country Risk
Various methods have evolved to measure, analyze, and predict potential political
risks. Simon provides a good overview of the political risk assessment in terms of
definition, approach, database, and variables. He classified the variables for assessing
political risk along several dimensions -- societal-related, government related, external
or internal, based on the origin of risk, based on whether they are macro or micro, or
based on whether government actions are directed at all foreign firms or only selected
industries in the host country.
The level of economic development and the type of political systems can be used as
additional variables for assessing political risks. According to the level of economic
development, countries may be either industrialized or developing, having either open
or closed political systems. A society is termed as open when people voice their
approval or discontent in the form of voting, protests, or boycotts. In closed societies,
the government does not encourage these forms of expression publicly, and the
repression of the people can lead to violent encounters.
Douglas and Craig proposed another model which comprises four distinct, vital
dimensions for the assessment of political risk. These dimensions could be objectively
measured, and had some indicators or variables associated with each of them. They
are -- domestic stability (riots, purges, assassinations); foreign conflict (diplomatic
expulsions, military violence); political climate (size of the countrys communist
party, number of socialist seats in the legislature); and economic climate (gross
national product, inflation, external debt levels, and frustration levels).
Small and medium-sized firms might not be in a position to do a country-risk analysis
due to factors such as cost, and lack of expertise and resources required. However,
there are ways to do so. One way is to interview people who have some knowledge or
experience with the countries of interest including business persons, bankers, and
government officials. Another alternative is to subscribe to reports prepared by an
organization that has studied the countrys risks. However, this form of risk analysis is
not entirely reliable.
Another relatively simple method for evaluating political risk is based on the LIBOR
(London Interbank Offer Rate). The LIBOR rate is the interest rate charged between
banks and is relatively risk free. Non-bank borrowers have to pay a premium over
LIBOR, where the premium (i.e., the spread between the loan rate and LIBOR)
indicates the extent of risk involved. A borrower has to pay a high premium, if he/she
88
is from a country with a high risk of default. Thus, the premium is a good indicator of
risk as it reflects a lenders assessment of the country in terms of debt levels and
payment records, after adjusting for volume and maturity.
Activity: Delta Limited is a Finland-based furniture manufacturing company, wellknown for its innovatively designed and good quality furniture. The company forayed
into Asia by setting up an outlet in an Asian country in 1999. The companys
products were unique, which attracted the countrys consumers. By 2003, the
company started earning profits. It also expanded its presence by setting up several
outlets in the other provinces of the country. In 2006, the countrys government
ordered the company to sell off its local operations, and quit the country. The
company negotiated with the government several times regarding the issue, but
failed. Ultimately, the company sold off its operations to a local manufacturer for a
very low price. What kind of a political risk brought the company to this situation?
Answer:
Check Your Progress

12. Which of the following statements best defines political risk?
a.
Official seizure of foreign property by a host country whose intention is to use the
seized property in the public interest.
b.
It refers to any government action that diminishes the value of a firms operations
with the political boundaries or influence of that government.
c.
A process by which controls and restrictions placed on the foreign firms to

gradually reduce the control of the owners.
Any resistance to the lawful authority of the state.
d.
13. Which of the following is not an element of political risk?

a. War risk
b.
c.
Contract repudiation
Fair regulatory environment
d.
Restrictions on currency convertibility
14. When government takes ownership of a firms property without providing

compensation, it results in
a. Confiscation b.
Expropriation
c.
d.
Domestication
Cancellation
89

15. In which of the following processes is an entire industry within a country
transferred from private to public ownership, with no discrimination as to foreign
or local ownership?
a.
Nationalization
b.
Unforeseen takeover
c.
Domestication
d.
Expropriation
16. Which of the following is not a feature of an open political system?

a.
Protests
b.
Voting
c.
Boycotts
d.
Repression
17. All the statements given below ware true regarding LIBOR (London Interbank
Offer Rate), except:
a.
It is a simple method for evaluating political risk.
b.
It is the interest rate charged between banks.
c.
A borrower pays a low premium over the LIBOR, if he/she is from a country with
a high risk of default.
d.
The premium in LIBOR is a good indicator of risk as it reflects a lenders

assessment of the country in terms of debt levels and payment records, after
adjusting for volume and maturity.
6.3 The Management of Political Risk

There are two important stages in the management of political risk -- identification
and measurement.
Identification
As political risk results from potential governmental action that reduces the firms
value, the risk manager should familiarize himself/herself with the host-countrys
government. The study, with respect to the host government, should include its
history, how it came to power, how power was transferred, who are the participants in
the political process (are large groups disenfranchised?), and the organization of the
political structure (what are the powerful ministries or agencies? who are the
influential political leaders?).
A major portion of this analysis is available through a variety of media including the
Internet. The risk manager should be careful about the fact that political analysts can
and do disagree. The risk manager should go in for internal analysis after gathering as
much publicly available information as possible. There are three sources from which
the risk manager should gather information before conducting an internal analysis -international managers located at headquarters; field managers on assignment in
foreign affiliates; and information specialists assigned to monitor political activity
from the firms headquarters.
90
A major source of concern is the information regarding political subdivisions within
the country, such as the provincial, state, or city governments. These smaller entries
may also offer economic inducements or tax incentives which, if withdrawn, could
have significant financial consequences.
Measurement
Many organizations, private as well as government, offer political risk assessment in
various forms. In developed economies, political polling, market research, and attitude
surveys are used to examine the preferences and feelings of consumers toward
political parties. But developing countries are relatively less open to analysis. In these
countries, information is not only scarce but also confusing as economies undergo
rapid political and economic changes.
Embassies of most countries regularly file reports with their state departments or other
national agencies or ministers. Also, most governments maintain a Country Desk
within their state department or other agency or ministry, wherein country-specific
information is available to national firms and citizens.
A company should not only collect information form various sources, but it should
also assess the impact of political risk with respect to a particular company or
industry, as events which matter very little to one company may mean the very
existence to another.
The most difficult task in political risk analysis is predicting the timing of events. It
may be relatively easy to predict that a particular disenfranchised group will attempt
to seize power in the future, but the means and the time of the seizure may not be
known even to the group itself.
6.4 Measures to Minimize Political Risk
Political risk cannot be eliminated, but it can be minimized. Given below are some of
the measures that a company can take to discourage a host country from taking control
of its assets.
Stimulating the local economy
This is a defensive investment strategy in which a company links its business
activities to the host countrys national economic interests. There are a number of
different ways in which the local economy can be stimulated. One strategy might be
the purchase of local products and raw materials by the company for its production
and operations. By assisting the local firms, the company can develop local allies who
can provide valuable political contacts in time of need.
Sometimes local sourcing is compulsory. Some governments may require products to
contain locally manufactured components because local content improves the
economy in two ways -- it stimulates demand for domestic components and it obviates
the need for a foreign exchange transaction. The company can also assist the host
country by being export-oriented.
91

Employment of Nationals
Companies try to minimize their political risk by hiring local workers into their
workforce. Automation is not encouraged in some countries (where there is cheap
labor and high unemployment) as it leads to job losses or job elimination. In such
countries, opting for automation would be a serious mistake.
Sharing Ownership
Firms can tackle political risk by sharing ownership with others, especially local
companies. This can be done by converting from a private to a local company, and by
converting from a foreign company to a local one. Another common technique for
sharing ownership is to enter into a joint venture, a loss in control is compensated by
some benefits. Joint ventures in international business not only help in reducing
exposure, but also make it difficult for the host government to takeover without
offending a number of nations all at once. Alternatively, firms can also opt for
domestication. That is, the foreign companies can reduce their holdings in the local
companies if the host government places any such restrictions.
Being Civic Minded
A company, apart from doing business in a foreign country, should strive to be a good
corporate citizen. This can be done by making small investments in civic projects.
This may prove to be costly initially, but can help the company earn goodwill in the
long run. MNCs can help in building schools, hospitals, roads, and water systems as
such projects benefit the host country as well as the company.
Political Neutrality
Companies should primarily focus on economic development. They should keep a low
profile and avoid political disputes among local groups or between countries.
Behind-the-scenes Lobbying
Political risk can be managed in a civilized manner through lobbying. At times, lobbying
quietly behind the scenes could become necessary. Lobbying is not necessarily carried
out in the home country alone; such kind of activity can also be done in the host country,
either by the concerned company or by the government. However, it should be
conducted in such a way that it attracts the least political clamor.
Observation of Political Mood and Reduction of Exposure
Companies can reduce their exposure to political risk by making right decisions at the
right time. They should always watch for changes in political situation, and keep a
contingency plan ready for when the political situation turns hostile.
Check Your Progress
18. Which of the following is a measure used by firms to minimize political risk in
which the company would primarily focus on economic development and avoid
political disputes among local groups or between countries?
a. Sharing ownership
b. Being civic minded
c. Political neutrality
d. Simulation of the local economy
92
19. Identify from the following, the measure that does not help a foreign firm to
discourage a host country from taking control of its assets.
a.
By lobbying
b.
By sharing ownership
c.
By being politically neutral
d.
By employing people only from its home country
20. From the following, identify the sources of information that the risk managers can
use to conduct an internal analysis.
i.
International managers located at the company headquarters
ii.
Field managers on assignment in foreign affiliates
iii. Information specialists assigned to monitor political activity from the firms
headquarters
a. Only i and ii b.
Only i and iii
c.
Only ii and iii
d.
i, ii, and iii
7. Interface of Politics with Business

Though overseas markets may offer substantial opportunities for business, these
opportunities are coupled with risks of intervention by the host governments. Today
nations consist of different groups, each of which seeks to maximize their individual
interests. In countries where foreign investments plays a significant role in shaping the
economy, the goals of special interest groups frequently necessitate interference in the
operation of foreign firms. Political intervention can be defined as a decision on the
part of the host country government that may force a change in the operations,
policies, and strategies of a foreign firm. This intervention may range from some sort
of control to complete takeover or annexation of the foreign enterprise. There are
different forms of intervention like expropriation, domestication, exchange control,
import restrictions, market control, tax control, price control, and labor problems.
7.1 Expropriation
Eiteman and Storehill defined expropriation as, official seizure of foreign property
by a host country whose intention is to use the seized property in the public interest.
Expropriation is recognized by international law as the right of sovereign states,
provided the expropriated firms are given prompt compensation, at fair market value,
in convertible currencies.
Other terms used interchangeably with expropriation are nationalization and
socialization. Nationalization refers to a transfer of the entire industry or assets within
that country from private to public ownership, with no discrimination as to foreign or
local ownership. After nationalization, the property is controlled or owned by the
government and the nationals of the host country. Socialization is similar to
nationalization, in that the property that has been taken over or transferred is kept with
the government. That is, private ownership, either foreign or local, is completely
93

excluded. Nationalization is also referred to as socialization, when used with reference
to socialist or Communist programs designed to put an end to private ownership of
property. Expropriation without compensation is called confiscation. Expropriation
patterns might vary according to the industry, geographic region, type of ownership,
technology, degree of vertical integration, asset size, and politico-economic situation.
7.2 Domestication
Domestication is a process by which controls and restrictions placed on the foreign
firms gradually reduce the control of the owners. Domestication may lead ultimately
to expropriation. This process offers a compromise to both parties. That is, the
multinational company continues to operate in the country, while the host government
is able to maintain control on the foreign firms through different restrictions and
regulations.
Domestication includes gradual transfer of ownership to nationals; promotion of a
large number of nationals to higher levels of management; greater decision-making
power accorded to nationals; more products produced locally rather than imported for
assembly; and specific export regulations designed to dictate participation in world
markets.
7.3 Other forms of intervention
Apart from expropriations and domestication, there are other means of government
intervention in foreign enterprises.
Exchange Control
Foreign exchange regulations are imposed by countries facing difficulties regarding
their balance of payments. These exchange control regulations are intended to
encourage domestic industry. As a result of exchange control, foreign businesses -cannot return profit and capital to the parent company from the host country at will,
and cannot freely import raw materials, spare parts, and machinery for operating
purposes.
The exchange control regulations in most developing countries are meant to protect
and regulate their hard currency balances. This in turn can lead to restrictions on the
import of some consumer goods (for example, cars, appliances, clothing, perfumes).
Not only the developing countries, but even the developed countries sometimes resort
to exchange control.
Import Restrictions
Import restrictions are usually imposed to support the domestic industry. Generally
governments impose import restrictions for an entire industry, and not a particular
company. When a country wants to encourage domestic industry as a matter of
industrial policy, import restrictions are adopted even if it is realized that the local
product will be inferior, at least initially. From the point of view of the government,
import restrictions may be reasonable; but they jeopardize the function of foreign
business.
94
Market Control
Governments of certain countries impose restrictions on foreign firms to prevent them
from competing in certain specified markets.
Tax Control
Government may impose certain excessive and unconventional taxes on foreign firms
for the following reasons -An unconventional tax burden on foreign firms indicates that they are not wanted
there any longer.
When a country is in a dire need of revenue inflows, it is quite possible that foreign
firms will become the target of attack, as it is more economical, convenient, and
politically prudent to do so.
If the government comes to know that the foreign firm has abused differences in
international taxation to deprive the host country of its due revenues, retaliatory taxes
can be imposed.
Price Control
Price control is usually taken up in public interest when the country faces with
economic difficulties. Many countries have resorted to price controls to improve their
economies. For example, a government might set an official price on essential
products such as drugs, heating oil, sugar, and cereals. When applied randomly, price
control brings its own set of problems. It also hampers the working of the foreign firm
if the firm has been singled out by such regulations that are not based on a sound
economic rationale.
Labor Restrictions
In many countries, labor unions are so strong that they may be able to negotiate terms
with the government to pass very restrictive laws that support labor at a heavy cost to
business. Their demands and the laws supporting them can pose major problems for
foreign enterprises. In such situations, the foreign firms may have no choice but to
leave.
8. Impact of International Political Environment on Domestic Business

A company originating in the US will continue to be known as a US company even
though it derives a major portion of its revenues from operations outside the country.
The relationship between the host country and home countrys government will also
affect the MNC, either directly or indirectly. Questions such as -- Do the governments
agree on issues debated by international agencies? Are there any points of discord
between the host country and the home country? Is there reason to believe that
relations between them will improve or deteriorate in the future? -- should be
addressed before commencing operations in an unknown foreign market.
95

Example: Nationalization of the Bolivian Oil & Gas Sector
On May 01, 2006 at the annual May Day function, Evo Morales Ayma (Morales),
President of Bolivia, announced the nationalization of the countrys oil and gas sector. As
a symbolic gesture of ownership, Morales sent the military to take over the oil and gas
installations. As per the nationalization decree, all foreign companies were required to
give up their ownership of oil and gas sector. The foreign companies were given six
months time to renegotiate their contracts with the government. All the future sales of the
foreign companies would be channeled through the state-owned oil company, YPFB
(Yacimientos Petroliferos Fiscales Bolivianos). The Morales government believed that
nationalization would help in enhancing revenues, promoting greater social welfare,
creation of more jobs to Bolivians, and increasing Bolivian nationalistic pride.
The decision regarding nationalization received criticism from various quarters. The
decision of Morales to send military troops to take control of the oil and gas fields
attracted heavy criticism from foreign investors and industry analysts. It was
estimated that 56 oil and gas fields had been occupied by the military troops with a
copy of the presidential decree and banners stating Nacionalizado: Propiedad de los
Bolivianos (Nationalized: Property of the Bolivians) being immediately displayed
outside the fields. The government justified the use of the military troops on the
ground that their presence would deter foreign companies from destroying important
documents necessary for the proposed audit and renegotiation of the contracts.
After the nationalization was announced, the European Union (EU) criticized the move
and said that it might affect the volatile world energy markets. It said that it would study
the nationalization and its effect on those foreign companies that were most likely to be
affected. The nationalization was also expected to lead to a direct confrontation with the
largest investor in the oil and gas sector in Bolivia, Petrobras, which had already
announced a freeze on all its proposed future investments in Bolivia and criticized the
nationalization. The Spanish government also expressed concern over the nationalization
in Bolivia as Respol-YPF was the biggest player in the oil and gas sector after Petrobras.
Nationalization was expected to affect production severely, if foreign companies chose to
leave Bolivia. Foreign companies bring in the latest techniques and technologies in
exploration and production that would help in easy location and quality production of oil
and gas. Bolivia was not self-reliant in those areas. It was only after the privatization of the
sector in 1996, that oil and gas exploration and production grew sharply in Bolivia.
Therefore without private participation, active exploration and production could be
severely affected in Bolivia. Upon their withdrawal, Bolivia would be unable to supply
gas to Brazil and Argentina as per the original contracts. This would result in loss of
revenues and termination of contracts. Further, it was also expected to create a shortage of
gas domestically for Bolivia. According to an estimate, it might necessitate the import of
12,000 barrels of natural gas per day by 2010. Hugo Chavez (Chavez), President of
Venezuela promised to offer technical help for refining and production through
Venezuelan state-owned oil company, Petroleos de Venezuela SA (PDVSA) in the event
of exit of foreign companies. This move was also criticized by analysts as they said that
PDVSA did not possess the required competence to help YPFB and therefore it was
unwise for Bolivia to rely on it.
Adapted from Case Study Bolivia Nationalizes the Oil and Gas Sector, The ICMR
96
Activity: ABP International (ABP) is a UK-based drug manufacturing company.

The company set up a manufacturing facility in Brazil in 2006. It employed the
local people in the manufacturing unit. It also entered into partnership with local
Brazilian manufacturers to fulfill its raw material requirements. In late 2008,
ABP joined with Aliana da Terra, an NGO in Brazil that s upports
environmentally responsible land management in the Amazon rainforest, and
Instituto Jacques Walter, an NPO that aims to preserve and recoup Atlantic
Forest in Espirito Santo, Brazil. In what way can these initiatives help the
company in the host country?
Answer:
Check Your Progress

21. What is the process used by the government in which controls and restrictions
placed on the foreign firms gradually reduce the control of the owners?
a.
Nationalization
b.
Socialization
c.
Domestication
d.
All of the above
22. In what form of intervention does the government impose restrictions on foreign
firms to prevent them from competing in certain specified markets?
a.
Import restrictions
b.
Market control
c.
Exchange control
d.
None of the above
23.
refers to official seizure of foreign property by a host country

whose intention is to use the seized property in public interest, in which the
foreign firms are given some compensation.
a.
Confiscation
b.
Nationalization
c.
Expropriation
d.
Socialization
97

24. All the statements given below are true regarding import restrictions, except:
a. These are usually imposed to support the domestic industry.
b. Governments generally, impose import restrictions on a particular company in an
industry, and not for the entire industry.
c. These restrictions may restrict the functioning of the foreign businesses.
d. When a country wants to encourage domestic industry as a matter of industrial
policy, import restrictions may be adopted even if it is known that the local
product will be inferior, at least initially.
25. Under which of the following circumstances do governments impose excessive
and unconventional taxes on foreign firms?
i.
When the foreign firms are not wanted in a country any longer
ii.
When a country is in a dire need of revenue inflows
iii. When the government comes to know that the foreign firm has abused differences
in international taxation to deprive the host country of its due revenues.
a. Only i and ii b.
Only i and iii
c.
Only ii and iii
d.
i, ii, and iii
9. Summary
The political environment forms one of the most important facets of the business
environment for any business today, since business is influenced by the political
happenings within a country, and internationally.
Governments can be classified according to their political systems or their economic
systems. They can also be classified on the basis of the number of political parties
present -- two-party, multiparty, single-party, and dominated one-party.
The economic system of classification is concerned with business ownership -whether businesses are privately owned, or government owned, or whether there is a
combination of private and government ownership. The economic system can be
further subdivided into three types -- communism, socialism, and capitalism.
MNCs should consider the political environment from different angles -- foreign
politics, domestic politics, and international politics.
domestic firms.
The elements of political risk include confiscation, expropriation, and nationalization;
contract repudiation and frustration; unfair regulatory environment; currency
inconvertibility; and war risk.
Simon, Douglas, and Craig have proposed various methods to measure, analyze, and
predict potential political risks. The LIBOR rate can also used to assess political risk.
There are two important stages in the management of political risk -- identification
and measurement.
98
Foreign companies can take certain measures to discourage a host country from
taking control of the assets. These are -- by stimulating local economy, employing
nationals, sharing ownership, by being civic minded, by being politically neutral, by
lobbying, and by observing political situations.
Political intervention can be defined as a decision on the part of the host country
government that may force a change in the operations, policies, and strategies of a
foreign firm.
There are different forms of political intervention like expropriation, domestication,
exchange control, import restrictions, market control, tax control, price control, and
labor problems.
The relationship between host country and home countrys governments will affect
MNCs, either directly or indirectly. Questions like whether the governments agree
on issues debated by international agencies and are there any points of discord
between the host country and the home country should be addressed before
commencing operations in a foreign market.
10. Glossary
Absolutist governments (closed) (sub-type of political system): These include
monarchies and dictatorships, where the ruling regime dictates government policies
without considering citizens needs or opinions.
Capitalist philosophy (sub-type of economic system): Under this, a free-market
system is provided that allows business competition and freedom of choice for both
consumers and companies.
Communist philosophy (sub-type of economic system): Under this, all resources
should be owned and shared by all people for the benefit of society (i.e., not for profit
seeking enterprises).
Confiscation: It occurs when a government takes ownership of a property without
providing compensation. Expropriation without compensation is called confiscation.
Domestic politics: Politics that exist in the companys home country, also known as
the parent or source country.
Domestication: It is a process by which controls and restrictions placed on the foreign
firms gradually reduce the control of the owners. Domestication may lead ultimately
to expropriation.
Dominant-party system (sub-type of political system): In this, only one political
party can become the ruling government. This is because the party is so strong that it
becomes dominant within the political structure of the country. The other parties are
allowed to operate freely, but are weak or ineffective to challenge the power of the
dominant party.
Expropriation: Official seizure of foreign property by a host country whose intention
is to use the seized property in the public interest. In expropriation, there will be some
compensation, though not necessarily adequate.
Foreign politics: Politics that are associated with the local or host country. The
association in this form of politics might range from being favorable and friendly to
being hostile and dangerous.
International politics: It refers to the interaction of the overall political environment
factors of two or more countries. The environment becomes highly complex when the
interest of the company, host country, and the home country do not coincide.
99

Multiparty system (sub-type of political system): In this, there are some large
parties, but these are unable to form the government because they fall short of the
required majority. The government is formed through coalitions between the various
parties, each one of which wants to protect its own interests.
Nationalization: It refers to a transfer of the entire industry within that country from
private to public ownership, with no discrimination as to foreign or local ownership.
Parliamentary government (open) (sub-type of political system): These
governments consult citizens from time to time for the purpose of learning of their
opinions and preferences. The policies of such governments reflect the desires of the
majority of members of the society.
Single-party system (sub-type of political system): In this system, only one political
party is legally allowed to form the government. Opposition to the ruling party in any
form is banned by law.
Socialist philosophy (sub-type of economic system): Under this, the government
owns and operates the basic, major industries, but allows private ownership of small
businesses.
Socialization: In this, the property that has been taken over or transferred is kept with
the government. That is, private ownership, either foreign or local, is completely
excluded.
Two-party system (sub-type of political system): In this, there are typically two
strong parties that take turns controlling the government, though there may be several
other parties. The two parties are generally governed by different philosophies, which
results in a change in the government policy when one party succeeds the other.

1.
Knowledge of the different forms of government can help one appraise the
political climate in any country. What are the different types and sub-types of
governments?
2.
Businesses have to face a complex political environment as they have to cope

with the political situation of more than one nation. Discuss the impact of the
international political environment on domestic business. How should the
multinationals look at the complexities in the political environment?
3.
Various factors contribute to political instability. Explain these factors in detail.
4.
operations within the political boundaries or influence of that government. It may
arise due to one or a combination of certain elements. Describe these elements in
detail.
5.
Describe the ways in which the political risk can be analyzed. Explain the stages
involved in the management of political risk. What are measures that a foreign
company can take to discourage a host country from taking control of its assets?
6.
Overseas markets offer substantial opportunities and at the same time are coupled
with risks of intervention by the host government. Identify the various forms of
political interventions.
100

1.
<http://www.booksites.net/online_courses/ema_uk_he_intlmktg_1p/sample_mate
rial/l03-the-political-environment/political-environment01.htm>
2.
Types of Government
<http://www.stutzfamily.com/mrstutz/WorldAffairs/typesofgovt.html>
3.
Types of Government
<http://en.wikipedia.org/wiki/Form_of_government>
4.
Types of Government
<http://depts.alverno.edu/dgp/GEC/Types%20of%20Government.html>
5.
Political Risk
<http://en.wikipedia.org/wiki/Political_risk>
6.
Managing Political Risk

<http://internationalinvest.about.com/od/globalmarkets101/a/countryresearch.htm >

1.
(a) Political system

According to the political system, governments are classified on the basis of the
number of political parties that are represented in it -- two-party, multi-party,
single-party, and dominated one-party. In a single-party system, only one political
party is legally allowed to form the government. Opposition to the ruling party in
any form is banned by law.
2.
(c) Single-party system

In a single-party political system, only one political party is legally allowed to
form the government. Opposition to the ruling party in any form is banned by
law. Countries like Cuba and Vietnam have single-party systems.
3.
(b) Opposition to the ruling party in any form by the other parties is banned
by law.
All statements are true regarding dominant-party system, except statement b. In
a single-party political system, opposition to the ruling party in any form is
banned by law.
4.
(b) Absolutist
Absolutist governments include monarchies and dictatorships, where the ruling
regime dictates government policies without considering needs or opinions of the
citizens. These are found in newly formed nations or those undergoing some kind
of political transition. Such governments are relatively rare now.
101

5.
(d) Communist
The economic system can be further subdivided into three types -- communism,
socialism, and capitalism. The communist philosophy holds that all resources
should be owned and shared by all people (i.e., not for profit seeking enterprises)
for the benefit of society.
6.
(d) Parliamentary
Governments can be classified as either parliamentary or absolutist.
Parliamentary governments consult citizens from time to time for the purpose of
learning their opinions and preferences. The policies of such governments reflect
the desires of the majority of members of the society.
7.
(a) The government form of government owns and operates the basic, major
industries but allows private ownership of small business.
A socialist government owns and operates the basic, major industries, but allows
private ownership of small businesses. The degree of government control that
occurs under socialism is comparatively less than the same under communism.
8.
(d) Capitalist
The economic system can be further subdivided into three types communism,
socialism, and capitalism. The philosophy of capitalism provides for a freemarket system that allows business competition and freedom of choice for both
consumers and companies. It is a market-oriented system in which individuals,
motivated by private gains, are allowed to produce goods or services for public
consumption under competitive conditions.
9.
(d) i, ii, and iii

To assess a companys political environment, it is vital to identify and evaluate
the relevant factors contributing to political instability in order to assess a
companys potential political environment. Potential sources of political
complication include social unrest, the attitudes of nationals, and the policies of
the host government.
10. (a) It refers to the politics that exist in the companys home country.
Domestic politics refers to the politics that exist in the companys home country.
These politics are usually thought as causing minimal problems, which is not true.
Labor and political organizations criticize a local companys international
activities by accusing it of exporting capital and jobs. The government, instead of
providing support, can become a hindrance in international trade. Also, when
national interests are at stake, a government may use certain companies as an
instrument to achieve its political goals.
11. (d) All of the above
International politics refers to the interaction of the overall political environment
factors of two or more countries. The environment becomes highly complex when
the interest of the company, host country, and the home country do not coincide.
And, sometimes, the problems cannot be solved.
102
12. (b) It refers to any government action that diminishes the value of a firms
operations with the political boundaries or influence of that government.
domestic firms.
13. (c) Fair regulatory environment
operations within the political boundaries or influence of that government. The
elements of political risk include confiscation, expropriation, and nationalization;
contract repudiation and frustration; unfair regulatory environment; currency
inconvertibility; and war risk.
14. (a) Confiscation
Confiscation is an element of political risk. In this, the host government takes
ownership of a property of the foreign company without providing any
compensation. After a property has been confiscated, it can either be nationalized
or domesticated.
15. (a) Nationalization
Nationalization is one of the elements of political risk. It refers to a transfer of the
entire industry within that country from private to public ownership, with no
discrimination as to foreign or local ownership.
16. (d) Repression
A society is termed as open when people voice their approval or discontent in the
form of voting, protests, and boycotts. In closed societies, the government does
not encourage these forms of expression publicly, and the repression of the
people can lead to violent encounters.
17. (c) A borrower pays a low premium over the LIBOR, if he/she is from a
country with a high risk of default.
All the statements are true regarding LIBOR, except statement (c). LIBOR is the
interest rate charged between banks and is relatively risk free. A borrower has to
pay a high premium, if he/she is from a country with a high risk of default.
18. (c) Political neutrality
Political neutrality is a measure used by firms to minimize political risk. In this,
the foreign company should primarily focus on economic development. They
should keep low profile and avoid political disputes among local groups or
between companies.
19. (d) By employing people only from its home country
In order to discourage a host country from taking control of its assets, a foreign
firm can take up the following measures -- stimulation of the local economy,
employment of nationals, sharing ownership, being civic minded, political
neutrality, behind-the-scenes lobby, and observation of political mood and
reduction of exposure.
103

The risk manager should go in for internal analysis after gathering as much
publicly available information as possible. There are three sources from which the
risk manager should gather information before conducting an internal analysis -international managers located at headquarters; field managers on assignment in
foreign affiliates; and information specialists assigned to monitor political activity
from the firms headquarters.
21. (c) Domestication
Domestication is a process by which controls and restrictions placed on the
foreign firms gradually reduce the control of the owners. This process allows the
multinational to continue to operate in the country. Also, the host government is
allowed to maintain control on the foreign firms through various restrictions and
regulations.
22. (b) Market control
Market control is a form of political intervention in which the host government
may force a change in the operations, policies, and strategies of a foreign firm. In
market control, governments of certain countries impose restrictions on foreign
firms to prevent them from competing in certain specified markets.
23. (c) Expropriation
Expropriation is a form of political intervention. Eiteman and Storehill defined
expropriation as, official seizure of foreign property by a host country whose
intention is to use the seized property in the public interest. Expropriation is
recognized by international law as the right of sovereign states, provided the
expropriated firms are given prompt compensation, at fair market value, in
convertible currencies.
24. (b) Governments generally, impose import restrictions on a particular
company in an industry, and not for the entire industry.
All the statements are true regarding import restrictions, except statement (b).
Governments impose import restrictions for the entire industry, and not a
particular company.
Government may impose certain excessive and unconventional taxes on foreign
firms for the following reasons -- an unconventional tax burden on foreign firms
indicates that they are not wanted there any longer; when a country is in a dire
need of revenue inflows, it is quite possible that foreign firms will become the
target of attack, as it is more economical, convenient, and politically prudent to
do so; and if the government comes to know that the foreign firm has abused
differences in international taxation to deprive the host country of its due
revenues, retaliatory taxes can be imposed.
104

Course Components
BLOCK I
Unit 1
Unit 2
Unit 3
Unit 4
BLOCK II
The Economic and Technological Environment of Business
Unit 5
Unit 6
Unit 7
Trade Environment
Unit 8
BLOCK III
The Legal and Ethical Environment of Business
Unit 9
Legal and Regulatory Environment
Unit 10
Tax Environment
Unit 11
Ethical Environment
BLOCK IV
Business Contracts
Unit 12
Law of Contracts
Unit 13
Special Contracts
BLOCK V
Law Relating to Corporate Business Entities
Unit 14
Formation and Organization of Companies
Unit 15
Company Management and Winding Up
BLOCK VI
Tax Laws
Unit 16
Direct Taxes
Unit 17
Indirect Taxes
Block
II
THE ECONOMIC AND TECHNOLOGICAL
ENVIRONMENT OF BUSINESS
UNIT 5
1-19
UNIT 6
20-42
UNIT 7
Trade Environment
43-73
UNIT 8
74-84
Expert Committee
Vice Chancellor
Hyderabad
Prof. S. S. George
Director, ICMR
Hyderabad
Prof. Y. K. Bhushan
Vice Chancellor
IU, Meghalaya
Dr. O. P. Gupta
Vice Chancellor
IU, Nagaland
Prof. Loveraj Takru

IU, Dehradun
Prof. D. S. Rao
Hyderabad

Prof. Vivek Gupta
Hyderabad
Ms. Hadiya Faheem

Hyderabad

Hyderabad

Hyderabad

IU, Dehradun
Ms. Padmaja
IU, Meghalaya

IU, Mizoram
Aizawal
Ms. Anurita Jois

IU, Sikkim

Block II

The second block of the course on Business Environment & Law deals with the concepts of
economic and technological environment of business. The block contains four units. The first
unit focuses on the economic environment and the impact of economic factors on business.
The second unit discusses the financial environment and its affect on the business. The third
unit discusses the significance of trade environment to business. The fourth unit examines the
technological environment and the growing importance of technology in making business
decisions.
The first unit, Economic Environment, gives an overview of the world economy. The unit
focuses on the classification of economies. It discusses various consumption patterns. The
unit also focuses on the significance of balance of payments. It then discusses national control
of international transfers and gives an overview of the Indian economy. The unit explains how
economic indicators are used to measure the overall economic activity.
The second unit, Financial Environment, deals with the concepts of money supply and gross
domestic product. The unit explains the functions of the financial system. It examines key
financial markets such as the capital market and the money market and also focuses on the
development of these markets. The unit explains the significance of financial institutions to
the economic well-being and future growth of a market-oriented economy. The unit also
discusses kinds of financial intermediaries and financial products.
The third unit, Trade Environment, helps in making one understand the significance of
liberalization and globalization of markets. The unit gives an overview of globalization in the
Indian industry. The unit then discusses the import policy and the export policy. It also
explains the objectives of the EXIM policy. The unit explains the basic issues in international
licensing and international franchising. It focuses on the kinds of middlemen mercantile
agents and merchant middlemen. The unit also explains the issues in the global economic
environment.
The fourth unit, Technological Environment, deals with the forces affecting technology which
result in the creation of new products, markets, and marketing opportunities. The unit
examines the definitions of technology and technology transfer. It then discusses the factors to
be considered while selecting a technology. The unit also explains the new risks introduced
by technology and environmental liability and the costs of technological advances.
Unit 5
Structure
1.
Introduction
2.
Objectives
3.
4.
The World Economy An Overview

Classification of Economies
5.
Consumption Patterns
6.
Balance of Payments
7.
National Control of International Transfers
8.
9.
The Indian Economy An Overview

Economic Indicators
10. Summary
11. Glossary
1. Introduction
This unit provides an introduction to the economic environment. Economic
environment refers to all those economic factors which have a bearing on the
functioning of a business. Business is dependent on the economic environment for
procuring the required inputs and for selling the finished goods. To be able to reach
sound business decisions in a dynamic economy, managers need to have a clear
understanding of economic interrelationships and their impact on business.
This unit provides an overview of world economy and the classification of economies.
The unit then discusses the consumption patterns, balance of payments, and national
control of international transfers. The unit also gives an overview of the Indian
economy and explains key economic indicators.
2. Objectives
describe the world economy.
classify the economies.
identify various consumption patterns.
explain balance of payments.
state the reasons for controlling international transfers.
describe the Indian economy.
identify several economic indicators.
3. The World Economy An Overview

The world economy has undergone revolutionary changes during the past few
decades, the most significant change being that of the emergence of global markets
and global competitors. Many remarkable changes took place. The first change is the
increased volume in capital movements. The capital movements far exceed the
volume of trade finance. In the past, when a country ran a deficit on its trade accounts,
its currency would depreciate. Today, it is capital movements and trade that determine
currency value. The second change is that although employment in manufacturing is
steady, the production is continuously growing. Another change is the emergence of
the world economy as a dominant economic unit. There is great competition and every
player provides something different and thus wins. Changes in the global competition
are bringing countries into more direct confrontation with their main economic rivals
which was not the case in the past.
The changes in the world economy in the past few years have been dramatic. A
remarkable change in the world economy is slowdown in economic growth mostly in
developed countries. The emerging markets, led by India, China, Brazil, and Russia
grew at a rate of 7% to 10% for years. North America and Europe were characterized
by consistent growth due to boom in property and stock markets till 2007. Investment
had brought about economic development in the Middle East and Africa. Japan also
recovered from its lost decade of deflation. However the growing world economy
was hit by a slowdown in the US economy. The slowdown was largely driven by
financial turmoil, rising commodity prices, and a downturn in the housing market in
early 2008. According to United Nations estimates, world growth fell from 3.7% in
2007 to 2.5% in 2008. It was expected to fall further to 1% in 2009.
The commodity prices that witnessed an increase in first half of 2008 also saw a drop
due to weakened demand. This led to easing the inflationary pressure on the world
economy. In addition to the decreasing commodity prices and weakening demand,
lower capacity utilization rates are expected to further ease the inflation in 2009.
4. Classification of Economies
The economies of the world can be classified on the basis of:
1.
Ownership of the means of production
2.
Level of development reached
4.1 Ownership of the Means of Production

The economic system of any country is an empirical hypothesis of its economic
environment. There are basically three types of economic systems based on the
ownership of the means of production. They are-capitalist, socialist, and mixed.
Capitalist Economy
Capitalist economy is a system in which all the means of production (land, labor, and
machinery) are owned and controlled by private individuals. All the economic
activities are steered by self-interest. Economic problems are solved by price
2
mechanism and there is a very limited role for the government. A capitalist economy
also helps the consumers to cut down the consumption if the price is high. All
economic activities are regulated through price. Price is fixed by the interaction of
demand and supply.
Socialist Economy
Socialist economy is a system in which all the means of production are owned by the
whole community and all economic decisions related to production, exchange, and
distribution are taken by the state.
Mixed Economy
In a mixed economy, there are three sectors:
Public sector (All firms and business houses are owned by the Government).
Private Sector (All firms and business houses are owned by private individuals).
Joint Sector (Has both public and private enterprises).
India is a good example of mixed economy. In India, while the government owns
some of the most important industries, some are owned by private individuals.
4.2 Level of Development Reached
On the basis of the level of development reached, countries can be classified as
developed, underdeveloped, or developing economies.
Developed Economies
A developed economy is one, which has reached a very high stage of development.
The per capita income and standard of living of the people is very high in such
countries.
Underdeveloped Economies
According to the United Nations, Countries in which per capita real income is low
when compared with the per capita real income of the United States of America,
Canada, Australia, and Western Europe.
Developing Economies
According to the World Bank, low income and middle income countries are termed as
developing economies. In 2008, the World Bank classified countries with Gross
National Product (GNP) per capita of less than US$ 11,905 as developing.
The International Monetary Fund (IMF) has defined a developing country as follows:
Low-and middle-income countries in which most people have a lower standard of
living with access to fewer goods and services than do most people in high-income
countries.
The term developing economies signifies that though still underdeveloped, the
process of development has been initiated in these countries.
3

Some of the physical characteristics of underdeveloped and developing countries
include low living standards, low levels of productivity, high population growth rate,
large scale unemployment and underemployment, and market imperfections.
Example: Brazil A World Economic Power in the Making
Brazil is known for its soccer prowess rather than its economic strength. However,
slowly and steadily, Brazil has been making its mark on the world economic
scenario. With well-developed agricultural, mining, manufacturing, and service
sectors, Brazils economy has overtaken many other South American economies
and is expanding its presence in the world markets. Brazil was one of the fastest
growing economies in the world between 1930 and 1995, with an average annual
growth rate of 6.1 percent. By 2000, Brazils per capita income stood at R$ 6,500.
In 2002, Brazil signed a trade and cooperation agreement with Russia, India, and
China calling it BRIC. A research report released by Goldman Sachs, a leading
consultancy firm, predicted a bright future for Brazils economy and other countries
like Russia, India, and China (identified as the BRIC countries) and said they
would be among the fastest growing economies in the next 50 years.
According to the study released by Goldman Sachs (Sachs) global economics
team, BRICs economies held the greatest potential for economic growth in the
21st century. The study predicted that the size of the BRIC economies could exceed
that of the G-6 countries, consisting of the US, Japan, Italy, France, Germany, and
the UK by 2039.
The study assumed that the rise in Gross Domestic Product (GDP) of the BRIC
countries in US dollar terms would come from a mix of a rise in real GDP and
currency appreciation. The growth model of Sachs study had a basis in terms of
labor, capital stock, and the level of technical progress or total factor
productivity to arrive at growth projections.
The BRIC report predicted that Brazil would be one of the top six economies of the
world. However, Brazil has had a history of struggling with inflation. Brazils first
major inflationary surge began in the late 1950s and continued until 1964. A second
surge began in the 1970s, partly as a result of the external shocks caused by the rise
in energy prices. Inflation worsened dramatically in the 1980s. The inflation rates
disrupted economic activity and discouraged foreign investment. By the late 1980s,
the annual rates of inflation increased exorbitantly. For the citizens of Brazil, life
was a great struggle. Between the end of World War II and Brazil's Real Plan in
1994, the price level increased greatly. However, the efficiency with which the
economic crisis was handled and the way the country is moving ahead on the
growth path make it appear as if the Goldman Sachs predictions about Brazil could
well come true.
Compiled from various sources.
Activity: Name at least three countries each classified on the basis of ownership of
production reached and the level of development reached.
Answer:
Check Your Progress

1.
a.
Business is dependent on this for procuring the required inputs and for selling the
finished goods.
Legal environment
b.
Trade environment
c.
d.
Social environment
2.
Which is the economic system in which all the means of production are owned by
private individuals?
a.
Socialist economy
b.
Capitalist economy
c.
Mixed economy
d.
Developed economy
3.
State ownership of all the means of production is an important feature of such an

economy
a.
Capitalist economy
b.
Developing economy
c.
Underdeveloped economy
d.
Socialist economy
4.
Which of the following is a notable feature of a developed economy?
a.
High population growth rate
b.
Large but neglected agricultural sector
c.
High per capita income and high standard of living
d.
Large-scale unemployment and underemployment
5.
India is a good example of such an economy
a.
Socialist economy
b.
Mixed economy
c.
Capitalist economy
d.
Communist economy
5

6.
In which type of economy ownership and control vest mostly in private hands?
a.
Mixed economy
b.
Capitalistic economy
c.
Socialistic economy
d.
None of the above
7.
Which of these is a characteristic of mixed economy?
a.
The state regulates economic activity and the operations of business and
industries
b.
Production and consumption is determined by the state
c.
There exist all different types of economies in the different parts of the country
d.
Private enterprises co-exist with government enterprise
5. Consumption Patterns
Let us look into the consumption patterns and the theories behind them to have a
focused attention on the economic development of a country.
5.1 Engels Law
Every marketer is aware of the relationship between income level and consumption
patterns and, therefore, frequently uses income segmentation in defining a market.
The nature of income elasticity (the relationship between demand changes and
changes in income) for food was first observed and formulated by the nineteenth
century Prussian statistician, Ernst Engel.
According to Engels Law, With rising incomes, the share of expenditures for food
(and, by extension, other) products declines. The resulting shift in expenditures affects
demand patterns and employment structures. Poorer family will spend a larger share
of their total expenditures on food than wealthier families.
5.2 Product Saturation Levels
In general, product saturation levels increases as national income per capita increases.
However, in markets where income is sufficient to enable consumers to buy a
particular product, other factors must be considered.
6. Balance of Payments
The currency price of any country is dependent on the quantity supplied in relation to
the quantity demanded especially when exchange rates are settled in an unregulated
market. Any factor that increases the demand for the currency would result in an
increase in the currencys foreign exchange value i.e. appreciates the currency.
Similarly, any factor that increases the supply of the currency would result in a
decrease in the foreign exchange value of the currency i.e. depreciates the currency.
The balance of payment account is a systematic record of transactions of a country
involving claims on and liabilities to the rest of the world. According to the Reserve
Bank of India, The balance of payments of a country is a systematic record of all
economic transactions between the residents of a country and the rest of the world. It
6
presents a classified record of all receipts on account of goods exported, services
rendered and capital received by residents and payments made by them on account
of goods imported and services rendered from the capital transferred to nonresidents or foreigners. The balance of payments account can be divided into
current and capital accounts.
The current account of the balance of payments is a record of the value of trade in
goods and services and of transfers between a country and the rest of the world.
Service transactions include travel and transportation, income and payments on
foreign investments. Transfer payments relate to gifts, pensions, private remittance,
and charitable donations received from foreign individuals.
A deficit on the current account means that more goods and services have been
imported into the country than have been sold abroad. A surplus in the current account
means more goods and services have been exported than imported.
Capital account may be defined as a record of investment and payment flows
between a country and the rest of the world.
The capital account of a country consists of its transactions in financial assets in the form
of short-term/long term lending and borrowing, and private and official investments.
In the capital account, borrowing from foreign countries and direct investments from
foreign countries represent capital inflows or credits (as these are receipts from
foreigners). The direct investments and lending to foreign countries represents debits
or capital outflows (as they are payments to foreigners). There are two types of
transactions in the capital account private and government. Private transactions
include all types of investment i.e. portfolio investment, direct investment, and shortterm investment. Portfolio investment refers to investments in financial instruments
that have a maturity period of more than one year. These investments are mainly made
in long-term securities such as equities (less than 10% ownership) and bonds. These
investments are of a passive nature with no active role by the investor. Direct
investment involves purchase of common stock of 10% or more of the voting stock of
a company. Wholly owned subsidiaries, foreign branches, and joint ventures are also
direct investments. Short-term investments include financial assets such as bills,
deposits, and currency. Government investments consist of loans to and from foreign
official agencies.
6.1 Disequilibrium in Balance of Payments
If the total receipts from foreigners on the credit side exceed the total payments to
foreigners on the debit side, the balance of payments is said to be favorable. If the
total payment to foreigners exceeds the total receipts from foreigners, the balance of
payment is unfavorable.
Causes of Disequilibrium
There are many factors that may cause a deficit or surplus in a countrys balance of
payments. The various causes of disequilibrium are discussed below:
A temporary disequilibrium may be caused by random variations in trade, the efforts
of the weather on agricultural production, seasonal fluctuations, etc.

Technological changes in the methods of production may affect the countrys ability
to compete in home or foreign markets.
A countrys balance of payments also depends on its state of economic development.
There may be chronic or fundamental disequilibrium due to changes in consumer
tastes within the country or abroad, which affect the countrys imports or exports.
Another cause is the change in the countrys national income. If a countrys national
income increases, it may lead to an increase in imports, thereby creating a deficit in its
balance of payments.
Inflation is another cause of disequilibrium in the balance of payments. If there is
inflation in the country, exports fall. At the same time imports increase and this results
in adverse balance of payments.
Example: US Current Account Deficit: Repercussions on Global Economy
The US economy, though, being an engine for economic growth suffered trade deficit
of over US$ 60 billion during November 2004 and a budget deficit of US$ 319 billion
in 2005. The huge tax cuts, terrorist attacks on the World Trade Center on September
11, 2001, the low rate of savings, and wars against Afghanistan and Iraq during the first
term of the then president, George W. Bush Jr., were the major reasons for the record
budget deficit. The US federal governments budget shifted from a surplus of around
two and a half percent of GDP in 2000 to a deficit of four and a half percent of GDP in
2004. Economists viewed the burgeoning trade and budget deficits combined with a
rapidly weakening US dollar against currencies like the euro and the yen as serious
threats to the global economy. The US borrowed approximately US$ 600 billion every
year to finance its trade and budget deficits. In fact, Asian governments were its
primary lenders. The US depended excessively on foreign central banks to finance its
current account deficit, which was above 5.6 percent of its GDP. By the end of 2003,
most central banks of various nations held 70 percent of their reserves in dollar
denominated assets and these banks financed around 80 percent of the USs current
account deficit through the purchase of dollar denominated assets.
Many countries were worried about the declining value of the dollar since it was
expected to have an impact on the exports of those countries for which the US is
the major market. The declining value of the dollar against currencies of certain
countries had a profound impact, especially on developing countries that had
enormous debts denominated in dollars. It also decreased the value of the dollar
denominations held by the people.
The decrease in dollar value had a direct effect on the income of oil producing
countries like Russia, Saudi Arabia, etc., as the oil was priced in dollars and hence
led to a decline in revenues. However, the increase in the prices of oil in 2004 had
fetched more revenue and had more than offset the losses suffered due to the
weakened dollar.
Economists felt that the US should not rely on currency appreciation in Asia or on
a weak dollar to make up for the US deficits. The US government was of the view
that the European countries should open their market for free trade.
8
7. National Control of International Transfers

The nation-states of the world exercise control over a wide range of international
transfers. The items transferred comprise not only goods and services but also
technology, people, money, and rights. There are several reasons for controlling
international transfers. The primary reason is to accomplish economic goals. Earlier,
controls over international transfers were guided by a revenue motive. Today, with the
exception of low-income countries, the revenue motive is not an important factor
guiding national policy in this area. Protection of local industry and fostering the
development of local enterprise are more common motives today. The three motives
work together. By increasing tariffs and duties on transfer of goods, a country can
increase national revenues and at the same time provide protection for local industries
and local enterprises.
Employment is another major economic goal that influences international transfers.
When the free play of economic forces results in heavy competitive pressure, it leads
to domestic unemployment.
Economic and political goals and different value systems are other prime reasons for
controls on international transfers.
Every country is free to protect its domestic producers by imposing controls on
transfer. This protection, however, proves to be quite expensive. There are two costs
to consider in this relation. The first is the cost to consumers business buyers as well
as house-hold buyers. Any curtailment of the access to markets of international
producers raises the price and cost to customers and lowers their standard of living (if
they are individuals), or their competitiveness (by increasing input costs) if they are
companies. The second cost arises because when companies are protected from
competition, they may be less motivated to innovate, create, and sustain world-class
competitive advantage. On the other hand, when companies compete with domestic or
international rivals, they improve their performance and chalk out plans to serve the
market better than others.
Check Your Progress

8.
changes in income) for food was first observed and formulated by:
a.
Ernst Engel
b.
Levine
c.
Fischer
d.
Keynes
9.
What is the record of investment and payment flows between a country and the
rest of the world?
a.
Capital account
b.
Current account
c.
Reserve account
d.
Receipts account
9

10. A deficit in this account of the balance of payments implies that more goods and
services have been imported into the country than have been sold abroad.
a. Capital account b.
Current account
c.
Reserve account
d.
Receipts account
11. International transfers are controlled in order to:

a.
Accomplish economic goals
b.
Protect local industry
c.
Foster the development of local enterprise
d.
All of the above.
8. The Indian Economy An Overview

India is one of the fastest growing economies in the world. The economic stagnation which
characterized the Indian economy has given way to increased economic activity. A new
spirit of economic freedom is now thriving in the country, bringing sweeping changes
in its wake. A series of ambitious economic reforms, aimed at deregulating the country
and stimulating foreign investment, moved India firmly into the front ranks of the rapidly
growing Asia Pacific region and unleashed the latent strengths of a complex and rapidly
changing nation. Moreover, skilled managerial and technical manpower give India a
distinct cutting edge in global competition.
In brief, the strengths of the Indian economy include abundance of natural resources,
large domestic agricultural and industrial production base, vast pool of skilled
manpower, well-developed distribution networks and established free market
infrastructure, large and growing consumer market, and deeply rooted industrialentrepreneurial culture.
In spite of these strengths, the Indian economy is facing some serious problems in terms of
population growth and increasing poverty. Despite several constraints, the Indian economy
had performed well and recorded a GDP real growth rate of 7.4% in 2008-2009.
India had shown significant developments in several sectors. We take a look at the
agricultural, industrial, and the service sector in India.
8.1 Agriculture Sector
Agriculture is the largest and the most important sector of the Indian economy. As of
2009, it provided employment to around 70 percent of the total workforce in the
country. Agriculture is also the primary source of exports. Agriculture accounts for
17% of the GDP.
8.2 Manufacturing Sector
The progress of industrialization since 1951 has been an important feature in Indias
economic development. The process of industrialization launched as a conscious and
deliberate policy under the Industrial Policy Resolution of 1956 and vigorously
10
implemented under the five year plans, involved heavy investments in strengthening
capacity over a broad range of industries. As a result, over the last 50 years, industrial
production has gone up by about five times, making India the tenth most industrial
country in the world. The industrial structure broadly covers the entire range of
capital, intermediate, and consumer goods.
Within the manufacturing sector, the small-scale industrial sector has become the hub
of many economic activities in the country.
Small-scale industries play a crucial role in India in increasing national income,
reducing the incidence of unemployment and underemployment, in reducing
inequalities in the distribution of income and wealth, in meeting the shortage of
consumer goods, in accelerating economic growth by making optimum use of natural
and human resources, in promoting balanced regional development, and in
development of local resources and promotion of exports.
According to the Economic Survey (2009), the industrial growth of India in 20072008 was 8.5 percent. However, growth in the industrial production in 2008-2009
stood at 2.4%. The manufacturing growth also showed a decline from 9% in 20072008 to 2.3% in 2008-2009. The slower growth contributed to the deceleration of the
industrial sector in India.
8.3 Service Sector
The service sector includes trade, hotels, transport, communications, banks, financial
institutions, real estate, business services, and professional services.
The 1990s witnessed liberalization of the Indian economy. This encouraged private
players to make investments in the industry and led to a sustained growth in the Indian
service sector. Increasing expenditures on rural extension services, social services,
public administration, and defense also had an impact on the development of the
Indian service sector. The service sector accounted for 56% of the growth of Indias
GDP during 2008-2009. Community, social and personal services also grew at a much
faster rate from 6.8% in 2007-2008 to 13.1% in 2008-2009.
Traditionally, agriculture was the major contributor in the process of Indias
development, followed by the industrial and services sector. However, of late, the
services sector is placed well before industry. This is partly attributed to India
catching up with and leading several countries in the information technology
revolution. But there are also other services in which expansion is taking place at a
higher rate, particularly in non-organized transport, travel, and the communications
sector.
9. Economic Indicators
The economy of any country operates in recurring phases of rising and falling activity,
which are referred to as business cycles. Economic indicators are used to measure
overall economic activity, for classifying it as either rising (expansion) or falling
(recession), as well as for determining the cyclical turning points of these expansions
and recessions. Though the level of economic activity or absolute volume have some
11

significance, movements from one period to another is important in order to keep a
track of the economy. The analysis of most of the economic indicators is related to the
cyclical fluctuations occurring between growth and expansion and decline and
recession. The indicators frequently indicate change in terms of index numbers or
percent, thus making relative comparisons easier over long periods of time.
9.1 Types of Indicators
While there are several types of economic indicators, the most important of them are
briefly discussed below.
Inflation and Index Numbers
Inflation is the average rate of increase in prices. Inflation affects the purchasing power
of peoples income and wealth (personal income and saving), and the
governments ability to manage the economy through fiscal and monetary policies
(government budgets and debt, money supply, interest rates). The tendency to channel
funds into different types of investment and the ability to compete in world markets
(balance of payments, value of currency) are also influenced by the inflation rate. A
low rate of inflation is a basic goal of economic policy because it protects purchasing
power, helps in designing fiscal and monetary policies to promote economic growth
and encourages investment in the production of goods and services.
Economic data represents various transactions between buyers and sellers in
consumer, industrial, and financial markets involving both private properties and
governments. In order to analyze this vast amount of data, the transactions are
summarized into groups and overall totals. This summarizing of data is usually done
using index numbers, which are a convenient way of quickly assessing the direction
and level of changes in economic activity. Index numbers are typically associated with
indicators of industrial production and prices, although they are also used for many
other economic activities. The different types of index numbers generally used are:
Consumer price index (it gauges the overall rate of price change for a fixed number of
goods and services bought by households)
Import and export price indexes (they measure price changes in agricultural, and
manufactured products for goods bought from and sold to countries abroad)
Industrial production index (it measures the change in output in manufacturing
mining, and other industries)
Producer price index (it tracks the rate of price change of domestically produced
goods in the manufacturing, mining, and other industries)
Gross National Product and Gross Domestic Product
Gross National Product (GNP) refers to the total value of final goods and services
produced in a country, plus income received from other countries minus payments
made to other countries. A related measure of the economys total output product is
Gross Domestic Product (GDP). GDP is the total monetary value of all the goods and
services produced in a country in one financial year. There is a technical difference
between GNP and GDP. GNP includes goods and services produced outside a nations
boundaries by the nations citizens and firms, but GDP excludes them. GNP excludes
12
goods and services produced within a nations boundaries by foreign citizens and
firms, but GDP includes them.
GDP and GNP are commonly used measures of national income, and are indicators of
growth and economic output. An economy is usually considered to be prosperous if
the GDP and GNP, calculated on a per capita basis, are high.
Interest Rates
Interest represents the cost of borrowing money. An interest rate is the annualized
percentage that interest is of the principal of the loan. The level of interest rates for
different loans reflects the length and the risk of the loan. Interest rates have a
significant impact on borrowing and spending. Generally business, household, and
government borrowing are stimulated when interest rates are perceived as low.
Unemployment
Unemployment figures indicate the number of persons without jobs. Thus,
unemployment manifests itself in the form of excess supply of labor over the demand
for labor. The unemployment rate refers to the percentage of labor force unemployed
at any given date. The unemployment rate is a prime indicator of the extent to which
the economy offers employment to job seekers.
Income Distribution
Income distribution implies the proportion of total household money income as
received by households in low, middle, and high-income groups. Income distribution
focuses on differences in the economic well-being of different groups in the
population. Economic growth is hindered when purchasing power and profitmotivated incentives are not broadly based. A large disparity in income results in
increasing discord and despair among the population. Measures of poverty are related
to the distribution of income.
Foreign Exchange Reserves
Foreign exchange reserves have a strong bearing on the process of economic growth
of an economy. Gold, statutory depository receipts, and foreign currency assets of the
central bank of a country constitute a countrys foreign exchange reserves. The
fluctuations in foreign exchange reserves emanate from the movements in the external
sector of the economy. In fact, improvement or deterioration in the countrys balance
of payment, capital inflow and capital outflow determine the size of the foreign
exchange reserves. Thus, the position of the foreign exchange reserves shows the state
of the countrys balance of payments.
Infrastructure
Infrastructure is also one of the economic indicators of a country because the
economic development of a country has to be accompanied by the development in
infrastructure. The better the infrastructural facilities in a country, the better is the
scope for economic development.
The infrastructure facilities of a country can be divided into soft and hard skills.
13

Soft skills include education and human skills. Education skills are significant since
the literacy rate of a country plays an important role in economic development.
Human skills are important since people equipped with better skills and knowledge
can help increase the output.
Hard skills include transport and Information and Communication Technologies (ICT). An
efficient and well developed system of transport and ICT is vital to the success of
economic development planning, which lays stress on rapid industrialization.
Transport
Transport is an integral part of commercial activities, and is intended to help the free
flow of exchange of commodities. Transport includes rail, road, sea, and air transport.
Rail
Railways are of great importance in the economy of any country. A good network of
railways facilitates free flow of commodities.
Road
Roads constitute a significant element in the transportation infrastructure. Road
transport is quicker, more convenient and more flexible. It is particularly good for
short distance movement of goods.
Sea
Inland water transport, comprising canals, rivers, etc, hold out a potential for a nations
transport sector. Sea transport is important as it gives access to most parts of the
world.
Air
Air transport also has a significant role to play in economic development. It saves time
and is best suited for long distance travel.
Information and communication technologies
The telecommunication system of a country can also play an important role in its
economic development. For instance, in India, telecommunication not only offers the
benefits of communication to people but also improves global competitiveness of the
economy and attracts foreign direct investment. With the advent of the Internet, the
efficiency in the process of communication has increased significantly. Businesses
have also benefited through the use of the Internet. The Internet has also had an
impact on customers, who have become more demanding as they now have more
information about new products and services. The consumer demand had led to the
development of information and communication technologies (ICTs). ICTs cover all
technical aspects for information processing and communication.
14
Activity: Take an example of any country and analyze its economic indicators for
the period 2008-2009.
Answer:
Check Your Progress

12. The total value of final goods and services produced in a country, plus income
received from other countries minus payments made to other countries is
generally termed as
a.
Gross domestic product
b.
Gross national product
c.
National income
d.
Net income
13. The economy of any country operates in recurring phases of rising and falling
activity. This is commonly referred to as:
a.
Trade cycles
b.
Business cycles
c.
Production cycles
d.
Economic cycles
14. What is the rise in the general level of prices known as?
a.
Recession
b.
Deflation
c.
Inflation
d.
Stagflation
15. Which of the following are the broadest indicators of growth and economic
output?
a.
Gross domestic product
b.
Gross national product
c.
Both a and b
d.
None of the above
15
10. Summary
The economies of the world can be classified on the basis of ownership of the means
of production and level of development reached.
Based on the ownership of the means of production, economic systems are classified
as capitalist, socialist, and mixed. Based on the level of development reached,
countries are classified as developed economies, underdeveloped economies, and
developing economies.
Consumption patterns could be described on the basis of Engels law and product
saturation levels. According to Engels Law, With rising incomes, the share of
expenditures for food (and, by extension, other) products declines. The resulting shift
in expenditures affects demand patterns and employment structures. Poorer family
will spend a larger share of their total expenditures on food than wealthier families.
A record of the factors influencing the supply of and demand for a countrys currency
is maintained in the balance of payments account. The balance of payments account
can be divided into current and capital account.
National control of international transfers is done to accomplish economic goals,.
Earlier, controls over international transfers were guided by a revenue motive. Today,
with the exception of low-income countries, the revenue motive is not an important
factor guiding national policy in this area.
India is one of the fastest growing economies in the world due to development in
agriculture, industrial, and service sectors.
The different economic indicators that are used to measure overall economic activity
in the country such as inflation and index numbers, GDP and national income, interest
rates, unemployment, income distribution, foreign exchange reserves, and
infrastructure.
11. Glossary
Balance of Payment Account: A balance of payment account is a systematic record
of transactions of a country involving claims on and liabilities to the rest of the
world.
Capital Account: Capital account is that portion of a countrys national accounting
system that records international transactions involving the purchase or sale of
financial or physically durable assets, such as money, securities, dividends, factories,
government debt, and land.
Capitalist economy: Capitalist economy is a system in which all the means of
production (land, labor, and machinery) are owned and controlled by private
individuals.
Current Account: Balance of payments account that records exports and imports of
goods, exports and imports of services, investment income, and gifts.
Developed Economy: A developed economy is one, which has reached a very high
stage of development. The per capita income and standard of living of the people is
very high in such countries.
Developing Countries: Countries characterized as having a relatively low per capita
GDP and comparatively low levels of output, living standards, and technology.
16
Gross Domestic Product: The gross domestic product (GDP) is the total monetary
value of all the goods and services produced in a country in one financial year.
Gross National Product: Gross National Product (GNP) refers to the total value of
final goods and services produced in a country, plus income received from other
countries minus payments made to other countries.
Mixed economy: A mixed economy consists of three sectors: public sector (all firms
and business houses are owned by the government), private sector (all firms and
business houses are owned by private individuals), and joint sector (has both public
and private enterprises).
Socialist economy: Socialist economy is a system in which all the means of
production are owned by the whole community and all economic decisions related to
production, exchange, and distribution are taken by the state.

1.
The world economy has undergone revolutionary changes during the past
decades. Briefly give an overview of the world economy.
2.
Classify the economies on the basis of ownership of means of production and the
level of development reached. Briefly explain.
3.
Describe in brief the consumption patterns and the theories supporting it.
4.
Define balance of payments. Explain the causes for disequilibrium in balance of

payments.
5.
Explain the concept of national control on international transfers.
6.
Give a brief overview of the Indian economy.
7.
Economic indicators are used to measure overall economic activity, for

classifying it as either rising (expansion) or falling (recession), as well as for
determining the cyclical turning points of these expansions and recessions.
Describe briefly the types of economic indicators.

1.
S K Misra and V K Puri, Economic Environment of Business, Himalaya

2.
Justin Paul, Business Environment: Text & Cases, Tata McGraw Hill
Publishing Company Limited, 2006.
3.
Maurice D Levi, International Finance, Routledge, 2005.
4.
Augustine C Arize, Balance of Payments Adjustment: Macro Facets of

International Finance Revisited, Greenwood Publishing Group, 2000.
5.
6.
World Economy
<http://www.economywatch.com/world_economy/>
17

7.
Balance of Payments
<http://www.customessaymeister.com/customessays/Tourism/11583.htm>
8.
Economic Indicators
< http://www.albany.edu/~aeco320/Lecture13.html>
9.
Transport and Communication

< http://nos.org/318courseE/L-29%20TRANSPORT%20AND%
20COMMUNICATION.pdf>

1.
(c) Economic environment

Economic environment refers to all those economic factors which have a bearing
on the functioning of a business. Hence, the dependence of business on the
economic environment is total; as it is rightly said, a business is one unit of the
total economy.
2.
(b) Capitalist economy

Capitalist economy is a system in which all the means of production (land, labor,
and machinery) are owned by private individuals. All the economic activities are
steered by self-interest. Economic problems are solved by price mechanism and
there is a very limited role for the government.
3.
(d) Socialist economy

Socialist economy is a system in which all the means of production are owned by
the whole community and all economic decisions related to production,
exchange, and distribution are taken by the state.
4.
(c) High per capita income and high standard of living

A developed economy is one, which has reached a very high stage of
development. The per capita income and standard of living of the people is very
high in such countries.
5.
(b) High per capita income and high standard of living

India is a good example of mixed economy. In India, while the government owns
some of the most important industries, some are owned by private individuals.
6.
(a) Capitalistic economy

Capitalist economy is a system in which all the means of production (land, labor,
and machinery) are owned and controlled by private individuals.
7.
(d) Private enterprises co-exist with government enterprise

In a mixed economy, private enterprises co-exist with government enterprise.
8.
(a) Ernst Engel

changes in income) for food was first observed and formulated by the nineteenth
century Prussian statistician, Ernst Engel. According to Engels Law, With
18
rising incomes, the share of expenditures for food (and, by extension, other)
products declines. The resulting shift in expenditures affects demand patterns
and employment structures. Poorer family will spend a larger share of their total
expenditures on food than wealthier families.
9.
(a) Capital account

Capital account may be defined as a record of investment and payment flows
between a country and the rest of the world. The capital account of a country
consists of its transactions in financial assets in the form of short-term/long term
lending and borrowing, and private and official investments.
10. (b) Current account

The current account of the balance of payments is a record of the value of trade
in goods and services and of transfers between a country and the rest of the
world. A deficit on the current account means that more goods and services have
been imported into the country than have been sold abroad.
11. (d) All of the above
International transfers are controlled in order to accomplish economic goals.
Earlier, controls over international transfers were guided by a revenue motive.
Today, with the exception of low-income countries, the revenue motive is not an
important factor guiding national policy in this area.
12. (b) Gross national product
Gross national product refers to the total value of final goods and services
produced in a country, plus income received from other countries minus
payments made to other countries.
13. (b) Business cycles
The economy of any country operates in recurring phases of rising and falling
activity, which are referred to as business cycles. Economic indicators are used
to measure overall economic activity, for classifying it as either rising
(expansion) or falling (recession), as well as for determining the cyclical turning
points of these expansions and recessions.
14. (c) Inflation
The rise in the general level of prices is known as inflation. Inflation affects the
purchasing power of peoples income and wealth (personal income and saving),
and the governments ability to manage the economy through fiscal and
monetary policies (government budgets and debt, money supply, interest rates).
15. (c) Both a and b
Gross Domestic Product and Gross National Product are indicators of growth
and economic output.
19
Unit 6
Structure
1.
Introduction
2.
Objectives
3.
Monetization of Economy
4.
Financial Systems
5.
Financial Markets
6.
Development of Financial Markets
7.
The Nature and Role of Financial Institutions in the Economy
8.
Summary
9.
Glossary

1. Introduction
In the previous unit, the economic environment and its significance to business were
discussed. In this unit, the financial environment is discussed.
The financial environment is changing constantly worldwide due to the development
of new financial products and changes in economic indicators such as balance of
payment, inflation, foreign exchange reserves, etc. Every business is affected by
financial markets and institutions.
As businesses are affected by the financial environment (financial markets, financial
institutions, financial products, etc.) prevailing in that country, it becomes necessary
to understand what types of markets exist in that country, what products are available
in each market etc.
This unit discusses the monetization of economy and the functions of a financial
system. The unit then discusses financial markets and its development. The unit also
discusses the nature and role of financial institutions in the economy.
2. Objectives
explain monetization of economy.
describe financial systems and its functions.
define financial markets.
describe the development of financial markets.
determine the nature and role of financial institutions in the economy.
3. Monetization of Economy
Monetization of economy refers to the extent to which money is used for entertaining
economic transactions. Monetization can be measured as broad money (M3) divided
by Gross Domestic Product. The formula shows the percentage of economy that is
monetized.
3.1 Money Supply
Money is sometimes defined as anything generally acceptable as a medium of
exchange. However, the means of transferring bank deposits from one person to
another (i.e. cheques) are not money. A cheque is simply an instruction to a bank to
transfer money from one account to another. A cheque that cannot be honored against
a bank deposits is worthless.
The Measures of Monetary Aggregates
According to a definition given by RBI in July 1935, money supply is the sum of
currency with the public and demand deposits with the banking system. This is known
as narrow money and is represented as M1. The concept of broad money, also
referred to as Aggregate Monetary Resources, equivalent to the sum of M1 and the
time deposits with the commercial banks, was first introduced in the financial year
1964-65. On acceptance of the Report of the Second Working Group in March 1970, a
series of new aggregates, given below, came into effect.
M1 = Currency with the public*
+ Demand Deposits with the Banking System
+ Other Deposits with the RBI
M2 = M1 + Post Office Savings and Bank Deposits
M3 = M1 + Time Deposits with the Banking System
M4 = M3 + Total Post Office Deposits
(excluding National Savings Certificates)
* Currency in circulation = Currency with the public + Currency with the commercial
banks.
Of the four concepts of money supply, RBI emphasizes two concepts viz., narrow
money (M1) and broad money (M3). These concepts are used extensively not only by
the monetary authorities but also by academicians. Narrow money excludes time
deposits based on the argument that they are income earning assets and therefore not
liquid. On the contrary, broad money includes time deposits following the argument
that, as time deposits are income earning assets and people have acquired them by
converting cash into time deposits for earning future interest income, some amount of
liquidity is present in time deposits.
21

The M2 and M4 measures of money supply include post office savings account and
other deposits with the post offices. As these are also considered to be liquid assets,
they should form a part of the aggregate monetary resources of the public.
3.2 Gross Domestic Product
The Gross Domestic Product is the total monetary value of all the goods and services
produced in a country in one financial year. GDP equals the total monetary value of
the consumption goods, investment goods, government purchases, exports, and
services produced inside the country in one year. The GDP can be used as a measure
of production and output.
Measuring the GDP
There are several methods for measuring the GDP. It is measured either as the flow of
products or as the sum of earnings method. These two methods of measuring GDP are
totally independent of each other.
The GDP takes into account only those goods that are produced in the current fiscal
year and does not take into account the goods and services that are produced in the
previous years but are consumed now. In addition, GDP only takes into account those
goods and services that are produced domestically, within the borders of a country.
For example, the goods produced by Indian citizens and companies in the Gulf
countries are not included in the GDP of India. But GDP does take into account the
goods and services produced by foreign citizens and companies in India.
Now let us take a birds eye view of the dos and donts of measuring the GDP.
According to convention, the goods and services produced by a country are measured
in terms of the proportional weightages assigned to them, in relation to the prices the
goods and services carry. Also, while measuring the GDP, sufficient care has to be
taken to avoid double counting.
Consider buying a sports car, where the car tyres are part of cars standard equipment.
Assume the cars tyres are worth Rs 20,000 and the over all worth of the sports car is
Rs 20, 00,000. It would be a fatal mistake to separately count the tyres for Rs 20,000
as only the final goods and services are considered for measuring the GDP. Here the
sports cars overall price includes the price of the tyres, and hence calculating the
tyres separately for GDP along with overall car price in the GDP would give a wrong
estimate of the GDP and would lead to double counting in the process of measuring
the GDP. But if the cars tyres were sold separately, then it automatically becomes the
final goods. To get the exact difference between intermediate and final goods, let us
understand that the intermediate goods are those goods that require further processing
in the value chain before they become final goods to be sold to the consumers.
Intermediate goods are hence part and parcel of final goods. Final goods are those
goods that are ready for consumption are part of finished goods inventory, and require
no further processing in the value chain. Only final goods are considered for
measuring the GDP.
22
Other methods used for measuring GDP include expenditure or flow of funds
approach and income or flow of income approach. The first method is expenditure or
flow of funds approach. In this method, GDP equals gross private domestic
investment, sum of personal consumption expenditure, net exports, and government
purchase of goods and services.
The second method is the income or flow of income approach. In this method, the
income of all the production factors is summed with employee compensation, rents,
proprietors income, interest, dividends, corporate income taxes, undistributed
corporate profits, and depreciation and indirect business taxes. Both the methods
should result in identical or near identical, GDP calculations.
4. Financial Systems
A financial system operates as an intermediary that facilitates the flow of funds from
areas where funds are in surplus to areas where funds are in deficit. It is composed of
several institutions, money managers, markets, analysts, claims and liabilities,
regulations and law, practices, and transactions.
The financial system helps determine both the cost and the volume of credit. This
system can affect an increase in the cost of funds, thus adversely affecting the
consumption, production, employment, and growth of the economy. On the other
hand, it could lower the cost of credit and have a positive affect and enhance all the
factors. Clearly, a financial system has an impact on the basic existence of an
economy and its citizens.
4.1 The Functions of a Financial System
The Savings Function
The savings that are again invested in the production function result in production of
better goods and services and an increase in societys living standards. When savings
decline, however, the growth of investment and living standard begins to fall.
Liquidity Function
Money in the form of deposits offers the least risk of all financial instruments. But its
value is mostly eroded by inflation. That is why one always prefers to store funds in
financial instruments like stocks, bonds, debentures, etc. However, in such
investments (1) a greater level of risk is involved, (2) and the degree of liquidity (i.e.
conversion of the claims into money) is less. The financial markets provide the
investor with the opportunity to liquidate the investments.
Payment Function
The financial system provides an expedient payment mode for goods and services.
The cheque system, credit card systems, etc. are some of the easiest methods of
payment in the economy; they also drastically reduce the cost and time of
transactions.
Risk Function
The financial markets provide protection against life, health, and income risks. They
offer health, life, and property insurance policies.
23

Policy Function
Modern day economies require huge sums of money for investment in capital assets
(land, equipment, factory, etc.), which are then used for providing goods and services.
The funds required are so huge that it is not possible for a single government/firm to
meet the requirement. By selling financial claims like stocks, bonds etc., the required
funds can be quickly raised from a variety of investors. The business firm/government
issuing such a financial claim then hopes to return the borrowed funds from expected
future inflows. Indeed, we see that the financial markets within the financial system
have made possible the exchange of current income for future income and
transformation of savings into investments, so that production and income grow.
5. Financial Markets
A financial market is a market where financial assets are either created or transferred.
Financial assets represent a claim to the payment of a sum of money sometime in the
future and/or periodic payment in the form of interest or dividend.
Financial markets are sometime classified as primary and secondary markets. But,
more often, financial markets are classified as money markets and capital markets.
The money market deals with all transactions in short-term instruments (with a period
of maturity of one year or less, like treasury bills, bills of exchange, etc.), whereas the
capital market deals with transactions related to long-term instruments (with a period
of maturity of above one year, like corporate debentures, government bonds, etc.) and
stocks (equity and preferences shares).
5.1 Money Market
A money market offers resources for working capital needs. In a money market,
savings are channeled into short-term productive instruments like treasury bills
market, call money markets, certificate of deposits, and markets for commercial paper.
5.2 Capital Market
The capital market offers resources to support medium and large-scale industries. The
capital market deals in long-term sources of funds (with more than 1 year maturity).
Check Your Progress

1.
Which of the following method(s) is/are used in measuring GDP?
a.
Product flow approach
b.
Sum of earnings approach
c.
Spending approach
d.
All of the above
2.
Which of the following(s) is/are not the function of a financial system?
a.
Consumption function
b.
Liquidity function
c.
Risk function
d.
Policy function
24
3.
Which of these represent a claim to the payment of a sum of money sometime in

the future and/or periodic payment in the form of interest or dividend?
a.
Financial market
b.
Financial asset
c.
Money market
d.
Capital market
4.
Which of the following is/are characteristic(s) of the money market?
a.
Offers resources for working capital needs
b.
Only highly illiquid and long term instruments are dealt in the money market.
c.
The instruments dealt in the money market constitute high risk.
d.
All of the above
5.
Which market deals with transactions related to long-term instruments and

stocks?
a.
Money market
b.
Financial market
c.
Capital market
d.
Al l of the above
6. Development of Financial Markets

In a rudimentary economy, there are no financial markets. In such an economy, each
person has to be financially self-sufficient. Every opportunity to invest is dependent
upon the individuals ability to save. Likewise, the desire to save is constrained by the
individuals opportunities to invest. Individuals who want to invest more than they can
possibly save are forced to cut back on their investment. And those who want to save
more than their opportunities allow are forced to cut back on savings. As a result, very
little of either gets done. Financial markets make it possible for acts of saving and
investment to be separated: these markets make it possible for some members of the
society to save, while others may assume responsibility for real investment operations.
The separation of the acts of saving and investment serves to increase both savings
and investment, and hence the wealth and growth of the economy. Individuals who
want to save but not invest can do so by lending in financial markets. Others who
want to invest but not save can do so by borrowing in financial markets.
The different individual decisions of participants in the market must be balanced. The
balancing process is facilitated through the movement of interest rates toward
equilibrium. The interest-rate price of lending and borrowing transactions adjusts
rapidly so that those who want to borrow can find willing lenders and vice versa.
The development of markets to bring those who want to save and lend together with
those who want to borrow and invest is an important step toward financial
development. However, direct face-to-face dealing between ultimate net savers and
25

ultimate net investors is often not practical. Securities brokers are needed when
face-to-face transacting is too costly. Financial intermediaries are needed to resolve
differences between the needs of savers and the needs of those who invest. Even if
savers-lenders and borrowers-investors can agree on an interest rate, they will
conclude their transaction only if they can further agree on all other terms such as
maturity, collateral, method of redemption, etc. Such agreement can be exceedingly
difficult. Most savers prefer to keep their savings liquid by lending short-term.
Investment, on the other hand, is usually long-term; it is usually financed through longterm borrowing. Obviously, a single market connecting such lenders with such borrowers
cannot work to mutual advantage. This, then, suggests the development of differentiated
markets one for short-term lending and one for long-term borrowing. This problem is
solved by the development of different types of financial intermediaries.
The presence of many various financial intermediaries in an economy indicates that
the economy is in an advanced stage of financial development.
Financial markets can be classified as negotiated and open financial markets. An
open market is one in which the unit of transactions is well known and does not need
to be negotiated every time a transaction is carried out. Open market securities can be
offered for bidding by many buyers. When the unit of transaction is very similar, even
if not identical, an open market readily develops. High-grade corporate bonds are not
all alike, but an open market in corporate bonds in general can be said to exist.
Negotiated markets, by contrast, include all the transactions that take place between a
single lender and a single borrower, or among a small number of parties. Between them
the terms of a loan are personally bargained. These terms include the interest rate.
7. The Nature and Role of Financial Institutions in the Economy

Financial institutions are vital to the economic well-being and future growth of a
market-oriented economy. In most industrialized economies today, the liabilities of
financial institutions are the principal means for making payments for goods and
services, and their loans are the chief source of credit for all economic units in
society-business, households, and governments.
7.1 The Nature of Financial Institutions
A financial institution is a business firm whose principal assets are financial assets or
claims stocks, bonds, and loans. They make loans to customers or purchase
investment in the financial marketplace.
Financial institutions can be divided into two groups financial intermediaries and
other financial institutions. Financial intermediaries acquire the IOUs issued by
borrowers-primary securities-and at the same time sell their own IOUs secondary
securities to savers.
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The major types of financial intermediaries in market-oriented economies include
commercial banks, credit unions, saving banks, savings and loans associations, money
market funds, life insurance companies, investment companies (mutual funds), finance
companies, pension funds, real estate investment trusts, and leasing companies.
7.2 Financial Institutions and the Financial System
Financial intermediaries and other financial institutions are part of a vast financial
system that serves the public. The basic function of the financial system it to transfer
funds that can be loaned from lenders to borrowers.
Savings-surplus units are those households businesses and units of government whose
current income receipts exceed their current expenditures, giving them extra funds to
lend to other units in the financial system.
Savings-deficit units on the other hands are those businesses, households and
governments whose current expenditures for consumption and investment exceed their
current income receipts.
7.3 Financial Intermediation
The term Financial Intermediation primarily means facilitating the supply of funds
to the buyer of funds from the seller of funds. That is, a financial intermediary is one
who facilitates the flow of funds from a person who has excess funds to the person
who needs it.
Kinds of Financial Intermediation
Financial Intermediaries actually perform various kinds of intermediation. They are:
Denomination intermediation occurs when small amounts of savings from individuals
and others are collected and pooled so as to give loans to others.
Default-risk intermediation occurs when financial intermediaries offer loans to risky
borrowers and at the same time issue safe liquid securities. Generally, the borrower
from a financial intermediary is perceived to be more risky than the financial
intermediary itself.
Maturity intermediation refers to the borrowing of relatively short-term funds from
savers (who often cannot commit their funds over long periods) and making long-term
loans to borrowers who require a long-term commitment to funds.
Liquidity intermediation refers to accessing of indirect financial claims while
accepting illiquid direct claims from investors. This entails high transaction costs and
considerable risk of loss if the claims were converted into cash.
Information intermediation refers to the process where the financial intermediaries
alternate their skill in assembling and processing information from the financial
market place for the saver, who has neither the expertise nor the time to stay ahead of
market developments.
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Activity: PR Brokerage Services (PRBS) is a brokerage firm based in New Delhi. It

wanted to expand its services to other cities. For this purpose, it decided to take loans.
As the nature of the business is highly risky, most banks did not accept the companys
proposal. The company then approached ICBI, a company involved in the business of
financial intermediation. ICBI issues safe liquid securities to high risk-involved
businesses like PRBS. Identify the kind of intermediation that ICBI can provide to
PRBS, and describe it. Name the other kinds of financial intermediation.
Answer:
7.4 Financial Products and Intermediaries

Mutual Funds
Mutual funds mobilize funds from various categories of investors and channel them into
productive investments. Apart from UTI, mutual funds sponsored by various banks
subsidiaries, insurance organizations, private sector financial institutions, Development
Finance Institutions and Foreign Institutional Investors have come up. These mutual funds
operate within the framework of SEBI regulations which prescribe the mechanism for
setting up of a mutual fund, procedure of registration, its constitution and the duties,
functions and responsibilities of the various parties involved.
Kinds of mutual funds
Mutual funds differ from each other in a variety of ways: their term, their investment
objectives, the type of investors, management style and load. The various classes of
funds are:
Classification based on term of the fund
The basic difference between two mutual funds can be their term structure. A mutual
fund may either be open-ended or close-ended. An open-ended fund remains open for
unlimited duration for issue and redemption of its shares. A close-ended fund can
issue shares only at the commencement of the duration. The shares could neither be
redeemed nor issued till the end of the fixed investment duration.
Classification based on investment objectives
Mutual funds are formed with different investment objectives. A fund where objective
is to generate capital gains rather than current income for the investors is referred to as
a growth fund. These funds generally invest in stocks. A fund which aims to generate
current income is called an income fund. These funds may invest either in shares
expected to distribute dividends, or in debt instruments, or in a combination of both.
Balanced funds are those which aim to generate both current income and capital gains.
The aim of liquid funds is to invest in extremely liquid securities.
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Specialized funds invest in particular industries, sectors or markets. Funds that invest
solely in foreign markets are referred to as international funds (also called offshore
funds), while those investing both in domestic markets and international markets are
referred to as global funds.
Internationally, there is a category of funds that invests in a portfolio of other mutual
funds. Such funds are called multi-funds.
Activity: Celia, a software engineer, invested in a mutual fund consisting of a
portfolio of Indian software companies. What kind of mutual fund investment did
Celia take up? Name the other classes of mutual fund investments.
Answer:
Classification based on types of investors

Some categories of funds differ from other funds because of their investor profile. An
example of such funds is pension funds. These funds manage the pension money of
their clients.
Classification based on management style
Funds can also be classified on the basis of the way the funds are managed. The
corpus of the fund is managed either actively or passively. Active management of
funds involves gathering of security specific information, analyzing it, and selecting
those securities that are most expected to fulfill the investment objectives. This
process entails a heavy cost that is charged to the scheme. Funds that manage their
corpus actively are called managed funds. On the other hand, passive management of
funds involves the selection of a market index. After an index has been selected, the
securities that form a part of the index are bought in the proportion in which they are
represented in the index. No further transaction is carried out and these securities are
held till a need to liquidate the corpus arises. If a part of the corpus is required to be
liquidated for redemption purposes, it is liquidated in the same proportion in which
the securities are held.
Classification on the basis of load
A fund incurs two types of costs marketing costs and operating costs. While the
operating costs of the scheme are charged to the schemes earnings, the marketing
costs may not be so charged. On the basis of the marketing costs charged to the
scheme, funds can be classified into load funds and no-load funds. Load funds charge
the marketing costs to the scheme, while the no-load funds do not. The no-load funds
recover the costs of marketing as part of management costs.
29

Load funds are of two types front load and back load. In a front load fund, the load
is charged at the time the investors invest in the fund. In the case of back load fund,
investors are required to pay the load charges while exiting from the fund.
Example: Other Classifications of Mutual Funds
Mutual funds are also classified on the basis of a specific purpose and are targeted
at specific customer groups. They are discussed below:
Tax savings schemes
There are various tax savings schemes in India and one such popular scheme is the
Equity Linked Savings Scheme (ELSS), which is a generic mutual fund product.
Most mutual fund companies offer ELS schemes under their respective brands.
Under an ELSS, investments up to a maximum of Rs.100, 000 are deductible from
the investors taxable income, under section 80C of the Income Tax Act. Funds
collected under this scheme are invested in equity markets. ELSS funds have a
minimum lock-in period of three years, and the risks associated with them are high
as they are invested in equities. These fund products are marketed to those
investors who are ready to take a high risk and are not worried about immediate
liquidity. Tata Tax-Saving Fund is an equity-linked, tax saving fund with a
minimum investment of Rs.500 and further investment in multiples of Rs.500.
Index funds
Under index funds, investments are made on the stocks that are present in standard
indices like the Bombay Stock Exchange Sensex (Sensex) and S&P CNX Nifty
(Nifty). When such investments are made, the returns from the portfolio behave in
the same manner as that of the corresponding indices. For example, the UTI Nifty
Fund, launched in 2000, is based on the S&P CNX Nifty index. The capital pooled
from this fund is invested in all the fifty stocks present in the Nifty. So, the
performance of this fund almost mirrors the performance of Nifty. In other words,
if Nifty gains, the fund also gains and vice versa.
Theme-based funds
Theme-based funds are based on thematic ideas such as leadership, lifestyle, or
industry/sector. Theme-based funds have all the associated characteristics of
equity funds. Some of the popular theme-based funds are ABN AMRO Future
Leaders Fund, Birla India GenNext Fund, Kotak Life Style Fund, Prudential ICICI
Service Industries Fund, etc.
Industry specific funds, also called sectoral funds, are based on the theme of an
industry/sector. They are special purpose funds meant for investing only in specific
industries. The same will be stated in the offer documents specifying the industry
in which they may be invested. For example, industries like IT, pharmaceuticals,
textiles, etc. have attracted investments through such funds. Sectoral funds under
SBI Mutual Fund, for instance, include the FMCG Fund, the Emerging Businesses
Fund, the IT Sector Fund, and the Pharmaceuticals Fund.
30
Advantages of mutual funds
Diversified investment improves the risk-return profile of the portfolio. The
transactions of a mutual fund are usually very large. The large volumes of transactions
attract lower brokerage commissions and other costs in contrast to the smaller
volumes of the transactions done by individual investors. Mutual funds offer several
schemes to cater to the needs of the investors. Thus the investors have the option to
choose between regular schemes and growth schemes. The mutual funds are managed
by well-experienced and knowledgeable professionals who devote their time solely to
track and update the portfolio. Thus, mutual fund investments save investors time and
effort and are also likely to generate better results.
Disadvantages of mutual funds
Investment in mutual funds has its disadvantages as well. For one, the investors
cannot choose the securities they want to invest in, or the securities they want to sell.
Secondly, the investors face the risk of the fund manager not performing well. Also, if
the fund managers compensation is linked to the funds performance, he may be
tempted to show good results in the short-term without paying attention to the
expected long-term performance of the fund. This would harm the long-term interest
of the investors.
Venture Capital
Venture capital refers to organized financing done privately or through an institution
to offer substantial amounts of capital through equity purchases and debt offerings.
This enables the growth oriented firms to grow and succeed.
Characteristics of venture capital
The three primary characteristics of venture capital funds are: (1) that it is either
equity or quasi equity investment, (2) it is a long-term investment; and (3) it is an
active form of investment. In a venture capital fund, the investor assumes risks and
there is no security for the investment made by the investor.
Non-Banking Finance Companies
As per Section 45 I(f) of the RBI Act, a non-banking finance company has been
defined as a financial institution which is a company, a non-banking institution
which is a company and which has as its principal business the receiving of deposits,
under any scheme or arrangement or in any other manner, or lending in any manner
and such other non-banking institutions or class of such institutions, as the RBI may,
with the previous approval of the Central Government and by notification in the
Official Gazette, specify.
Regulatory environment
The regulations governing the NBFCs were relatively low compared to the other type
of financial intermediaries like banks and DFIs. Entry barriers were low, there were
no capital adequacy norms, no prudential norms, and to add to all this, there was little
restrictions on the interest rates they could offer to the depositors. All this culminated
in the booming of a number of NBFCs operating in India. And by offering higher
31

interest rates, these NBFCs were attracting a large volume of deposits. This boom in
the NBFCs led to the entry of many fly-by-night operators. Incidents of depositors
losing their money either due to mismanagement or due to fraud were cropping up.
Since NBFCs have an important role in the financial environment, it is important to
ensure a proper regulatory framework for their operations. The regulatory provisions
for the NBFCs were given in Chapter III-B, III-C and V of the Reserve Bank of India
Act, 1934. Regulations governing the various types of NBFCs are given below.
Non-Banking Financial Companies (Reserve Bank) Directions, 1998. The directions
were amended in July 2009.
The Miscellaneous Non-banking Companies (Reserve Bank) Directions, 1977. The
RBI revised the regulation and issued a master circular to NBFCs in July 2009.
Residuary Non-Banking Companies (Reserve Bank) Directions, 1987. In July 2009,
RBI issued a master circular consisting of directions on return specifications to be
submitted by NBFCs.
Housing Finance Companies (NHB) Directions, 1989. The RBI have made many
amendments to these directions starting from 2001 till 2009 in matters related to
ceiling of borrowings, rate of interest, public deposits, period, liquid assets, etc. In
September 2009, RBI amended guidelines related to modification in risk weight.
Three new sets of directions were issued by the RBI for governing the operations of
the NBFCs.
Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank)
Directions, 1998. These directions were amended in July 2009.
Non-Banking Financial Companies Prudential Norms (Reserve Bank) Directions,
1998. These directions were amended in July 2009.
Non-Banking Financial Companies Auditors Report (Reserve Bank) Directions,
1998. The RBI revised the regulations and issued a master circular to NBFCs in July
2009.
Public deposits
Public deposits as defined under Section 45-I (bb) of the RBI Act, is money received
by way of deposit or loan or in any other form, excluding certain specified items. The
section also provides the list of items that are to be excluded from being considered as
public deposits.
Another major regulation that has been brought about by the NBFC Public Deposit
Directions is the linking of the NBFCs credit rating to the acceptance of public
deposits. Thus, an NBFC will be allowed to accept public deposits if it has a minimum
Net owned Fund (NOF) of Rs 25 lakhs but less than 200 lakhs, it has a minimum
investment grade to other specified credit rating for FDs from any one of the approved
credit rating agencies at least once in a year, and it has complied with all prudential
norms. In June 2008, the ceiling on public deposits for NBFCs has been revised. As
per the revised regulations, the maximum rate of interest an NBFC can offer is 12.5
percent and the period for which these deposits can be accepted/renewed by the
NBFCs should not be less than 12 months and exceed 60 months.
32
Insurance
The term Insurance conveys different meanings to different people. Websters
explains Insurance as a guarantee against risk of loss or harm, to secure indemnity to
or on, in case of loss, damage or death.
Meaning and concept
The amount of compensation for the loss through insurance will be based on various
factors such as the perceived value of the insured object, the value or benefit that is being
and that will be accrued on the insured object, and of course the value for which the object
is insured for. Therefore, only an entity with a value and which provides a basis for
evaluation to determine its value can be insured. All General Insurance contracts insure
non-life properties, and are entered into only after a careful evaluation of the value based
on the prevailing market price and on the revenue generating capacity of such an asset. But
to value a life for a life Insurance contract is a difficult proposition.
There are two reasons for this difficulty:
Unlike general insurance, there cannot be any compensation for loss of life. It is only
the loss of income due to the death of the individual that may be compensated; and
Loss of income to the family of the insured itself depends on factors like longevity
and earning capacity of the individual.
Once these two parameters are reasonably determinable, a value can be assigned to
that particular life. On the basis of such value, a policy can be taken to insure that
life. Determination of the value of the subject matter in case of general insurance is
based on its present value at the time of taking up insurance, while it is the future
streams of cash inflows of the insured that is considered for valuing life in case of life
insurance.
Terminology
Any insurance contract sold by an insurance company is termed as a Policy. A policy can
be any type of contract of insurance that is liable to be paid by the insurance company on
fallen due. A policy is said to have fallen due if the insured risk translate to losses.
The contribution that is to be paid by the insured in order to maintain the continuity of
the policy is termed as Premium. The amount of premium that is paid for the
continuation of the policy depends on various factors (these will be examined in detail
later in the discussion).
Sum Insured is the amount that is promised by the insurance company in case of a claim
either by maturity (in case of life insurance policies) or by loss to the insured subject.
Surrender Value is the amount which the insurer is prepared to pay to the assured if
the insured discontinues the policy to the insurer. The policy is said to be paid-up when
a payment is made by the insured. The Life of the Policy refers to the time period
during which the insurance policy is in effect. The policy is said to have expired
when the cover ceases to exist.
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Hazards are conditions that increase the frequency/severity of losses. Based on the
attitude of the insured, hazards are classified into Moral Hazard and Morale Hazard.
Moral Hazard refers to the malafide intentions of either of the parties of the contract in
fulfilling their obligations with respect to the performance of the contract. A Morale
Hazard in insurance terminology refers to the indifference to the loss created by the
purchase of insurance contract.
Classification of insurance
Insurance has been classified on the lines of kinds of coverage it is able to offer.
Primarily, insurance is offered either as Life Insurance or as General Insurance. Life
Insurance covers insurance of life, and covers risks related to the death of a person for
whom insurance is bought. In case of loss of life of the person who has bought
insurance (the insured), the insurance company (insurer) will pay an amount to the
deceaseds family and estate. General Insurance encompasses all those kinds of
insurance contracts that cover non-life subjects. It has to be noted that insurance of
health or insurance against personal disability is also classified under General
Insurance.
While the primary classification of insurance remains as Life and General, there are
various sub-classifications in General Insurance based on the peril against which the
general insurance is sought. Insurance may be sought against loss by fire (fire
insurance), water (marine insurance), earthquake, theft, infidelity and fraud. The
Insurance industry around the world has, in fact, been able to offer insurance for any
kind of loss, provided it is predictable and quantifiable.
Various kinds of insurances
Life insurance: Insurance provided for the payment of a sum of money on the death
of the insured person due to natural causes (such as disease, old age, debility, etc.) or
on the expiry of a certain number of years if the insured person is then alive, fall
within the purview of life insurance. Primarily, there are two types of life insurance
policies. They are (i) Whole Life Policy (amount payable in the event of death) (ii)
Endowment Policy (amount payable at the end of a certain period of time or death,
whichever is earlier.
General insurance: Insurances other than life insurance fall within the purview of
General Insurance. General insurance covers loss of every other physical or nonphysical asset. The loss may be due to the fire, theft, accident, etc.
Insurance of interest: This classification comprises mainly the fidelity guarantee
insurance and the guarantee insurance. Fidelity insurance covers loss by fidelity of an
employee in the company. Guarantee insurance covers loss by providing of garnet on
a product offered by the company that is getting such insurance.
Insurance of liability: Public (third party) liability insurance, products liability
insurance, and professional indemnities fall under this classification. All risks arising
out of performance of ones own duty or mistake and the effect of such mistake to
others and damage thereof is insured as liability insurance. That is, this insurance
covers any unforeseen liabilities arising out of damage to others (including or
excluding those persons not directly involved) in the process of usage of the product
or service offered by the company.
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Example: Life Insurance Corporation of India: The Undisputed Leader

The Life Insurance Corporation of India (LIC), a public sector enterprise, is the
largest insurance company in India, selling insurance products and related services.
Business volumes in the life insurance sector are usually assessed on the basis of
the premium collected.
The company has a variety of insurance plans to cater to various categories of
people and their diverse needs. It offers life insurance and group insurance. It also
provides social security schemes and pension schemes. Each of its business
products offered a variety of different plans to suit different customers and
situations. Investment in LIC was considered by a majority of its customers to be
reliable and secure.
Housing loans were granted through its subsidiary and LIC sold its market savings
and investment products through its mutual fund subsidiary, LIC Mutual Fund Ltd.
The company dominated the life insurance sector till the end of the twentieth
century. Post 2000, with the setting up of the Insurance Regulatory & Development
Authority (IRDA) and the entry of private players, there was a significant increase
in competition.
By 2006, there were more than a dozen players in the life insurance segment in
India. Many foreign players, who identified the huge potential of the Indian life
insurance market, made an entry into the market by forming joint ventures with
Indian companies.
Despite increasing competition from domestic and foreign players, LIC is still the
undisputed leader in the life insurance segment. For the year 2008-2009, it
recorded a market share of 64.86 percent in premium income and 70.52 percent in
number of policies.
Banking
The Indian banking system works under the limitations that go with public ownership
and social control. The public ownership of banks was achieved in three stages: 1955,
July 1969, and April 1980. In addition to the public sector banks, private sector and
foreign banks are also required to meet targets in sectoral deployment of credit, and
regional credit deposit ratios, and regional distribution of branches.
Theoretical basis of banking operations
Commercial banks are simple commercial or business concerns that offer several
financial services to customers in return for interest, fees, discounts, and commission.
The objective of these banks is to make profits. They differ from other business
concerns in the way they balance the principle of profit maximization with other
principles.
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Liquidity
In banks, the liquidity maintenance is greater than other business concerns due to the
nature of their liabilities. Since banks deal with other peoples money, a substantial
portion of the money has to be repaid on demand. Hence, liquidity management is
important for banks.
Banks hold some part of the deposits as cash reserves. The ratio of cash reserves to
deposits is known as the Cash Reserve Ratio (CRR) prescribed by the Central Bank of
the country.
Scheduled banks
According to the Second Schedule of Banking Regulation Act, 1965, scheduled banks are
those that, (a) must have paid-up capital and reserve of not less than Rs 5 lakhs; (b) it
must also satisfy the RBI that its affairs are not conducted in a manner detrimental to the
interests of its depositors. Scheduled banks are required to maintain a certain amount of
reserves with the RBI; they, in return, enjoy the facility of financial accommodation and
remittance facilities at confessional rates from the RBI.
Regional rural banks
Regional Rural Banks (RRNs) were set up in the late 1975 after receiving
commendation from the Banking Commission. The RRBs were proposed to operate
solely in rural areas and were set up to offer credit and other facilities to agricultural
laborers, small and marginal farmers, artisans, and small entrepreneurs.
Branch banking
The phenomenon of branch banking has aggravated the problem of organizational and
operational inefficiency in the banking sector. Some banks in India were operating
inefficiently due to their large scale. Branch banking has highlighted another problem,
namely, the drain of resources taking place from rural to urban areas, so much that the
authorities had to set diverse targets of credit/deposit ratio for areas differing by
geography.
Unit banking
In branch banking, a single bank accepts deposits through its branches at one or more
locations in the same city, district or state. On the other hand, in a unit banking
system, the bank conducts its overall operations from a single office. Unit banks are
found to be compact in size, facilitating cutting of red tape, promoting good rapport
between the staff and management, motivating the staff, and giving better service to
the customers and community.
Privatization of banks
Recognizing the need to introduce greater competition in the Indian banking sector
which can lead to greater productivity and efficiency, the RBI allowed the entry of
new private sector banks.
36
While permitting the new private sector banks, the RBI set out that they should
promote the underlying goals of the financial sector reforms, be financially viable,
result in up gradation of technology in the banking sector, avoid shortcomings such as
unfair pre-emption and concentration of economic power, cross holdings with
industrial groups, and other such factors that beset the private sector banks prior to
nationalization.
Liabilities of banks
Deposits
Commercial banks deal with money deposited by people. These deposits are used as a
means of payment and medium of saving.
Indian banks accept two main types of deposits-demand deposits and term deposits.
Demand deposits can be subdivided into two categories: current and savings. Current
deposits are chequable accounts that have no restrictions on the number of
withdrawals or the amount to be withdrawn. Savings deposits earn interest. Although
checks can be drawn on savings accounts, the number of withdrawals and the
maximum amount to be withdrawn from the account without prior notice is restricted.
Call deposits is a subcategory of demand deposits. They are taken from fellow
bankers and are repaid on demand. They carry an interest charge. They form an
insignificant portion of the total bank liabilities. Term-deposits are also known as
fixed deposits and they are an authentic medium for saving. They have different
maturity period and rate of interest on the maturity period.
Banking assets
Investment
The liquidity requirements of bank are served by investment in cash and government
securities.
Bank credit
Types of credit: The various types of advances provided by them are: loans, cash
credit, overdrafts (OD), demand loans, purchase and discounting of commercial bills,
and installment or hire purchase credit. A Loan is an advance received for a fixed
amount which is repayable in installments or on demand. They are repayable made in
lump sums and interest is paid on the entire amount. There are two categories of
loans: demand loans and term loans. Demand loans are short-term loans that are
repayable on demand. Term loans are defined as loans approved for a period of more
than a year with a precise schedule of repayment.
Cash credit and overdrafts are running accounts wherein a borrower can withdraw
funds as required. Purchasing and discounting of bills-internal and foreign-is a method
used by banks for advancing credit. It is done mainly to finance the movement of
goods and trade transactions.
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Check Your Progress

6.
a.
b.
c.
d.
Which households businesses and units of governments current income receipts

exceed their current expenditures, giving them extra funds to lend to other units in
the financial system?
Savings-deficit units
Savings-surplus units
None of the above
All of the above
7.
a.
b.
c.
d.
Unit banking refers to the system

With a single bank having units at different places
With the overall operations of a bank conducted from a single office
Which deals with the units of UTI
Which deals with credit operations only
8.
Which of the following refers to the borrowing of relatively short-term funds

from savers and making long-term loans?
Denomination intermediation
Default-risk intermediation
Maturity intermediation
Liquidity intermediation
a.
b.
c.
d.
9.
a.
b.
c.
d.
Which of the following intermediation(s) is/are performed by financial

intermediaries?
Information intermediation
Maturity intermediation
Denomination intermediation
All of the above
10. Mutual funds can be classified on the basis of:

a. Term of the fund b.
Management style
c. Both a and b
d. None of the above
11. In front load mutual funds, when is load charged?
a. At the time of exit from the fund
b. At the time of investment in the fund c.
At the time of reallocation of the fund
12. Which of the following is an organized private or institutional financing that can
provide substantial amounts of capital?
a. Venture capital
b. Mutual funds
c. Insurance
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8. Summary
The Gross Domestic Product is the total monetary value measured from the goods and
services produced in a country for one financial year. It is measured either as the flow
of products or as the sum of earnings method.
A financial system operates as an intermediary that facilitates the flow of funds from
areas where funds are in surplus to areas where funds are in deficit.
A financial market is a market where financial assets are either created or transferred.
Financial assets represent a claim to the payment of a sum of money sometime in the
future and/or periodic payment in the form of interest or dividend.
In a rudimentary economy, there are no financial markets. In such an economy, each
person has to be financially self-sufficient. The presence of many financial
intermediaries in an economy indicates that the economy is in an advanced stage of
financial development.
A financial institution is a business firm whose principal assets are financial assets or
claims-stocks, bonds, and loans-instead of real assets, such as buildings, equipment
and raw materials. The term Financial intermediation primarily means facilitating
the supply of funds to the buyer of funds from the seller of funds.
Mutual funds mobilize funds from various categories of investors and channelize
them into productive investments. Mutual funds can be classified on the basis of term
of the fund, investment objective, and type of investors, management style, and load.
Venture capital refers to organized private or institutional financing that can provide
substantial amounts of capital, mostly through equity purchases and occasionally
through debt offerings, to help growth oriented firms develop and succeed.
Insurance provides monetary compensation for the loss suffered. The occurrence of
loss must be within the framework covered by the specific terms of the insurance
contract.
Commercial banks ordinarily are simple business or commercial concerns that
provide various types of financial services to customers in return for payments in one
form or another, such as interest, discounts, fees, commission, and so on.
9. Glossary
Capital to Risk - Weighted Assets Ratio: Capital to risk-weighted assets ratio is also
called as capital adequacy ratio. It is the ratio of banks capital to its risk. The risk can
be either in the form of weighted assets or the minimum total capital requirements of
the respective nations regulator.
Intermediaries: Third parties that specialize in facilitating imports and exports.
Life insurance: Insurance on the person.
Mutual funds: Financial intermediaries that gather funds from investors in exchange
for mutual fund shares, investing the money in specified stocks, bonds, government
obligations, savings bonds, and other instruments.
39

Net owned Fund: Net owned Fund consists of free reserves, capital reserves that
arise out of sale proceeds of assets, paid up equity capital, and balance in share
premium account. It is computed on the basis of last audited balance sheet.
Nonlife insurance: Insurance that covers direct and indirect losses from damage to
property and from legal liability.

1.
Define money supply and gross domestic product. Describe the methods to
measure GDP.
2.
Define financial system. Briefly explain the functions of the financial system.
3.
Financial markets are sometime classified as primary and secondary markets.

Explain them in detail.
4.
Explain the concept of development of financial markets.
5.
Define financial intermediation. Briefly explain the kinds of financial

intermediation.
6.
What are mutual funds? Describe its various classifications.
7.
Describe in brief the characteristics of venture funds.
8. Define Insurance. Describe in brief the kinds of insurances.

1.

2.
3.
Financial System
<http://highered.mcgrawhill.com/sites/dl/free/0072957395/250896/rose_chap1.pdf>
4.
Functions of Financial System

<http://choosyinfo.com/finance/financial-system-and-its-functions>
5.
Financial Markets
<http://www.indianmba.com/Faculty_Column/FC177/fc177.html>
6.
Classification of Mutual Funds

<http://lastbull.com/classification-of-mutual-funds/>
7.
NBFC Regulations
<http://www.rbi.org.in/Scripts/BS_NBFCNotificationView.aspx?Id=3449>
40
8.
NBFC Amendments
<http://tatacsonline.com/indexpage/IndexYearlist.php?cat=Banking&catid=9&sdi
d=5&lCrtId=&lJurisId=&yr=2009&sdoc=Circular&page=4>
9.
Public Deposits
<http://www.rbi.org.in/SCRIPTs/PublicationsView.aspx?id=10265>

1.
(d) All of the above

Gross Domestic Product (GDP) is measured either as the flow of products or as
the sum of earnings method. It is also measured using methods such as product
flow approach, sum of earnings or income approach, and spending approach.
2.
(a) Consumption function

The functions of a financial system include the savings function, liquidity
function, payment function, risk function, and policy function. Therefore,
consumption function is not a function of the financial system.
3.
(b) Financial asset

Financial asset represents a claim to the payment of a sum of money sometime in
the future and/or periodic payment in the form of interest or dividend.
4.
(a) Offers resources for working capital needs

A money market deals with all transactions in short-term instruments. It offers
resources for working capital needs.
5.
(c) Capital market

Capital market deals with transactions related to long-term instruments (with a
period of maturity of above one year, like corporate debentures, government
bonds, etc.) and stocks (equity and preferences shares).
6.
(b) Savings surplus units

Savings-surplus units are those households businesses and units of government
whose current income receipts exceed their current expenditures, giving them
extra funds to lend to other units in the financial system.
7.
(b) With the overall operations of a bank conducted from a single office
In a unit banking system, the bank conducts its overall operations from a single
office.
8.
(c) Maturity intermediation

Maturity intermediation refers to the borrowing of relatively short-term funds
from savers (who often cannot commit their funds over long periods) and making
long-term loans to borrowers who require a long-term commitment to funds.
41

9.

The term Financial Intermediation primarily means facilitating the supply of
funds to the buyer of funds from the seller of funds. It performs denomination
intermediation, default-risk intermediation, maturity intermediation, liquidity
intermediation, and information intermediation.
10. (c) Both a and b

Mutual funds mobilize funds from various categories of investors and channel
them into productive investments. They can be classified on the basis of term of
the fund, management style, investment objectives, types of investors, and load
funds.
11. (b) At the time of investment in the fund
In a front load fund, the load is charged at the time the investors invest in the
fund.
12. (a) Venture capital
Venture capital refers to organized private or institutional financing that can
provide substantial amounts of capital, mostly through equity purchases and
occasionally through debt offerings, to help growth oriented firms develop and
succeed.
42
Unit 7
Trade Environment
Structure
1.
Introduction
2.
Objectives
3.
Liberalization and Globalization
4.
Globalization of Indian Industry
5.
Import Policy
6.
Export Policy
7.
EXIM Policy (2002-2007)
8.
9.
10. International Licensing

11. International Franchising
12. Home Trade
13. Issues in the Global Economic Environment
14. Summary
15. Glossary
1. Introduction
In the previous unit, the financial environment and how businesses are affected by
financial markets and institutions was discussed. In this unit, the trade environment is
discussed.
Most third world countries are characterized by a colonial past marked by extensive
and intensive exploitation of their economies by colonial powers. Foreign trade served
as one of the important instruments of this exploitation. The colonies or the
underdeveloped countries, however, had the worst of both worlds, as consumers of
manufactured articles and producers of raw materials. This imbalance was a result of
declining prices of raw material or primary goods and increasing prices of
manufactured goods, which in course of time led to considerable deterioration in the
terms of trade for the under-developed countries (which were exporters of raw
material). Therefore, foreign trade and investment was viewed with a certain amount
of suspicion by many underdeveloped countries that won independence in the post
World War II period. Hence, these countries reduced their dependence on the

developed countries for manufactured goods and emphasized inward oriented
policies. This was done through large-scale import substitution, direct controls on
imports and investments, and overload exchange rates in the foreign trade sector. In
such countries the export sector was often neglected. In India, for example, the widely
prevalent view in Government circles after independence was that Indian exports
faced a stagnant world demand and nothing much could be done to increase them.
However, the outlook toward foreign trade has now undergone a radical change.
Programs of import liberalization and export promotion adopted by many developing
countries in the sixties have achieved remarkable success.
In this unit, the process of liberalization and globalization is discussed. The unit then
discusses import policy, export policy, EXIM policy, international licensing, and
international franchising. The unit also explains the organization of home trade and
issues in the global economic environment.
2. Objectives
explain liberalization and globalization.
describe globalization of Indian industry.
describe the import policy and its constituents.
state the objectives of the export policy.
identify the objectives of EXIM policy.
underline the basic issues in international licensing.
describe franchising and state the issues in international franchising.
define home trade and list the kinds of middlemen.
identify the issues in the global economic environment.
3. Liberalization and Globalization

Liberalization is the process of breaking down government and artificial barriers to
international trade and investment. It permits more number of firms to access the
market in a bid to enhance competition.
3.1 The Process of Liberalization in India
In June 1991, the then finance minister, Manmohan Singh announced a new economic
policy (NEP). The policy aimed at reducing fiscal deficits, wiping out the current
account deficits, cutting down government expenditures, rationalizing subsidies,
controlling inflation, alleviating poverty, and achieving social equity. The
fundamental objective of the New Economic Policy was to bring about a qualitative
and sustained improvement in the standard of living of the people of India. The NEP
consists of two sets of economic reforms: a group of measures which was
implemented as short-term stabilization and aimed at containing inflation, reducing
the fiscal deficit, and correcting the adverse balance of payments; another set of
reform measures dealing with the aspects of structural adjustment of medium term
nature and are aimed at achieving the goals of poverty alleviation and social justice.
44
Trade Environment
The results of the NEP were impressive. Trade liberalization had led to an increase in the
ratio of exports and imports to GDP to 23% by 1994-95 from 15% in the mid-1980s. Since
then the liberalization process continued at a steady pace. Investment had increased mainly
in the consumer electronics and automobile sectors, while foreign investment flows had
also increased. Despite impressive results, significant reforms were still needed since
tariffs were still high compared to international standards. Experts opined that the state
sector also needed to be reformed to increase efficiency.
In 1998, the BJP led government opened up the sector for import penetration. In
addition to removing quantitative restrictions and lifting import controls, import tariffs
were also lowered. In 2004, the average tariff ratings stood at just 20% compared to
80% to 100% tariffs in the 1990s.
Liberalization also resulted in growth of the Indian economy. It has created
employment opportunities for non-technical and English speaking graduates. It also
created opportunities for skilled professionals in the information technology (IT)
sector. In 2003-2004, exports from software and IT services registered a 33% growth
contributing nearly US$ 12.8 billion. By 2005, exports had become the major growth
driver behind GDP and manufacturing in India. In 2004-2005, the growth in export of
goods was over 30%.
In 2007, India reaped the benefits of liberalization since it recorded a GDP growth rate
of 9% in 2006-2007. It became the second fastest growing economy in the world after
China. Experts predicted that India would grow further by recording 30% growth from
export of goods for 2008-2009, contributing nearly US$ 200 billion to the economy.
However, with the slowdown in the economy, exports growth, the major driver in the
GDP growth declined by 20% in January 2009.
The true effects of large, multilateral trade liberalization exercises are beginning to be
understood by economists. It has been found that despite overall global gains, there
are also going to be some losers in the process, namely the poorer countries. The
reason underlying these negative effects is the removal of agricultural subsidies in the
European Union and the US. This will result in higher world prices for some
agricultural products. Many countries are net importers of these products and will
hence suffer a terms of trade loss: it will cost them more to buy imports than it used
to, but their income from export will not increase. However, in the long run, nearly all
countries gain. The spillover effects from rich countries offset the preliminary losses
incurred by poor countries.
4. Globalization of Indian Industry

A short definition of globalization is the growing liberalization of international trade
and investment, and the resulting increase in the integration of national economies.
With the advent of globalization, Indian companies have begun to think about
marketing globally. This changed attitude towards trade is making a big difference in
the way they do business. It also implies that the age of the Indian multinational has
arrived. Almost every Indian company is thinking of globalization, from textiles to
pharmaceuticals and from plantations to engineering.
45

A significant area of globalization is foreign investment. With the relaxation of the
rules pertaining to foreign investment, many Indian companies are, in fact, setting up
manufacturing base abroad for various products. Some of these bases are even being
set up in developed countries.
Most of the Indian businesses are still in a nascent stage as far as going global is
concerned. Moreover, since liberalization is a fairly recent phenomenon, it will take
years for Indian businesses to catch up with Japanese businesses, or even businesses
in South Korea or China. However, many Indian companies have started going
overseas . For instance, some Indian pharmaceutical companies have merged with, or
acquired foreign pharmaceutical companies. Similarly, Indian IT companies have
merged with global companies as part of their growth strategy.
Example: Overseas Acquisitions by Indian Companies
Several Indian companies have adopted aggressive strategies to establish a
presence in international markets. For instance, in February 2006, Dr. Reddys
Laboratories Limited (DRL), a leading Indian pharmaceutical company, acquired
betapharm Arzneimittel GmbH (betapharm), the fourth-largest generic
pharmaceutical company in Germany, for US$ 570 million. Through this
acquisition DRL got immediate access to the German generic market and the scope
of leveraging this presence to expand in the European market.
In January 2007, Tata Steel Limited (Tata Steel), one of the leading steel producers in
India, acquired the Anglo dutch steel producer, Corus Group Plc for US$ 12.11 billion.
The acquisition gave Tata Steel access to Corus' strong distribution network in Europe.
In June 2008, India-based Tata Motors Ltd. announced that it had completed the
acquisition of the two iconic British brands - Jaguar and Land Rover (JLR) from
the US-based Ford Motors for US$ 2.3 billion. The acquisition enabled Tata
Motors to acquire a global footprint and enter the high-end premier segment of the
global automobile market.
On December 15, 2008, HCL Technologies Limited (HCL), a division of Delhibased IT company, HCL Enterprises, announced its acquisition of UK-based
Systems Applications and Products in Data Processing (SAP) consultancy firm,
AXON Group Plc. (Axon) for 440 million. The acquisition was expected to
provide Axon with the opportunity to expand in the SAP segment since it had
captured only 2 percent share of the SAP market. Through this acquisition, HCL,
whose SAP market was concentrated mostly in the US, would gain access to the
European SAP market.
4.1 The New Boom Global Markets
The Asia-Pacific region represents a huge consumer market in which multinationals
can reap big returns. The rapid pace of development and enormous size of the AsiaPacific region had attracted several western multinationals. This region thus serves as
a high potential area for multinationals.
46
Trade Environment
However, in spite of the phenomenal growth rates and huge numbers of consumers,
western companies entering Asia have found that it not so easy to do business in the
region. Such large populations and geographical markets as are found in this region
require equally large investments. Inflation poses a major problem and the cost of real
estate is exorbitant. In addition, a major challenge lies with the distribution networks
in countries of the size of China and India. Other hurdles arise due to bureaucracy, the
problem of finding the right local partner, and putting together an effective sales force.
There are other challenges, too. Asia is not just one market but represents a mix of
cultures, media and advertising sectors. The Asian region is viewed as a very complex
collection of different cultures and different countries which are at different stages of
development.
The Greater China region, which comprises Hong Kong, Taiwan and China, is a subregion where advertisers can use a common ad message. However, China a far less
sophisticated ad market than the other two and in some areas has more in common
with Indonesia and India.
4.2 Select Key Business Strategies to Create Indias MNCs
To identify key business strategies for creating Indian MNCs, one must first identify
areas in which India possesses or is in a position to develop and sustain competitive
advantage on a rapid scale. Such advantage should also have the potential to be
sustainable in a low tariff environment and be able to compete with the worlds best
companies and products. The success of good companies lies in the identification of
key industries and subsequent focused support by their respective governments. Some
Indian companies are going for overseas mergers and acquisitions, and strategic
alliances in order to make a global presence. For instance, in May 2007, India-based
Hindalco Industries Limited (Hindalco) acquired US-Canadian aluminum company
Novelis to strengthen its global presence.
4.3 Nurturing Indias Multinationals
Indian companies that are well-positioned and have global aspirations can be nurtured to
enter global markets. The Indian government should play a crucial role in encouraging
financial institutions to set up a fund that would support the Indian multinationals.
5. Import Policy
A trade policy of a country consists of its import policy and its export policy. In the
post-independence period, Indias import policy was guided by considerations of a
growth-oriented policy aimed at leading the country to self-reliance:
(a) As far as possible, imports should be limited so as to conserve foreign exchange.
(b) Imports of those items which would help the industrialization of the economy
were to be encouraged while imports of such items which could be produced at
home were discouraged or completely banned. It was necessary to differentiate
between essential and non-essential items of import in view of the fact that, in a
developing economy, even the demand for imports of capital goods and other
equipment could be at such a magnitude that there might be difficulty in finding
the foreign exchange for development imports.
47

(c) The nature of imports should be so modified as to help export promotion, and
thus ultimately mitigate the deficit in the balance of payments position.
However, the situation started changing in the subsequent decades. By the 1980s, the
government liberalized imports with the aim of enhancing the export competitiveness
of large sections of Indian industry. From 1985 to 1989, import liberalization
extended to capital and intermediate goods. The 1991 economic reform further
liberalized trade. The period from 1995-2001 was marked by elimination of
quantitative restrictions on several consumer and agricultural product imports by the
government.
In 2008, the import policy of India had three objectives:
To make essential imported goods easily available, including necessary capital
goods for upgrading and modernizing technology
To simplify import licensing procedures
To promote self-reliance and efficient import substitution
5.1 Import Restrictions
Mahalanobis strategy of development encouraging large-scale industrialization of the
country was implemented in the second five year plan (1956-57). The period marked
the beginning of severe import restrictions in India. With mounting foreign exchange
difficulties, more and more items were brought under import restrictions over a period
of time. However, by 2008, the import restrictions had eased significantly. The import
restrictions that existed were on grounds of health and environmental protection,
security, or because the goods are reserved for production by small enterprises.
The Indian government laid down policies to achieve the tariff level that is prevalent
in the ASEAN region. In 2008, the basic customs tariff rate ranged from 0 to 40%
with an additional duty of 2%. The average customs tariff rate is nearly 30%.
Under a duty exemption scheme, imports are allowed duty free for export production.
The government had also removed quantitative restrictions on import of capital goods
and intermediate goods. Import of second-hand capital goods is permitted if they have
a residual life of minimum five years. The government started an Export Promotion
Capital Goods (EPCG) Scheme that allows exporters to import capital goods at
concessionary customs duty.
5.2 Import Regulations and Procedures
As of 2008, imports fall under four categories:
Freely importable items: Items in this category do not require import licenses and
can be imported freely by an individual or entity.
Licensed imports: Items such as consumer goods; products related to safety and
security; precious and semi-precious stones; seeds, plants and animals; some
insecticides, pharmaceuticals and chemicals; some electronic items; several items
reserved for production by the small-scale sector; and 17 miscellaneous or specialcategory items can be imported using licenses.
48
Trade Environment
Canalized items: Here the items can be imported by specific public-sector
agencies.
Prohibited items: Products like animal rennet, tallow fat, unprocessed ivory, and
wild animals are banned from importation.
5.3 Import Substitution
The important substitution policy in India went through various phases. At first,
import subscription mostly took the form of domestic production of consumer goods
followed by replacement of the import of capital goods. Finally, emphasis was laid on
reducing dependence on imported technology by developing and encouraging the use
of indigenous technology. While the Indian industries had grown to develop their own
technology, certain industries such as the defense sector were still heavily dependent
on import materials and products. In September 2009, Union Minister for home
affairs, P Chidambaram called upon Indian industries to spearhead import substitution
efforts and help the country reduce its dependence on imports.
6. Export Policy
The broad objectives of Indias export policy are:
1.
To earn adequate foreign exchange to finance the required volume of imports
2.
To effect a change in the directional patterns with a view to reducing dependence

on a single or limited number of countries
3.
To supplement domestic demand for increasing employment opportunities
4.
To raise unit value realization by promoting exports of value-added items
5.
To impose minimum price regulation (floor pricing) where competition is intense
6.
To impose controls when domestic availability is less than adequate
6.1 Export Promotion Policies: An Overall View

The following are the important export measures undertaken by the Government of
India.
Cash Compensatory Support (CCS)
Introduced in 1966, CCS was designed to provide compensation for unrelated indirect
taxes paid by exporters on inputs, higher freight rates, and market development costs.
Duty Drawback System
The objective of the duty drawback system is to reimburse exporters for the tariffs
paid on imported materials and intermediates, and central excise duties for inputs
produced domestically and which enter into production of exports. The duty drawback
system is practiced worldwide.
49

Replenishment Licenses
In order to help the exporters procure imported raw materials and other components
necessary for export production, the government introduced the Import Entitlement
Scheme (IES) in 1957. Although the devaluation of the Indian rupee in 1966 led to the
withdrawal of the IES, it was soon reintroduced in another garb in a revised from and
under a new name Import Replenishment Scheme (IRS). Replenishment licenses
granted under this scheme make it possible for exporters to obtain items that are either
canalised or restricted in the import policy, subject to the limits and conditions
specified.
EPZ and 100 Percent EOUs
Export Processing Zones (EPZs) have been set up by the government in order to give
an impetus to exports. These EPZs provide an almost free trade environment for
export production so as to make Indian exports products competitive in the world
market.
Export Credit and Assistance of EPCS
During the early 1980s, CCS accounted for a major part of market development
assistance (almost 90 to 95 percent). Of what remained, about two-third was used to
finance the assistance to commercial banks on export credit extended by them in the
form of pre-shipment and post-shipment credit. Export promotion councils and
approved organizations, export houses, consultancy organizations and individual
exporters are also granted assistance in the form of grants-in-aid to undertake (a)
market research, area survey, etc; (b) exports publicity and dissemination of
information; (c) trade delegations and teams; (d) participation in exhibitions and trade
fairs; (e) establishment of offices and branches abroad; (f) research and development
schemes, etc; and (g) any other scheme that would promote the development of the
market for Indian goods abroad.
7. EXIM Policy (2002-2007)

The Export-Import policy of the government of India guides the foreign trade in the
country. It is regulated by The Foreign Trade Development and Regulation Act 1992.
It consists of several policy decisions concerning import and exports. The central
government prepares and announces the EXIM policy. The Indian EXIM policy aims
to develop export potential, improve performance of exports, encourages foreign
trade, and creates favorable balance of payment position.
The new EXIM policy, 2002-2007, was announced by the Government of India on
February 5, 2002.
The general objectives of the EXIM Policy (2002-2007) were:
(i) To set up the framework for globalization
(ii) To encourage the productivity competitiveness of the industries in India
50
Trade Environment
(iii) To enable the industries to attain international standards of quality
(iv) To boost export by allowing access to raw material, components, capital goods, and
consumables from the international market
(v) To encourage import substitution and self-reliance.
8. EXIM Policy (2004-2009)

In 2004, the Government of India felt that the EXIM policy 2002-2007 was limited in
its scope and insufficient to meet the countrys objectives related to foreign trade.
Hence, an integrated approach for developmental requirements of foreign trade in
India was taken up. This led to the announcement of Foreign Trade Policy 2004-2009
in August 2004.
The objectives of Foreign Trade Policy 2004-2009 were:
(i) To double the percentage share of global merchandize trade within 5 years
(ii) To act as an effective instrument of economic growth by giving a thrust to
employment generation.
To achieve these objectives, special focus initiatives were announced in sectors such
as agriculture, handicraft, handlooms, leather, gems & jewelry, and marine sector. In
addition to these, new sectoral initiatives were announced from time to time. In April
2007, an annual supplement to the Foreign Trade Policy 2004-2009 was announced.
The supplement aimed to provide momentum to exports growth. The export target that
was fixed at US$ 160 billion in 2007-2008 was raised to US$ 200 billion for 20082009. In 2008, the Government of India released another annual supplement to
Foreign Trade Policy 2004-2009.
9. EXIM Policy (2009-2014)

In 2009, the Government of India released the Foreign Trade Policy 2009-2014.
According to Ministry of Commerce, the exports grew to US$ 168 billion in 2008-2009
from US$ 63 billion in 2003-2004. Indias share of global merchandise trade rose to
1.45% in 2008 from 0.83% in 2003 as per the estimates by WTO. Indias share of the
global commercial services exports stood at 2.8% in 2008 from 1.4% in 2003. The total
share in goods and services trade of India increased to 1.64% in 2008 from 0.92% in 2003.
The government also claimed that nearly 14 million jobs were created either directly or
indirectly due to augmented exports from 2004-2009.
The objectives of Foreign Trade Policy 2009-2014 are:
(i)
In the short term, to arrest and reverse the declining trend of exports and to
provide additional support especially to those sectors which have been hit badly
by recession in the developed world.
(ii) To achieve an annual export growth rate of 15% with an annual export target of
US$ 200 billion by March 2011.
(iii) To double the countrys export of goods and services by 2014.
51

To meet these objectives, the Government of India was taking up various measures
including fiscal incentives, institutional changes, procedural rationalization, enhanced
market access across the world and diversification of export markets. It was considering
bringing in improvement in infrastructure related to exports; bringing down transaction
costs, and providing full refund of all indirect taxes and levies.
Check Your Progress

1.
Which of the following is not a basic objective of the New Economic Policy
(NEP) of India announced in June 1991?
a.
Reducing fiscal deficits
b.
Wiping out the current account deficits
c.
Controlling inflation
d.
Achieving self-sufficiency in food grains production
2.
What does the trade policy of a country consist of?
a.
Import policy
b.
Export policy
c.
Tariff policy
d.
Both import and export policy
3.
Which of the following were the objectives of the import substitution program of
i.
To preserve scarce foreign exchange
ii.
To achieve self-reliance in production of as many goods as possible
Indias import policy?
iii. To remove quantitative restrictions on imported goods

a.
(i) only
b.
(ii) only
c.
(i) and (ii) only
d.
(i), (ii) and (iii)
4.
Which among the following are the objectives of Indias export policy?
i.
To earn adequate foreign exchange to finance the required volume of imports.
ii.
To raise unit value realization by promoting exports of value-added items.
iii. To effect a change in the directional patterns with a view to reducing dependence
on a single or limited number of countries.
a. (i) and (ii) only b.
(ii) and (iii) only
c.
(i) and (iii) only
d.
(i), (ii) and (iii)
52
Trade Environment
5.
Which of the following export measure was designed to provide compensation

for unrelated indirect taxes paid by exporters on inputs, higher freight rates, and
market development costs?
a.
Cash Compensatory Support
b.
Duty Drawback System
c.
Duty Exemption Scheme
d.
Export Promotion Capital Goods Scheme
10. International Licensing

Licensing is a means of entering a foreign market. In the process, a firm called the
licensor sells the right to use its intellectual property technology, patents, copyrights,
work methods, brand names, or trademarks - to another firm, called the licensee, in
return for a fee. As an entry mode, the use of licensing is affected by host country
policies. When there are no host country restrictions, licensing serves as a popular
mode for entering foreign markets. The meager out of-pocket costs associated with it
make it a popular choice of many international firms. Through licensing, a firm can
select an international location and enjoy the benefits of foreign production without
any obligation related to ownership, management, or investment.
10.1 Basic Issues in International Licensing
A firm involved in licensing negotiations must carefully consider not only the terms of
the proposed license but also its advantage and disadvantages. The issues to be
addressed include:
Boundaries of the Agreement: In a licensing agreement, the rights and privileges
should be clearly communicated in the agreement.
Compensation: Compensation under a licensing agreement is termed as royalty. It is
usually paid to the licensor, most commonly in the form of a percentage of the sales of
the licensed product or service or otherwise in the form of a flat fee or a fixed amount
per unit sold.
Rights, Privileges, and Constraints: The rights and privileges given to the licensee
and the constraints imposed on it by the licensor is another basic issue that needs to be
addressed in licensing agreements. Licensing agreements are framed in such a manner
as to limit the licensees freedom to divulge the information obtained by him/her from
the licensor to some other third party. Licensing agreements, hence, specify the type
and form of records that have to be kept by the licensee regarding sales of the licensed
products or services, and define standards regarding product and service quality that
will be adhered to by the licensee.
Dispute Resolution: The manner in which disputes and disagreements are to be
resolved should also be specified in detail in the licensing agreement. For instance,
suppose the licensor feels that the materials used by the licensee are inferior, but the
latter argues that they meet the minimum quality standards, it could be expensive and
time-consuming for both the parties to take the matter to the court. If the licensing
agreement requires, for example, the use of a third-party mediator for the resolution of
disagreements, it is possible to reduce the costs of such conflicts.
53

Duration of the Contract: The licensing agreement may be a short-term strategy of
the licensor to obtain low-cost, low-risk data about the foreign market. Only if the
sales of its products and services are strong, the licensor may want to enter the market
himself after the duration of the agreement has ended. However, if the contracts
duration is too short, the licensee may be unwilling to invest in necessary consumer
research, distribution networks, and / or production facilities, due to the belief that it
will be unable to amortize its investment over the life of the licensing contract.
10.2 Advantages and Disadvantages of International Licensing
Similar to importing and exporting licensing too has advantages and disadvantages.
Licensing has relatively low financial risk, provided licensor fully investigates its
market opportunities and the abilities of its licensees. Licensing also allows the
licensor to know more about the sales potential of its products and services in a new
market without incurring significant investment in financial and managerial resources.
At the same time, licensees too benefit from the opportunity to make and sell the
products and services that have been proven successful in other international markets
and incurring relatively little R&D cost.
Licensing, however, is accompanied by opportunity costs. The market opportunities
for both parties are restricted as a result of licensing agreements. There exists a mutual
dependence between the licensor and the licensee to promote the brand image of the
product and maintain its quality. Improper actions by one party can damage the
interests of the other party. There is always the risk of problems and
misunderstandings accompanying a licensing agreement, no matter how carefully it
may be worded. Finally, the long-term strategic implications of licensing a firms
technology are of great concern to any firm. Most firms are concerned that sharing
their technology will inadvertently create a potential competitor. The licensee can
learn the manufacturing secrets of the licensor or develop new production methods of
his own while producing under the licensing agreement.
Check Your Progress

6.
In the process of licensing, what is the party or firm that sells the right to use its
intellectual property to another firm known as?
a.
Franchisor
b.
Licensor
c.
Exporter
d.
Importer
7.
In international licensing, what is the term used to refer to the firm that obtains
the right to use the intellectual property of another firm, in exchange for a fee?
a.
Licensor
b.
Franchisor
c.
Licensee
d.
Franchisee
54
Trade Environment
8.
The legal contract in a licensing arrangement addresses which of the following

issues?
i.
Boundaries of the agreement
ii.
Compensation
iii. Rights, privileges and constraints

iv. Dispute resolution
v.
Dispute of the contract
a.
(i) and (ii) only
b.
(iii) and (iv) only
c.
(i), (ii) and (iv) only
d.
(i), (ii), (iii), (iv) and (v)
9.
What is the compensation under a licensing agreement termed as?
a.
Patent
b.
Tariff
c.
Royalty
d.
Tax
Activity: The increasing popularity of its Hyderabadi Biryani and other food
items in countries like the US and the UK, made Hyderabad -based Hyd
Specials Private Limited (HSPL) decide to expand internationally in 2007. To
maintain consistency in the quality of its food items, the company signed
agreements with local restaurants in the cities of New York in the US and
London in the UK. The company gave the recipe details to the local restaurants,
in return for 35% of the revenues earned by the restaurants for selling its food
items. However, it did not share the recipe of a major ingredient with the
restaurants. The ingredient played a major role in differentiating the companys
food items from that made by the other restaurants. What kind of an agreement
has HSPL entered into with the local restaurants in the US and th e UK? Explain
the issues involved in this agreement.
Answer:
11. International Franchising

Franchising serves as yet another popular strategy for internationalizing a business.
Essentially, franchising is a special form of licensing. Franchising allows the licensor
more control over the licensee and provides for support from the licensor to the
55

licensee. International franchising is one of the rapidly developing forms of
international business. Under a franchising agreement, a franchisee such as an
independent entrepreneur or organization is permitted to operate a business under
another companys name, called franchisor, in return for a fee. The franchisor
provides trademarks, operating systems, and well-known product reputations, as well
as continuous support services such as advertising, training, reservation services (for
hotel operations), and quality assurance programs to its franchisees.
11.1 Basic Issues in International Franchising
The existence of certain market conditions is a prerequisite for the success of
international franchising:
Considerable success in franchising has already been achieved by the franchisor in its
domestic market. For instance, prior to building the first of its restaurants abroad,
McDonalds already had hundreds of franchised restaurants in the United States.
The firms need to be successful domestically because of their unique products,
operating procedures, and systems. The initial success of McDonalds was an
outcome of its consistent and popular menu, and quick and efficient service.
Domestic success factors should be transferable to foreign locations. In the case of
McDonalds, the popularity of American food in other countries, value given to
efficiency and lower prices by consumers worldwide, and the desire among foreign
visitors to visit a McDonalds restaurant, have been instrumental in its success.
There must be foreign investors who are interested in entering into franchise
agreements, which is not a problem for well-established franchisors.
Similar to licensing agreements, franchising, agreements too, are spelled out in formal
contracts with terms as listed below:
Based on the franchisees sales, the franchisor receives a fixed payment plus a royalty
for the rights available to the franchisee to use the franchisors name, formulas, and
operating procedures.
The franchisee agrees to adhere to the franchisers requirements regarding
appearance, financial reporting, and operating procedures. Franchisors, however, are
likely to allow some degree of flexibility in order to meet local customs and tastes.
The franchisor assists the franchisee in setting up a new business.
11.2 Advantages and Disadvantages of International Franchising
There are both advantages and disadvantages of international franchising.
On one hand, franchisees can enter a business that has an established and proven
product and operating system. Franchisors can expand internationally with relatively
low risk and cost. Also, it is possible for the franchisor to obtain critical information
about local market customs and cultures from the host country entrepreneurs. Further,
the franchisor can learn valuable lessons from franchisees that apply to the host
country as well as many others.
On the other hand, just as with licensing both parties to a franchising agreement have
to share the profits earned at the franchised location. Also, compared to domestic
franchising, international franchising may be much more complicated.
56
Trade Environment
Example: McDona lds Franchising

Practices
McDonalds, US-based fast-food giant was considered as one of the most
renowned brands in the fast food segment. Its history can be traced back to 1955
when its founder Ray A Kroc started the first McDonalds
restaurant in Des
Plaines, Illinois, USA. Within a very short time, McDonalds extended its
operations throughout the world. McDonalds fast expansion into international
markets could be attributed to its franchisee model.
McDonalds chose franchising as the best method of doing business in international
markets and was regarded as a premier franchising company around the world. As
of 2009, 70 percent of its restaurant businesses were owned and operated by
franchisees. McDonalds strongly believed that its success depended upon the
success of its franchisees. Therefore, it was very particular with regard to choosing
its franchisees and followed a distinct procedure in doing so.
The franchisees were selected on the basis of certain parameters like highly
qualified individuals in terms of education, individuals overall business
experience, past business and personal history of the individual, ability to lead the
people, high interpersonal relationships and full dedication to the success of the
business. The choice of site location lay with the franchiser and it also took up the
responsibility of acquiring the property and constructing the building. Every
franchisee had to attend training programs conducted by McDonalds. However,
McDonalds allowed its franchisees the freedom to manage their business and did
not interfere in their day-to-day operations.
The franchisees received support from the parent company in areas like operations,
training, advertising, marketing, real estate, construction, and purchasing
equipment. Thus, even after setting up its own business, the franchisee was offered
support by the franchisor. The training program was provided to the franchisees
free of cost. The training started with teaching basic restaurant operations like
cooking, serving, cleaning, etc. Once the trainees had gained knowledge in these,
the training was then conducted at regional training centers. Here, the emphasis
was on various areas such as business management, leadership skills, team
building, and handling customer enquiries. In the final part of the training program,
the franchisees were given coaching in controlling the stock and ordering,
recruiting of people, and maintaining of accounts. In 1961, McDonalds established
the Hamburger University, a world-wide management training center in Oak
Brook, Illinois, USA, to train its employees and franchisees.
McDonalds gave utmost importance to quality and laid down certain standards to be
followed by its franchisees all over the world. To satisfy customers, the company relied
on quality service, cleanliness, and providing value for money. McDonalds also
believed in customizing the menu to suit the tastes of the local customers and in
constant improvisation of the menu to meet customers changing needs.
57
12. Home Trade

The term Trade refers to mere buying and selling of goods. The term Commerce,
on the other hand, is a more comprehensive term and includes not only the transfer
and exchange of goods but the activities of various agencies that ensure a free flow of
goods and services between the actual producers and the ultimate consumers. These
agencies are referred to as auxiliaries to trade or aids to trade. Hence, the term
Commerce in short, includes trade as well as aids to trade.
Thus Commerce is related mainly to the distribution of goods.
Commercial activities are further classified into the following subdivisions:
Trade
Transport
Warehousing
Insurance
Banking and Finance
Mercantile agents
Trade is, in turn, broadly divided into two types:
Home Trade
Foreign Trade
12.1 Organization of Home Trade
The increasing complexity of the production process and the gap between the products
and buyers increases the function of the middlemen and makes them more important.
Middlemen are merchants who act as intermediaries between the producer and the
consumer. There are two types of middlemen:
Mercantile Agents
Mercantile agents are those persons who meditate between the producers and the
consumers and earn a commission for their services. They do not, however, obtain
ownership of the goods. Mercantile agents comprise of the following:
Brokers: Agents who negotiate sale or purchase of goods on behalf of other parties
are termed as brokers. They earn a certain percentage commission on the value of the
transactions concluded by them.
Commission agents: Commission agents are agents who sell goods on behalf of the
principal. They take possession of the goods and arrange for their proper storage.
They are paid a commission at a certain percentage on the sale affected by them. They
sometimes agree to sell the goods on credit and assume the risk of collecting the
amount. A special commission called the del credere commission is paid to them
for assuming the risk of bad debts. These agents are known as del credere agents.
Certain additional functions such as sorting, grading, packing etc. may also be
58
Trade Environment
undertaken by commission agents in order to facilitate the sale of goods. The
commission agents who have enlarged authority and liability over the consigned
goods are called Factors.
Auctioneers: Auctioneers take possession of the goods and make arrangements for
their display and sale at a public auction. An auctioneer is entitled to receive a
commission for his services and has a lien on the goods for the charges.
Clearing, forwarding and shipping agents: These agents make arrangements for
completing all customs formalities and clearing goods from the docks-either for export or
import. They forward the imported goods to their clients and make arrangements for
shipping the export goods to foreign countries on behalf of their clients.
Warehouse keepers: The business of warehouse keepers is to receive the goods for
the purpose of diligence in the storage of goods. They have a lien on the goods for the
charge payable to them.
Merchant Middlemen
Merchant middlemen are those merchants who buy the goods outright and sell them to
the consumers at a profit. They purchase and sell the goods at their own risk.
Merchant middlemen are of two kinds wholesalers and retailers.
Wholesalers: A wholesaler represents the first link in the sequence of intermediaries
between the producer and the consumer. The wholesaler may also be defined as the
trader who buys goods in large quantities from the manufacturers and producers and
sells them to retailers in smaller quantities. A wholesalers business may also consist
of supplying raw materials to industrial consumers, viz., manufacturers. The
wholesaler, in some cases, functions as an importer and exporter.
A number of marketing functions such as grading, sorting and packing of goods, are
undertaken by the wholesaler (who also arranges for the safe-keeping of the goods). In
the course of this business the wholesaler follows the principle of small margins and a
quick and large turnover.
Retailers: A retailer represents the last link in the distribution chain, and is engaged in
the sale of goods to the ultimate consumer. The retailer serves both the consumer,
with whom he comes into direct contact, and the manufacturer or wholesaler. Retail
agencies may be classified into small scale retailers and large scale retailers.
Small scale retailers: This category includes all those traders who conduct their
business from properly established shops, but whose turnover and capital are limited.
These small shops or unit stores may be further classified into general shops and
single line shops.
Large scale retailers: Large retail stores have come into existence due to the mass
production of goods and the need for their distribution. Large scale retailers are
further classified into department stores, multiple shops, and cooperative stores.
59
Activity: Arts & Crafts Private Limited (A&C) is an organization that sells antique
pieces, paintings, etc. The company secures the items from various people, puts
them on public display, and sells them. A&C retains 30% of the sale proceeds as
commission, and gives the remaining amount to the people from whom the items
have been collected. In the given situation, what role does A&C play? Explain.
Answer:
Check Your Progress

10. How does licensing differ from franchising?
i.
Franchising allows the licensor more control over the licensee
ii.
Franchising provides for support to the license from the licensor
a.
(i) only
b.
(ii) only
c.
Both (i) and (ii)
d.
Neither (i) nor (ii)
11. What is the process of mere buying and selling of goods referred to as?
a.
Commerce
b.
Business
c.
Trade
d.
Transaction
12. What is the term used to refer to the process that involves not only the transfer
and exchange of goods but also the activities of various agencies that ensure a
free flow of goods and services between the actual producers and the ultimate
consumers?
a.
Trade
b.
Commerce
c.
Business
d.
Transaction
13. What are the various agencies that ensure a free flow of goods and services
between the actual producers and the ultimate consumers referred to as?
a.
Aids to trade
b.
Auxiliaries to trade
c.
Either of the above
d.
Neither of the above
60
Trade Environment
14. What do trade and aids to trade together constitute?
a. Business
b.
Commerce
c.
Import
d.
Export
15. Home and Foreign are the broad divisions of which of the following?
a. Commerce
b.
Trade
c.
Logistics
d.
Banking
16. What are the merchants who act as intermediaries between the producer and the
consumer known as?
a.
Brokers
b.
Traders
c.
Businessmen
d.
Middlemen
17. Which of the following represent the two types of middlemen?

i.
Brokers
ii.
Commission agents
iii. Mercantile agents

iv. Merchant middlemen
a.
(i) and (ii)
b.
(iii) and (iv)
c.
(i), (ii), (iii) and (iv)
d.
(i), (ii), and (iv)
18. Who are the persons who mediate between the producers and the consumers, earn
a commission for their services but do not obtain ownership of the goods?
a.
Mercantile agents
b.
Merchant middlemen
c.
Commission agents
d.
Brokers
19. Brokers, Commission agents, Auctioneers, Clearing, forwarding and shipping

agents and warehouse keepers fall under which of the following categories of
merchants?
a.
Traders
b.
Mercantile agents
c.
Merchant middlemen
d.
Businessmen
61

20. Which of the following does not apply to Brokers?
a.
They are a type of mercantile agents
b.
They negotiate sale or purchase of goods on behalf of other parties.
c.
They acquire title to the goods and assume possession of goods
d.
They earn a certain percentage commission on the value of the transactions

concluded by them
21. What is the term used to refer to agents who sell goods on behalf of the principal?
a.
Commission agents
b.
Brokers
c.
Auctioneers
d.
Clearing, forwarding and shipping agents
22. What are the commission agents having enlarged authority and liability over the
consigned goods known as?
a.
Commission officers
b.
Stockists
c.
Factors
d.
Brokers
23. Which of the following does not apply to Commission agents?

a.
They are agents who sell goods on behalf of the principal
b.
They take possession of the goods and arrange for their proper storage
c.
They never assume the risk of bad debts
d.
Certain additional functions such as sorting, grading, packing etc may also be
undertaken by them to facilitate the sale of goods
24. What is the term given to the agent who is entitled to a commission for his
services and has a lien on the goods for the charges?
a.
Broker
b.
Commission agent
c.
Merchant middlemen
d.
Auctioneer
25. Which among the following have a lien on the goods for the charge payable to
them?
i.
Brokers
ii.
Commission agents
iii. Auctioneer
iv. Warehouse keepers
a.
(i) only
b.
(iii) only
c.
(iv) only
d.
(iii) and (iv) only
62
Trade Environment
26. What are the merchants who buy the goods outright and sell them to the
consumers at a profit referred to as?
a.
Brokers
b.
Commission agents
c.
Mercantile agents
d.
Merchant middlemen
27. Which of the following fall into the category of merchant middlemen?
i.
Brokers
ii.
Commission agents
iii. Auctioneers
iv. Wholesalers
v.
Retailers
a.
(i) and (ii)
b.
(ii) and (iii)
c.
(i), (ii) and (iii)
d.
(iv) and (v)
28. Which of the following represents the first link in the sequence of intermediaries
between the producer and the consumers?
a.
Wholesaler
b.
Retailer
c.
Shopkeeper
d.
Manufacturer
29. Which of the following does not apply to the Wholesaler?

a.
He is a trader who buys goods in large quantities from the manufacturers and
producers and sells them to retailers in smaller quantities
b.
He also functions as an importer and exporter
c.
He represents the last link in the sequence of intermediaries between the producer
and the consumer
d.
The wholesaler follows the principle of small margins and a quick and large
turnover in the course of his business
30. Which of the following denotes the last link in the distribution chain, and is
engaged in the sale of goods to the ultimate consumer?
a.
Wholesaler
b.
Retailer
c.
Manufacturer
d.
Customer
63
13. Issues in the Global Economic Environment

13.1 General Agreement on Tariffs and Trade (GATT)
GATT was formed in 1947, with the objective of reducing barriers to international
trade by lowering tariffs, quantitative restrictions and subsidies. Twenty three major
nations, including India, signed the agreement on January 01, 1947. Although it
functioned with a small secretariat, GATT was a treaty, not an organization. Member
nations met at frequent intervals to discuss tariffs and quotas. Effectively, GATT
represented a contractual agreement between willing nations. With the passage of
time, it turned out to be a permanent international mechanism working for the growth
of international trade.
Objectives
Although GATT was formed with the sole objective of reducing tariff barriers and
discrimination in international trade, the following objectives were enshrined in GATT:
International trade expansion
Increasing world production by ensuring full employment in the member nations
Development and maximum utilization of world resources
Raising the standard of living of the world population
13.2 Most Favored Nation Clause
According to the most favored nation (MFN) clause that was introduced by Article I
of the Agreement, each participating nation agrees to grant the status of the MFN to
the other nation in respect of export duties. In other words, it mean that if a favor,
privilege, advantage, or immunity is granted to a product of a nation, a similar favor,
privilege, advantage, or immunity is permissible to a similar product of the other
participating countries. If a bilateral agreement is reached and a benefit is decided
between two MFNs, the same stands are extended to the rest of the member nations.
13.3 Tariff Negotiation
According to a finding of GATT, tariffs were a general impediment in the growth of
international trade. Negotiations for the reduction of tariffs were allowed for members
countries. The guidelines specified for such a reduction were:
A Reciprocal and Mutual basis must always be attempted while negotiating a
reduction;
Negotiation may be for a tariff reduction or a binding low tariff;
An atmosphere of utmost good faith must prevail during negotiations.
Two countries with some commodity may negotiate and arrive at terms
convenient to them under GATT. As per the most favored nation scheme, these
terms would be uniformly applied to all other member countries.
The following difficulties were, however, likely to arise with this procedure:
The underdeveloped members nations finding the terms arrived at to be unfavorable;
Tariff structures were subject to variation;
64
Trade Environment
Difficulties in the case of low tariff countries due to their already low tariff and harm
likely to be caused due to further reduction;
Slow pace of tariff reduction
13.4 World Trade Organization
The World Trade Organization (WTO) was formed on January 1, 1995, replacing GATT.
Around 76 governments became members of WTO on the day of its formation. WTO,
which unlike GATT is a permanent institution with its own secretariat, is committed to
establishing a stable foundation of international cooperation in trade and commerce,
through adoption of principles such as non-discrimination, trade negotiations, trade
liberalization, etc. WTO was formed after the series of trade negotiations held under
GATT. The first round of negotiations primarily dealt with reduction in tariffs. Later it
included other areas such as non-tariff and anti-dumping measures.
The WTO replaced GATT for several reasons. While GATT rules were applicable only
to trade in merchandise goods, WTO rules were applicable to trade in services and
Intellectual Property Rights. Other reasons included formation of a multilateral
agreement which required commitment from all members while GATT was a
multilateral agreement with several plurilateral agreements that made it selective in
nature. Moreover, the disputes in WTO were settled faster than the GATT system. By
the end of July, 2008, WTO had 153 members representing nearly 95% of the total trade
in the world. For the year 2008, WTO Secretariat budget stood at US$ 179 million
Since its inception, many differences cropped up between the member nations of
WTO, with regard to what came to be known as the implementation issue. While
the WTO negotiations progressed, differences between the developed and the
developing countries intensified. The implementation issue had been on the WTO
agenda for the First Ministerial Meeting at Singapore in 1996. At that time the major
industrial nations summarily dismissed the issues and concerns. Developing countries,
however, continued to press the issue. At the 1998 Geneva Ministerial Meeting, they
forced it on to the agenda for the Seattle preparatory process. They then tabled a
number of proposals with respect to various agreements, and called for ministerial
decisions on some of them before or at Seattle. They wanted the others to be
considered through a special process at the General Council and resolved by the end
of 2000.
The proposals covered many substantive questions related to trade-related intellectual
property, the trade-related investment measures, subsidies, anti-dumping rules, the
agriculture agreement, the provisions on balance of payments applicable to developing
countries, the Agreement on Textiles and Clothing. The negotiations were intended to
start in Seattle USA in 1999. However, the negotiations did not take place due to
different events including protests from developed nations. Hence it was decided that
the negotiations would take place at the next ministerial conference that was to be
held at Doha, Qatar in 2001. In November 2001, Doha Ministerial conference was
launched to eliminate barriers in highly protected sectors, such as agriculture and
services and write new rules for globalization in areas such as investment and
competition policy. Most of all, the Doha round claimed to focus on helping the poor.
65

It aimed at reducing trade-distorting farm support, slashing tariffs on farm goods and
eliminating agricultural subsidies; cutting industrial tariffs, especially in areas that
poor countries cared about, such as textiles and freeing up trade in services.
Between 2003 and 2008, many rounds of negotiations took place in Cancn, Mexico
(2003), Hong Kong (2005), Geneva, Switzerland (2004, 2006, 2008), Paris, France
(2005), and Potsdam, Germany (2007) but not much progress was made as often
negotiations collapsed due to differences between the member nations. At the G20
Summit in London (2009) it was announced that another WTO Ministerial Conference
will be held in November 2009.
Example: WTO A Global Trade Regulator
The WTO came into existence on January 1, 1995, replacing the General
Agreement on Trade and Tariffs (GATT) that came into existence in 1948. In fact,
WTO was an extension of GATT, which was primarily concerned with
international trade in goods whereas WTO guides trade in services and intellectual
property along with trade in goods. The headquarters of WTO is located at Geneva,
Switzerland. The main objective behind setting up WTO was trade liberalization
between the countries. The main functions of WTO include administering trade
agreements between the trading countries of the world, facilitating trade
negotiations among the countries, and handling trade disputes as a negotiating
forum and to maintain cooperation between international organizations such as the
World Bank, International Monetary Fund, etc.
According to Supachai Panitchpadki, former Director-General of the WTO, the
WTO is primarily responsible for the transformation of commercial interactions
between nations, which has been quite evident in the 10 years since its inception.
With its membership comprising developed, developing, and underdeveloped
economies, WTO influences the trade relations of the majority of the countries of
the world to a large extent. Worldwide, trade analysts are of the opinion that the
role of developing economies in altering international trade is becoming stronger in
the 21st century. Nations like China, India, and Brazil showed an upsurge in their
trade with other nations. Further, by being members of the WTO, the member
countries are helped to find new avenues for marketing their products.
In fact, the WTO advocates trade liberalization and intends to protect the interests
of trading countries without allowing the domination of international trade by any
specific country. However, the role of developed and strong economies such as the
US in influencing the policies of the WTO is a cause for concern for the developing
and underdeveloped countries. These countries have alleged on various platforms
and occasions that the rules of international trade framed by the WTO were mainly
dictated by the US and its allies. Trade regulations, quotas, and the restriction on
import of goods from some countries by the US and other European Union
countries were hindering complete trade liberalization, they said. Experts all over
the world were of the opinion that there was a growing need to make the operations
of the WTO more transparent and more useful to fulfill the needs of the poor in the
various nations of the world.
Contd
66
Trade Environment
Contd
Some analysts opined that the WTO should consider steps like facilitating open
panel hearings, improving representation of member countries at WTO meetings,
and adopting a new approach for improving environmental and labor standards
while concentrating on the main objectives of trade liberalization. All these
additional steps will help it have a positive impact on the world economy.
Some analysts feel that the advantage of having an international organization to
regulate trade between the countries is that there will be a systematic approach to
trade rather than it being driven by power centers.
They are also of the opinion that an increase in incomes and employment among
the world population in general will definitely encourage the governments of
member countries to work on broader interests. Thus, the WTO can bring these
benefits to all the economies of the world, if it focuses on its set objectives and
comes out of the influence of stronger economies of the world and works toward
trade harmony between countries.
14. Summary
Liberalization is the process of breaking down government and artificial barriers to
international trade and investment.
Globalization is the growing liberalization of international trade and investment, and
the resulting increase in the integration of national economies.
The import policy of the Government of India has two important constituents (i)
import restriction and (ii) import substitution.
The objectives of the export policy is to earn adequate foreign exchange to finance the
required volume of imports, to effect a change in the directional patterns with a view
to reducing dependence on a single or limited number of countries, to supplement
domestic demand for increasing employment opportunities, to raise unit value
realization by promoting exports of value-added items, to impose minimum price
regulation (floor pricing) where competition is intense, and to impose controls when
domestic availability is less than adequate.
The Export-Import policy of the government of India guides the foreign trade in the
country. It is regulated by The Foreign Trade Development and Regulation Act 1992.
In the process, a firm called the licensor sells the right to use its intellectual property
technology, patents, copyrights, work methods, brand names, or trademarks - to
another firm, called the licensee, in return for a fee.
In a franchising agreement an independent entrepreneur or organization, called the
franchisee, is allowed to operate a business under the name of another, called
franchisor, in return for a fee.
The term Trade refers to mere buying and selling of goods. The term Commerce,
on the other hand, is a more comprehensive term and includes not only the transfer
and exchange of goods but the activities of various agencies that ensure a free flow of
goods and services between the actual producers and the ultimate consumers.
67

General Agreement on Tariffs and Trade (GATT) confines itself to a general
agreement between willing nations for negotiating of tariff fixation.
WTO is committed to establishing a stable foundation of international cooperation in
trade and commerce, through adoption of principles such as non-discrimination, trade
negotiations, trade liberalization, etc.
15. Glossary
Franchiser: Franchiser is a firm that allows an independent entrepreneur or
organization to operate a business under its name.
Franchising: Franchising is a special form of licensing allowing the licensor more
control over the licensee while also providing more support from the licensor to the
licensee.
General Agreement on Tariffs and Trade (GATT): General Agreement on Tariffs
and Trade (GATT) confines itself to a general agreement between willing nations for
negotiating of tariff fixation. It represents an international forum for discussion of
tariffs.
Import substitution: According to import substitution, a country should promote and
protect those local industries that compete directly with imports in order to minimize
balance of payment deficits.
Intermediaries: Intermediaries are third parties that specialize in facilitating imports
and exports.
Liberalization: Liberalization is the process of breaking down government and
artificial barriers to international trade and investment.
Licensee: Licensee is a firm that buys the rights to use the intellectual property of
another firm.
Licensing: Licensing refers to a transaction in which a firm (called the licensor) sells
the rights to use its intellectual property to another firm (called a licensee) in return for
a fee.
Licensor: Licensor is a firm that sells the rights to use its intellectual property to
another firm.
Most favored nation (MFN) principle: According to the most favored nation
principle, any preferential treatment granted to one country must be extended to all
countries.
Tariffs: Tariffs refer to taxes levied on imported goods.
Trade: Trade is a voluntary exchange of goods, service, or assets between one person
or organization and another.
World Trade Organization (WTO): The World Trade Organization (WTO) was
formed on January 1, 1995. It is committed to establishing a stable foundation of
international cooperation in trade and commerce, through adoption of principles such
as non-discrimination, trade negotiations, trade liberalization, etc.
68
Trade Environment

1.
Describe the process of liberalization in India.
2.
With the advent of globalization, Indian companies have begun to think about
marketing globally. Explain.
3.
Explain the concepts of import restriction and import substitution.
4.
List the objectives of India's export policy. Give an overview of export promotion
policies.
5.
Define the EXIM policy and list its objectives.
6.
What are the basic issues in international licensing?
7.
What is international franchising? Briefly explain its advantages and

disadvantages.
8.
Briefly explain mercantile agents and merchant middlemen.
9.
Describe the issues in the global economic environment.

1.

2.
3.
Import Policy
<http://www.pbs.org/wgbh/commandingheights/lo/countries/in/in_trade.html>
4.
Import Policy Regulations

<http://www.citehr.com/117815-export-import-import-policy.html>
5.
Import Substitution
<http://economictimes.indiatimes.com/Infotech/Hardware/PC-asks-industry-toget-back-to-import-substitution/articleshow/5039956.cms>
6.
Import and Export Policy

<http://www.oppapers.com/essays/Import-Export-Policy-India/135990>
7.
EXIM Policy
<http://www.scribd.com/doc/4975093/Ch-03-EXIM-POLICY-OF-INDIA>
8.
EXIM Policy Supplement 2007

<http://commerce.nic.in/PressRelease/pressrelease_detail.asp?id=2010>
9.
EXIM Policy Supplement 2008

<http://www.eximtimes.in/cexim/eximpol/ftp-ansulp0809.pdf>
10. Foreign Trade Policy 2009-2014

<http://164.100.9.245/exim/2000/dn/ftpdnl/high0910-eng.pdf>
11. Global Economic Environment
<http://www.economics.gov.nl.ca/E2009/global.pdf>
69

1.
(d) Achieving self-sufficiency in food grains production

In June 1991, the then finance minister, Manmohan Singh announced a new
economic policy (NEP). The policy aimed at reducing fiscal deficits, wiping out
the current account deficits, cutting down government expenditures, rationalizing
subsidies, controlling inflation, alleviating poverty, and achieving social equity.
Hence, achieving self-sufficiency in food grains production is not a basic
objective of NEP.
2.
(d) Both import and export policy

A trade policy of a country consists of its import policy and its export policy.
3.
(c) (i) and (ii) only

The import substitution program in India had two broad objectives: (a) to
preserve scarce foreign exchange for the import of more important goods, and
(b) to achieve self-reliance in the production of as many goods as possible. Hence
(c) is correct.
4.
(d) (i), (ii) and (iii)

The broad objectives of Indias export policy are:
To earn adequate foreign exchange to finance the required volume of imports
To effect a change in the directional patterns with a view to reducing
dependence on a single or limited number of countries
To supplement domestic demand for increasing employment opportunities
To raise unit value realization by promoting exports of value-added items
To impose minimum price regulation (floor pricing) where competition is
intense
To impose controls when domestic availability is less than adequate.
Hence option (d) is correct.
5.
(a) Cash Compensatory Support

Introduced in 1966, Cash Compensatory Support was designed to provide
compensation for unrelated indirect taxes paid by exporters on inputs, higher
freight rates, and market development costs.
6.
(b) Licensor
In the licensing process, a firm called the licensor sells the right to use its
intellectual property technology, patents, copyrights, work methods, brand
names, or trademarks to another firm.
70
Trade Environment
7.
(c) Licensee
In international licensing, the firm that obtains the right to use the intellectual
property of another firm, in exchange for a fee is termed as a licensee.
8.
(d) (i), (ii), (iii), (iv) and (v)

The basic issues in international licensing include boundaries of the agreement;
compensation; rights, privileges and constraints; dispute resolution; and duration
of the contract.
9.
(c) Royalty
Compensation under a licensing agreement is termed as royalty.
10. (c) Both (i) and (ii)

Franchising is a special form of licensing. Franchising allows the licensor more
control over the licensee and provides for support from the licensor to the licensee.
11. (c) Trade
The term Trade refers to mere buying and selling of goods.
12. (c) Commerce
The term Commerce, on the other hand, is a more comprehensive term and
includes not only the transfer and exchange of goods but the activities of various
agencies that ensure a free flow of goods and services between the actual
producers and the ultimate consumers.
13. (c) Either of the above
The agencies that ensure a free flow of goods and services between the actual
producers and the ultimate consumers referred to as aids to trade and auxiliaries
to trade.
14. (b) Commerce
The term Commerce in short, includes trade as well as aids to trade since
they ensure a free flow of goods and services between the actual producers and
the ultimate consumers.
15. (b) Trade
Trade is broadly divided into home trade and foreign trade.
16. (d) Middlemen
Middlemen are merchants who act as intermediaries between the producer and the
consumer.
17. (b) (iii) and (iv)
Mercantile agents and merchant middlemen are two types of middlemen.
18. (a) Mercantile agents
Mercantile agents are those persons who meditate between the producers and the
consumers and earn a commission for their services. They do not, however,
obtain ownership of the goods.
71

19. (b) Mercantile agents
Brokers, Commission agents, Auctioneers, Clearing, forwarding and shipping
agents and warehouse keepers are kinds of mercantile agents.
20. (c) They acquire title to the goods and assume possession of goods
Brokers are kind of mercantile agents who negotiate sale or purchase of goods on
behalf of other parties. They earn a certain percentage commission on the value of
the transactions concluded by them. They do not acquire title to the goods and
assume possession of goods.
21. (a) Commission agents
Commission agents are agents who sell goods on behalf of the principal.
22. (c) Factors
Commission agents having enlarged authority and liability over the consigned
goods are called Factors.
23. (c) They never assume the risk of bad debts
Commission agents are agents who sell goods on behalf of the principal. They
take possession of the goods and arrange for their proper storage. They
sometimes agree to sell the goods on credit and assume the risk of collecting the
amount. They undertake additional functions of sorting, grading, and packaging
to facilitate the sale of goods.
24. (d) Auctioneer
An auctioneer is entitled to a commission for his services and has a lien on the
goods for the charges.
25. (d) (iii) and (iv) only
Auctioneers and warehouse keepers have a lien on the goods for the charge
payable to them.
26. (d) Merchant middlemen
Merchant middlemen are those merchants who buy the goods outright and sell
them to the consumers at a profit.
27. (d) (iv) and (v)
Brokers, commission agents, and auctioneers are mercantile agents whereas
wholesalers and retailers are merchant middlemen.
28. (a) Wholesaler
A wholesaler represents the first link in the sequence of intermediaries between
the producer and the consumer.
72
Trade Environment
29. (c) He represents the last link in the chain of intermediaries between the
producer and the consumer.
A wholesaler is a trader who buys goods in large quantities from the
manufacturers and producers and sells them to retailers in smaller quantities. The
wholesaler, in some cases, functions as an importer and exporter. A wholesalers
business may also consist of supplying raw materials to industrial consumers viz.,
manufacturers. A wholesaler represents the first link in the chain of
intermediaries between the producer and the consumer.
30. (b) Retailer
A retailer represents the last link in the distribution chain, and is engaged in the
sale of goods to the ultimate consumer.
73
Unit 8
Structure
1.
Introduction
2.
Objectives
3.
Defining Technology and Technology Transfer
4.
Technology Selection
5.
Environmental Liability and the Costs of Technological Advances
6.
Summary
7.
Glossary
8.
9.
Suggested Readings/Reference Material
1. Introduction
In the previous three units, we discussed the economic, financial, and trade
environment. In this unit, the technological environment is discussed.
Technological environment consist of forces affecting technology and which result in
the creation of new products, markets, and marketing opportunities.
In this unit, we will discuss technology, technology transfer, and the factors to be
considered while selecting a technology. The unit also explains the new risks
introduced by technology and environmental liability and the costs of technological
advances.
2. Objectives
define technology and technology transfer.
identify the factors involved in technology selection.
analyze the new risks introduced by technology.
explain environmental liability and the costs of technological advances.
3. Defining Technology and Technology Transfer

Technology is knowledge of methods to perform certain tasks or so lve problems
pertaining to products and services. The basic elements of the technology
continuum are formed from the information on product design, production
techniques, quality assurance measures, human resources development, and
management systems.
Technology transfers covers developing and marketing of technology, selection of
technology, mechanism and process, economic, political and legal aspects; and
government policies. The complexity of technology transfer depends on the nature of
the industry and the technical and commercial aspects involved.
Example: Technology Transfer: A Global Phenomenon
Technology has brought about dynamic changes in the way organizations work.
And organizations that use the latest technologies have shown tremendous growth
compared to those that have resisted such technology. It is quite evident that in
todays technology era, more and more organizations are showing a preference for
the latest technologies to improve their businesses.
Of all the technologies, information technology has a special place and has become
indispensable to businesses. It has changed the way organizations function.
Businesses, large or small, have realized that it is in their interests to adopt the
latest technology. But the extent to which an organization adopts technology is
difficult to assess. It may vary from employing a computer to carry out business
transactions to making huge investments in using management information systems
to carry out numerous transactions. Most businesses have even created separate
departments for managing information systems.
Earlier, any innovation would take place in a handful of developed countries.
Developing countries had to buy and adopt this technology through the process of
technology transfer. However, rapid developments in the fields of space research,
electronics, semiconductors, medical science, information technology, automobiles,
etc., during the end of 20th century made it difficult for a single country or a firm to
carry out research and development in all fields. Therefore, technology transfer became
an integral part of global innovation and many countries and firms are now engaged in
technology transfer in one field or the other, creating a borderless global economy.
Technology transfer has taken place primarily in fields like manufacturing, agriculture,
defense, pharmaceutical and medical products, and computers.
Moreover, information technology has played a big role in transferring a large
amount of information between businesses established in different countries within
a short time. For instance, computers connected through networks make it easy for
people to share and transfer information. They allow them to communicate quickly
and thus reduce the time required to pass on information.
However, transfer of technology or adoption of a new technology is not an easy
process. Sometimes technology transfer involves a huge amount of investment and
the transfer takes place mostly among established producers or among developed
countries. Developing countries thus find it difficult to get access to such
technology. Also, the dynamic nature of technology makes it difficult for
developing countries to apply the latest technologies. There are many prerequisites
for technology transfer to take place efficiently. One needs to have a clear idea
about the right kind of technology to be used and how to adopt the technology to
suit local conditions. Most developing countries lack expertise in these areas.
75
4. Technology Selection
Technology needs of any large organization, which operates in a high technology area
in the engineering sector, are characterized by continuous product innovation and
large spending on R&D. Most companies around the world recognize that technology
needs cannot be solely met through their own engineering and R&D efforts. Usually
each technology requirement is subjected to the make-or-buy decision and judicious
mix of indigenous and imported technologies. In some areas, the rate of technological
obsolescence is so fast that by the time a technology is selected, imported, absorbed,
and adapted, the technology gets outdated. Hence, the strategies for selection of
technologies must be dynamic.
4.1 State-of-the-Art Production Technology
Production systems and processes have undergone a sea change. CAD (ComputerAided Design) and CAM (Computer-Aided-Manufacturing) have accelerated the
development of products and increased productivity in manufacturing. Higher levels
of product-quality are also possible through an integration of CAD and CAM systems.
Group technology, where parts are classified according to manufacturing
characteristics and produced in clustered cells of machines, results in significant
savings. This leads to the development of flexible manufacturing systems.
The introduction of industrial robots into the manufacturing process has altered the
economies of manufacturing productivity.
Machine vision systems for automatic inspection have been developed, which provide
for accuracy, precision, repeatability, tirelessness, and rapid payback. These systems
are important in speeding up the process of measurement, to keep up the speed of
automation. Modern parts require extremely close tolerance or have complex
dimensions. These systems eliminate human error and subjectivity.
4.2 Factors to be Considered in the Choice of Technology
The main factors to be considered in the selection of technology are:
Product competitiveness and market potential.
Customer preferences.
Speed of introduction of new products and processes.
Comparative studies of technology gap between India and the rest of the world.
Availability of technology for import in strategic areas.
Suitability of technology in the context of organizational culture.
Outflow of resources, foreign exchange, etc.
76
Activity: Kylie wanted to join her fathers auto component manufacturing business
upon finishing her MBA. The company was facing a downturn for quite some time,
and therefore, the top management of the company decided to replace the existing
technologies and equipments used in the manufacturing process to new ones. Kylie,
who was also a mechanical engineer, has been given the responsibility to select the
technology that would benefit the company. As she was new to the system, Tom,
the purchase manager, who had been with the company ever since its inception,
assisted her. Imagine yourself as Tom. Explain to Kylie the various factors to be
considered while selecting a particular technology.
Answer:
4.3 Technology Hazards

Advances in technology are increasing the complexity of systems, thereby increasing
the uncertainty in predicting untoward events. The main risk factors in the complex
systems are the low-probability and high-security events. The potential for disasters
has been further increased by the highly interactive, tightly coupled, and high risk
technological systems. However, most research studies indicate that management
teams whose members are characterized by higher levels of functional heterogeneity,
education, shorter organizational tenures, and high tenure heterogeneity can manage
these post industrial risks effectively. Proper staffing of teams creates an atmosphere
that duplicates complex thinking and better decision making.
4.4 Computer Fraud and Failures
Firms cannot always be protected from exposure to risks by state-of-the-art security
and recognition and integration of organizational factors. Signatures can be forged and
encrypting devices be broken into. It is a well known fact that electronic fraud-credit
card abuse and ATM thefts-already exists.
4.5 Liability Issues
Employment liability and harassment suits are the major concerns and potentially
damaging areas of liability exposure to firms. E-mails disposed off now can be
retrieved at a later date from the computer system. Such facilities are helping lawyers
to search for incriminating messages by summoning electronic files and computer
records. Exposure to liabilities may also occur when resentful employees send internal
data of the company outside or through the copyright violations while employees
download or post copyright material.
77

The laissez faire attitude employees increase the risk of electronic copyright
infringement. Firms need to institute risk management procedures to safeguard against
such risks.
Companies whose employees use the Internet for research and distribution of material
also face risks due to plagiarism for websites. Further, defamation can also pose
liability to firms.
4.6 Damage to Systems and Records
Employee carelessness is also responsible for the increase in risk faced by
companies. Many times an employee might unknowingly install a devastating
virus on the system and damage data records. Many firms are therefore
imposing restrictions on the downloading of software by employees into
company computers. Companies need to build strong firewalls to safeguard
their systems.
Activity: BabyCare Ltd. (BCL), a provider of baby care products planned to
launch a new food product for babies in the market. However, before it could
do so, the file containing the composi tion of the food product was corrupted.
After investigation by the BCLs management, it was found that the file was
corrupted by a virus. What kind of technology risk has the company faced in
this case? What measures can BCL take in order to avoid such inc idents in the
future? What are the other risks introduced by technology for business
organizations?
Answer:
4.7 Invasion of Privacy

The new technology also has a significant influence on an individuals right to
privacy. Data collected over a period of time maybe used to trace the consumption and
lifestyle behaviors of individuals, who may prefer to keep such information private.
Though such information enhances the target marketing abilities of firms, they also
expose them to lawsuits pertaining to invasion of privacy. Though at present the laws
regulate the privacy rights of individuals as well as government agencies, the laws
pertaining to the ability of the private sector to gather, disseminate and use
information about an individual are not very clear. Legislation on such matters is
expected in future.
78
Example: Data Security through Firewalls

Firewalls are used for protecting information. They may be hardware components,
software or a combination of both. Firewalls are mainly used to prevent
unauthorized access to information on private networks such as intranets. The
simplest type of firewall consists of a dedicated server with two network cards, one
connected to the internal network and the other to the Internet. The dedicated server
is referred to as the bastion host. The bastion host is connected to the two networks
through a proxy server. The proxy server filters requests that are received and sent
on the network.
Alternatively packet-filtering firewalls can be built. In this technique, routers are
used to specify Internet Protocol (IP) packets and their destination. Security can be
enforced by blocking certain source and destination addresses. Network address
translation can also be used for firewalls. Intranet addresses can be the same across
several organizations since they are internal to the organization. Three types of
ranges of IP addresses are available for intranets. In this method, Internet
connection to systems in the organization is routed through a hub or central server.
It is possible to have another firewall between each system and server.
5. Environmental Liability and the Cost of Technological Advances

5.1 The Problem
The development of any product or technology is associated with side effects, usually
in the form of waste or pollutants. Though technological advances are generally
beneficial for mankind, they may produce potentially deadly byproducts as a natural
side effect.
Growing environmental concerns have paved way for a drastic increase in regulation
and legislation regarding environmental pollution. These laws hold businesses liable
for any environmental pollution caused by them and allow governments to sue the
offending firms, individually or collectively.
The Costs
For individual firms that develop or use advanced technology and cause
environmental damage, the costs of cleaning up and paying compensation to the
parties involved are usually enormous. Very few companies and insurers can sustain
losses incurred as a result of such damages.
Who is Liable
Many of the major corporations are purchasing environmental liability insurance to
transfer some of the risks they face because of such environmental liabilities. The
magnitude of this pollution indemnification problem is causing problems for the
insurance industry.
79

The pollution liability problem can be split into two segments:
1.
Liability for clean-up of existing pollution due to past technological advances.
2.
Liability for preventing or controlling new pollution from new advances.

However, it is difficult to decide who should be held responsible for cleaning up
this trash from technology. Also, it might be difficult to fix responsibility
unless the limits for liabilities of prior pollution are set up.
5.2 New Threats to the Environment

Technological advancement is a continuous process and so is pollution. This is
compounding the existing pollution problem. A part of this pollution can be controlled
by regulating the systems and monitoring fresh pollution. The estimated costs for the
technology-based pollution might grow even larger in the future. Moreover, procedures
which are currently considered environmentally safe could prove to be dangerous later
because the identification of damages of technological advances is done by the
measurement of successively small dose levels. New dangers may also be discovered.
Pollution is continuously degrading the global ecosphere. Though a strict liability
system in one country might reduce pollution, it would simultaneously give firms an
incentive to locate the industry in countries with less stringent regulations.
5.3 Possible Solutions
There seems to be neither a simple and efficient method of financing the
environmental clean-up nor a method to compensate equitably the injured parties.
Mutual Insurance Pools
Mutual insurance pools can be formed to insure select classes of exposure or a
particular industry group to overcome the barriers to insurability (uncertainty in
predicting losses). This pool may be owned by a group of insurers. These insurers are
presumed to be experts in a particular technological area and to possess superior loss
prevention and underwriting capabilities.
The pool is expected to accept only those risks which would meet the acceptable
underwriting standards. Hence the pool could function as a way of suggesting
minimum acceptable industry standards. Moreover, all the insurers would have vested
interests in the financial operations of the pool.
The policy makers could help in designing state-of-the-art pollution control
mechanisms which could reduce negligence penalties. They could also dictate the
extent to which the government and the insurance industry should share the burden of
the clean-up costs. The prices and insurer uncertainty could be reduced by investing
more money into clean-up by sharing these costs on a no-fault basis.
Assigned Risk Pools
Some firms may not be able to obtain insurance from the private market. Such firms
might obtain insurance from the assigned risk pools created by the government.
Government can mandate participation in such pools, thereby expanding its risk
80
spreading ability. A major limitation of these pools in the past has been the severe
under pricing of insurance. This has resulted in a large deficit, which was ultimately
paid by taxpayers.
Environmental Trust Funds
In situations where no international polluter is identified, the Environmental Trust
Funds pay for the clean-up of those hazardous sites. The environmental Trust Funds
are financed through end-use taxes or broad-based taxes.
Technological Advances in Financial MarketsThe differences between the financial
and traditional risk management approaches are fast reducing. Insurers are using the
currency futures and financial desirable instruments to hedge the risk of assets. In
addition, the loss exposure is being hedged using the knowledge that value of special
commodities and loss exposures are strongly correlated. The commodity futures
market could be used to partially hedge the loss exposure. However, managing
traditional risks through reinsurance contracts is now being replaced by innovative
techniques like Act of God bonds, etc. As a result the insurance prices would remain
more stable. The ultimate benefit of this shift is to insurance customers and insurance
company owners.
Most companies are usually unaware of the risks they are exposed to in derivatives.
The use of derivative instruments has not yet resulted in a risk in insurance premiums.
This, however, can change with the occurrence of a single indemnified multibillion
dollar derivative loss. The new financial derivatives have many advantages. They not
only provide access to broader and richer capital markets but also allow the hedging
and transfer of previously unavailable risk coverage. However, these derivatives have
their disadvantages too. If left unmonitored, they make the firms vulnerable to
tremendous potential losses.
Check Your Progress

1.
What is defined as the knowledge of methods to perform certain tasks or solve

problems pertaining to products and services?
a.
Planning
b. Innovation c.
Technology
d.
Knowledge Management
2.
The basic elements of technology continuum are formed from:
a.
Information on product design and production techniques
b.
Quality assurance measures
c.
Human resources development and management systems
d.
All of the above

81

3.
What is the process that covers developing and marketing of technology,

selection of technology, mechanism and process; economic, political, and legal
aspects; and governmental policies?
a.
Innovation Process
b.
Technology Transfer
c.
Technical Documentation
d.
All of the above
4.
The risks introduced by technology include:
a.
Technology hazards
b.
Damage to systems and records
c.
Computer frauds and failures
d.
All of the above
5.
Which group of insurers is formed to insure select classes of exposure or a

particular industry group to overcome the barriers to insurability (uncertainty in
predicting losses)?
a.
Assigned risk pools
b.
Mutual insurance funds
c.
Mutual insurance pools
d.
None of the above
6.
Which of the following has the limitation of severe under pricing of insurance?
a.
Assigned risk pools
b.
Mutual insurance pools
c.
None of the above
d.
Both and b
7.
Which category of funds is financed through end-use taxes or broad-based taxes?
a.
Assigned risk pools
b.
Environmental trust funds
c.
Mutual trust funds
d.
All of the above
6. Summary
Technology is knowledge of methods to perform certain tasks or solve problems
related to products or services.
Technology transfer covers developing and marketing of technology, selection of
technology, mechanism and process, economic political and legal aspects, and
government policies.
The technology needs of any organization are met by continuous product innovations
and large spending on R&D.
82
With advances in technology, organizations now face new risks like computer frauds
and failures, liability issues, damages to systems and records, technology hazards and
invasion of privacy.
Technological advances also produce potentially deadly by-products as a natural side
effect. It threatens not only the financial survival of the firms manufacturing this
technology, but also the health of the society. Possible solutions to these
environmental threats are: mutual insurance pools, assigned risk pools, and
environmental trust funds.
7. Glossary
Technology hazards: Dangers that are by-products of innovations or technology.
Technology transfer: The process that covers developing and marketing of
technology, selection of technology, mechanism and process, economic, political and
legal aspects; and government policies is termed as technology transfer.
1.
Define technology and technology transfer.
2.
Explain the factors to be considered while selecting a technology.
3.
Briefly explain the risks introduced by technology.
4.
Describe the concept of environmental liability and the costs of technological advances.

1.

2.
3.
Technology Transfer
<http://www.africa.upenn.edu/Comp_Articles/Technology_Transfer_12764.html>
4.
Technology Selection
<http://www.epa.gov.et/epa/departments/pollution_control/files/pdf/guidellines_o
n_technology_selection_and_transfer.pdf>
5.
Mutual Insurance Pools

< http://www.ehow.com/about_5144278_definition-mutual-insurance.html>
6.
Assigned Risk Pools

<http://www.carinsurance.com/kb/Content41143.aspx>
83

1.
(c) Technology
Technology is defined as the knowledge of methods to perform certain tasks or
solve problems pertaining to products and services.
2.

The basic elements of the technology continuum are formed from the information
on product design, production techniques, quality assurance measures, human
resources development, and management systems.
3.
(b) Technology transfer

Technology transfer is the process that covers developing and marketing of
technology, selection of technology, mechanism and process; economic, political,
and legal aspects; and governmental policies
4.

The risks introduced by technology consist of technology hazards, computer
fraud and failures, liability issues, damage to systems and records, and invasion
of privacy.
5.
(c) Mutual insurance pools

Mutual insurance pools are group of insurers formed to insure select classes of
exposure or a particular industry group to overcome the barriers to insurability
(uncertainty in predicting losses).
6.
(a) Assigned risk pools

Firms that do not obtain insurance from the private market obtain it from assigned
risk pools created by the government. The major limitation of assigned risks
pools is of severe under pricing of insurance.
7.
(b) Environmental Trust Funds

Environmental trust funds are financed through end-use taxes
84

Course Components
BLOCK I
Unit 1
Unit 2
Unit 3
Unit 4
BLOCK II
Unit 5
Unit 6
Unit 7
Trade Environment
Unit 8
BLOCK III
Unit 9
Unit 10
Tax Environment
Unit 11
Ethical Environment
BLOCK IV
Business Contracts
Unit 12
Law of Contracts
Unit 13
Special Contracts
BLOCK V
Unit 14
Unit 15
BLOCK VI
Tax Laws
Unit 16
Direct Taxes
Unit 17
Indirect Taxes
Block
III
THE LEGAL AND ETHICAL ENVIRONMENT OF
BUSINESS
UNIT 9
1-24
UNIT 10
Tax Environment
25-37
UNIT 11
Ethics in Business
38-58
Expert Committee
Vice Chancellor
Hyderabad
Prof. S. S. George
Director, ICMR
Hyderabad
Prof. Y. K. Bhushan
Vice Chancellor
IU, Meghalaya
Dr. O. P. Gupta
Vice Chancellor
IU, Nagaland
Prof. Loveraj Takru

IU, Dehradun
Prof. D. S. Rao
Hyderabad

Prof. Vivek Gupta
Hyderabad
Ms. Hadiya Faheem

Hyderabad

Hyderabad

Hyderabad

IU, Dehradun
Ms. Padmaja
IU, Meghalaya

IU, Mizoram
Aizawal
Ms. Anurita Jois

IU, Sikkim

Block III

The third block of the course on Business Environment & Law deals with the legal and ethical
environment in business. The block contains three units. The first unit focuses on the legal
and regulatory environment of business. The second unit discusses the tax environment. The
third unit examines the importance of ethics in business.
The first unit, Legal and Regulatory Environment, discusses two of the external environment
factors the legal environment and the regulatory environment. The unit discusses about the
legal environment of business by examining international laws and the host country laws. It
then discusses how the disputes can be settled related to international business. The unit also
examines the regulatory environment by explaining the various forms of government
regulations and the purpose of framing regulations.
The second unit, Tax Environment, deals with how taxation affects the business of
organizations. The unit examines the purpose of taxation, and then moves on to discuss the
various types of taxation policies. The unit also explains the features or traits of an ideal tax
policy.
The third unit, Ethics in Business, provides an overview of the ethical environment of
business. The unit examines the various definitions of ethics, followed by its importance in
the field of business from the macro and the micro perspectives. The unit also includes a brief
discussion on the ethical codes such as the Cadburys code of ethics and the Kumar
Mangalam Birla report on corporate governance, which define the principles of appropriate
behavior in organizations.
Unit 9

Structure
1.
Introduction
2.
Objectives
3.
International Legal Perspective
4.
Host Country Laws
5.
Conflict Resolution, Dispute Settlement and Litigation
6.
Regulatory Environment: Role of the Government
7.
Purpose of Regulations
8.
Summary
9.
Glossary

1. Introduction
In the last unit of the previous block, we have discussed about technological environment.
In this unit, we will discuss about the impact of the legal and the regulatory environments
on business. The term legal environment refers to laws that govern the setting up and
operation of the business. A domestic firm must follow the laws and customs of its home
country. For the firm that has a global presence, the task is more complex as it must obey
the laws of its home country and all the host countries it operates in.
The legal environment differs from country to country posing many problems for
firms operating internationally. Diverse legal systems can pose significant challenges
for the firm. An understanding of the legal environment in the host country and
knowledge of international business regulations is therefore necessary for the firm
irrespective of its business.
A competitive market should be able to ensure that good quality and fairly-priced
products are made available. The Government intervenes through regulations to
ensure that producers and service providers are reliable. In many developing
countries, an additional goal may be promoting the domestic industry and ensuring
that the national industries contribute to overall economic development. Thus, an
understanding of the regulatory environment is necessary for every business operating
within a country as well as in the global market.
In this unit, we will first discuss the legal environment under which we will discuss
international laws and the host country laws. We will then discuss how to solve
conflicts and settle disputes in international business. We will then move on to discuss
the regulatory environment and the various forms of government regulations. Finally,
we will discuss the purpose of framing regulations.
2. Objectives
understand international legal perspective.
study the various laws that play a major role in the entry of companies into foreign
markets.
understand conflict resolution and dispute settlement processes in global markets.
assess the role played by the government in creating a regulatory environment.
determine the purpose of regulations.
3. International Legal Perspective

International law may be defined as the rules and principles that states and nations
accept as binding. It can also be defined as a collection of treaties and agreements
between nations that are (more or less) legally enforceable. The field of international
law is complex. The two unique characteristics of operating in an international legal
environment are: (a) The national law is not applicable overseas. It is binding only till
the trade is conducted within the state or nation, and (b) There is no international
judicial and administrative framework or a body of law that forms the basis of a
comprehensive international system.
For the purpose of understanding the varying legal philosophies among countries,
legal systems can be categorized as common law and statute law. Common law, also
called British law, is followed by about 25 countries including the United Kingdom,
India, and the United States (US). This legal system depends heavily on precedents
and conventions. These are tradition-oriented and judgments are based on previous
court decisions.
Statute law (also known as code or civil law) guides countries by embodying the main
rules of the law in legislative codes. Thus, under this system, the interpretations of the
law are strict and literal. Each circumstance is clearly spelled out to indicate what is
legal and what is not. Japan and most of the continental European countries follow
this legal system. There is a little distinction between the two systems. However, the
personal judgment of the judges and their interpretation of the laws (which constitutes
the only major distinction) significantly affect business decisions and strategies.
3.1 Multiplicity of Legal Environment
Legal environments can be domestic, foreign, or international. Laws of a particular
country regulate the businesses of organizations operating in that country. Legal
disputes that may arise during the course of conducting business are very costly and
time consuming. Thus, it is imperative for a global company to understand the legal
environment, and its implications on the business.
Domestic Legal Environment
In this environment, the laws of the home country govern the business. Laws can
affect both imports and exports. Import/export of certain dangerous products like
narcotics and toxic substances are prohibited. Imports/exports of cultural treasures,
gold, automobiles, etc., are restricted, but not prohibited.
2

Foreign Legal Environment
As the company crosses the national border, the company and its practices will be
governed by the laws of the host country. The company has to conform to the laws of
the host country.
International Legal Environment
This environment is a combination of legal systems and laws of various nations put together.
It includes all national laws, combined with various treaties among nations, bilateral and
multinational conventions, and regional laws. There is no international law as such that
describes acceptable and legal behavior for organizations. Thus, international organizations
such as the World Trade Organization are constantly striving to promote free trade and settle
disputes among nations.
3.2 Jurisdiction of Laws
There is no international body that makes rules and ensures that the parties follow
them. In the present scenario, a business incorporated in a particular country carries
the burden of complying with the laws of both the home country and the host country.
Major problems arise when laws of more than one country must be respected. When a
dispute occurs between two contracting parties, the question arises as to which
countrys laws should be used to resolve the dispute. If the contract between the
parties contains a jurisdiction clause stipulating which countrys legal system should
be used to settle disputes, the matter can be resolved accordingly. However, if the
parties have not included jurisdiction clause in the contract, two alternative courses of
action are possible settle the dispute by following the laws of the country where the
agreement was made, or resolve the dispute by applying the laws of the country where
the contract has to be fulfilled. If the two alternatives are likely to lead to different
conclusions, each party naturally would like to settle the issue as per the legal system
that is favorable to it. This will in turn lead to legal and counter legal actions,
presumably in different courts and perhaps in different countries.
3.3 Extraterritorial Reach
Extraterritoriality refers to the state in which certain diplomatic organizations and
people operating in a foreign country are exempted from the jurisdiction of the laws in
that country. For instance, ambassadors, diplomatic agents, military bases, offices of
the United Nations, etc., are some entities that come under the state of
extraterritoriality.
In the case of businesses, extraterritoriality can occur when a government extends the
application of a law to people or organizations operating outside the countrys
boundaries. For instance, the US has imposed an embargo on trade with Cuba. If the
US government decides to enforce this embargo even in the case of non-US
government organizations say companies operating in the EU and these
organizations comply, they may well find themselves in breach of EU legislation
prohibiting such compliance. Therefore, such laws sometimes put businesses in
difficult situations.
The concept of extraterritoriality is however not very clear, and is a highly debatable
topic. For example, though they may be owned by Indian companies, foreign
subsidiaries of Indian companies are non-Indian firms doing business in a foreign
3

country. It is debatable whether these subsidiaries should comply with the home
country laws or the host country laws. When a country follows extraterritoriality,
conflicts may occur among nations in the areas of anti-trust1, securities regulations,
product liability, tax collections, and export controls. They may sometimes lead
further to impeding trade worldwide and intergovernmental disputes.
Activity: SpeedCars is a sports car manufacturing company based in Brazil. The
company wanted to introduce its cars in the US market. For this, the company has
to conform to various regulations laid out by the US government. Under what kind
of a legal environment does SpeedCars operate? Explain the impact of such
environment on its business.
Answer:
Check Your Progress

1.
can be defined as a collection of treaties and agreements

between nations that are legally enforceable.
a.
Domestic law
b.
Foreign law
c.
International law
d.
All of the above
2.
Identify the characteristics of the international legal environment.
i.
The national law is not applicable overseas.
ii.
The national law is binding only till the trade goes on within the nation and with
only one other country.
iii. There is no international judicial and administrative framework or a body of law

that forms the basis of a comprehensive international system.
iv. The international legal environment is highly complex.
a.
Only i, ii, and iii
b.
c.
Only i, ii, and iv
d.
Only i, iii, and iv
Anti-trust refers to the government policies aimed at opposing and controlling business
monopolies such as trusts and cartels. These policies are aimed at promoting free
competition, and achieving the benefits that free competition can provide to the economy
and to the entire society.

3.
Identify the statements that do not hold true regarding legal systems.
a.
The common law system depends heavily on precedents and conventions.
b.
Statute law is also called British law and is followed by countries like the UK,
India, and the US.
c.
The common law system is tradition-oriented and judgments are based on

previous court decisions.
d.
Under the statute law system, the interpretations of the law are strict and literal.
4.
guides countries by embodying the main rules of the law in

legislative codes. Under this, the interpretations of the law are strict and literal.
Statute law
British law
Common law
None of the above
a.
b.
c.
d.
5.
a.
b.
c.
d.
6.
a.
b.
c.
d.
7.
i.
ii.
iii.
a.
c.
d.
Which of the following is the legal environment in which the laws of the home
country govern the business?
Domestic legal environment
Foreign legal environment
International legal environment
Both (a) and (b)
Identify the characteristic of the foreign legal environment.
The laws of the home country govern the business.
It is a combination of legal systems and laws of various nations put together.
The company and its practices will be governed by the laws of the host country as
the company crosses the national border.
It includes all national laws, combined with the various treaties among nations,
bilateral and multinational conventions, and regional laws.
Which of the following statements holds true regarding the international legal
environment?
It is a combination of legal systems and laws of various nations put together.
It includes all national laws, combined with the various treaties among nations.
There are some international laws that describe acceptable and legal behavior for
organizations.
Only i and ii b.
Only i and iii
Only ii and iii
Only i, ii, and iii
8.
In what ways can conflicts be resolved between two parties engaged in

international business in the absence of a jurisdiction clause in the contract?
i. By following the laws of the home country
ii. By following the laws of the country where the agreement was made
iii. By applying the laws of the country where the contract has to be fulfilled
a. Either i or ii
b. Either i or iii
c. Either ii or iii
d. Either i or ii or iii
5

9.
a.
b.
c.
d.
refers to the state in which certain diplomatic organizations and

people operating in a foreign country are exempted from the jurisdiction of the
laws in that country.
Expropriation
Nationalization
Extraterritoriality
Confiscation
3.4 Intellectual Property Rights

Intellectual property refers to ideas that are translated into tangible products,
writings, and so on, and that are protected by the state for a limited period of time
from unauthorized commercial exploitation. Intellectual property rights broadly
include patents, trademarks, copyrights, and trade secrets.
Patents
Patent laws differ from country to country. Most countries follow the first-to-file
principle, while countries like the US follow the first-to-invent principle. These
differences may lead to litigation as competing patent applicants may try to prove that
they were the first to invent the product or the first to file the application.
Trademarks
A trademark is a word, symbol, or device that identifies the source of goods and may
serve as an index of quality. It is primarily used to differentiate or distinguish a
product or service from another. Most countries mandate registration for a trademark
to be protected. Companies interested to do business globally should register their
trademarks in every country in which protection is desired.
Copyrights
Copyrights protect original literary, dramatic, musical, artistic, and certain other
intellectual works. In some countries, registration is required for protection of
intellectual works, while in some, copyrights protection is offered without registration.
There are also some countries which offer little or no protection for the works of
foreign companies.
Trade Secrets
A trade secret is any classified or confidential information that provides an edge to an
organization over its competitors. It differs fundamentally from patents, copyrights,
and trademarks with regards to the protection aspect. A trade secret is protected for an
unlimited period of time as long as the secret is maintained. They are protected
without any registration or legal formalities. Given below are some ways in which a
trade secret can be protected.
By restricting access to the secret information by locking it away at a secure place
By limiting the number of people who know the information
By making people who know the trade secret and people who come to know the
trade secret (by chance) sign non-disclosure agreements
By marking the written documents containing the trade secret as proprietary
6

The Coca-Cola formula is considered as the most famous trade secret. Known by the
code name, Merchandise 7X, the Coca-Cola formula is known only to a few people
within the company who have signed non-disclosure agreements. The formula is also
kept in the vault of a bank in Georgia.
Intellectual property has gained importance over a period of time and has become a
source of competitive advantage. It can be violated very easily. To avoid this, nations
should enforce the ownership rights of the companies. The laws dealing with
intellectual property are not consistent across nations, and they cannot be extended
across national boundaries. Even if there is some similarity across nations, the levels
at which they are implemented differ widely. International treaties like the Paris
Convention for the Protection of Industrial Property, the Berne Convention for the
Protection of Literary and Artistic Works, and the Universal Copyright Convention
(developed by the United Nations as an alternative to the Berne Convention) provide
some protection to intellectual property rights.
Example: Trademark Problems for Ugg Boots in Australia
Uggs, a short term for Ugly Boots, was a very common word in Australia. They
were mainly used in Australia and New Zealand and were relatively unknown in
other parts of the world till the mid 1970s. In 1978, an Australian surfer, Brian
Smith (Smith), took them to the US, obtained a trademark for the term Ugg, and
started a company Ugg Holdings Inc. (Ugg Holdings). In 1995, Smith sold Ugg
Holdings to the US-based Deckers Outdoor Corporation (Deckers), which started
selling the products under the Ugg label. Deckers repositioned Uggs as a highfashion luxury item by the late 1990s. They were featured in some of the worlds
well-known fashion magazines and were endorsed by many Hollywood celebrities.
During the early 2000s, as the popularity of Uggs grew in the US, the demand for
them was so high that shoppers often had to return empty handed from the stores.
Many of them then resorted to buying Uggs online. The online demand for the
boots reached its peak in 2003 when bidding on auction websites for the Ugg
Australia boots was as high as US$ 500 for a single pair. To cash in on the
popularity of the Uggs, Australian sheepskin boot manufacturers too sold their
Uggs in the US through Internet auction sites such as eBay.com but for a much
lower price. Several consumers then started buying Uggs from the Australian
manufacturers through these websites. This irked Deckers which was concerned
about lost sales.
In 2003, Deckers issued legal letters to as many as twenty Australian sheepskin
boot manufacturers and retailers that used different versions of the word Ugg to
stop using the word while selling and marketing their products. The firms were
asked to withdraw catalogues, labels, signs, price lists, advertisements, and business
names that contained the words Ugg, Ug, or Ugh. The letter sought to prohibit
the Australian companies from selling Ugg boots to American consumers
through auction sites in the US. Deckers threatened them with legal action if they
continued to use the term Ugg.
Contd
7
Contd
Though the Australian manufacturers had been trading their products using Ugg for
several years, it was only in 2003 that Deckers decided to take action against them,
including against those who were selling their products online. This triggered a conflict
between Deckers and Australian sheepskin boot manufacturers. According to the
Australian manufacturers, the word Ugg was generic in Australia and therefore could
be used by all the manufacturers of sheepskin boots. They claimed that several of them
had been using the name much before Deckers or Smith had registered it as a
trademark. They also alleged that Deckers was trying to bully smaller businesses.
According to them, trademark laws in Australia offered no protection for generic
words. Thus, a legal dispute started between Australian sheepskin boot manufacturers
and Ugg Holdings, which claimed to own the UGG Australia brand.
As many as three applications were filed with IP Australia by Australian
manufacturers seeking the removal of Ugg trademarks owned by Deckers. They
claimed that the registered trademarks of Ugg had not been used by Deckers over
three consecutive years (relevant period) in Australia, thus making them invalid.
The first application was filed on December 30, 2003, for the removal of the
trademark UGH-BOOTS owned by Deckers. On January 16, 2006, IP Australia
ordered the removal of the trademark UGH-BOOTS from the trademark register as
the evidence provided by Deckers was not sufficient to prove that the trademark
had been used in Australia within the three-year period. On March 27, 2006,
another trademark UGH was removed from the Australian trademark register
after Deckers withdrew its opposition. The case was filed by Mortel who claimed
non-use of the trademark UGH in Australia. The decision was issued by IP
Australia and was subject to appeal in the Federal Court of Australia. In another
trademark hearing, Deckers was successful in retaining the trademark UGG
Australia in the trademarks registry.
On July 30, 2004, Luda Productions Pty Ltd (Luda) filed an application for removal
of the trademark Ugg Australia for its non-use in Australia. Deckers filed a notice
of opposition on the grounds that the trademark or versions of the mark
had been used within the relevant period. On August 11, 2006, Alison Windsor,
Hearing Officer, issued a decision relating to the application filed by Luda. The
decision was that the trademark (number 785466) would remain on the Australian
trademark register as it had been commercially used within the relevant three-year
period, i.e., from June 30, 2001 to June 30, 2004. John Kalinich, Vice President of
Consumer Direct and Intellectual Property for Deckers, provided evidence in
support of the trademark use in Australia. According to him, approximately
195,000 pairs of boots manufactured in Australia and with the trademark UGG
Australia embossed onto the boot soles were shipped to the US during that period.
He also stated that all the companys boots manufactured in Australia during the
period also carried the UGG Australia wordmark.
Analysts felt that Deckers owned the trademark in the US which meant that
Australian manufacturers could face a difficulty in selling their products in the US in
future. To avoid litigation, many Australian Ugg Boot manufacturers like Koolaburra
and Warmbat started marketing Ugg boots as sheepskin boots in the US.
Adapted from Case Study The Ugg Boot Controversy in Australia. IBS
8
Activity: Fusion Records (FR) is an Africa-based music recording company. An

Indian music director used a song developed by FR in one of his movies. The
music director did not take any permission from FR prior to using the song. He
made certain modifications (changed the lyrics) to it to suit the Indian audience.
The management of FR came to know about this. It filed a case against the music
director as the works of the company were protected according to the laws in
Africa. What is this intellectual property right of FR called as? Name other
intellectual property rights.
Answer:
Check Your Progress

10. Which of the following can be defined as ideas that are translated into tangible
products, writings, etc., and that are protected by the state for a limited period of
time from unauthorized commercial exploitation?
a. Diffusion
b. Intellectual property
c. Self-reference criteria
d. Either (a) and (b)
11.
is a word, symbol, or device that identifies the source of goods

and may serve as an index of quality.
a. Patent
b. Copyright c.
Trademark d.
Trade secret
12. Identify the statement that holds true regarding copyrights.
a.
b.
c.
d.
It follows first-to-file and first-to-invent principles.

All countries mandate registration for protection of intellectual works.
It is primarily used to differentiate or distinguish a product or service from another.
They protect original literary, dramatic, musical, artistic, and certain other
intellectual works.
13. Identify the statement that holds true regarding trade secrets.
a. It is legally protected just like patents and trademarks.
b. It is primarily used to differentiate or distinguish a product or service from another. c.
Registration and certain legal formalities have to be fulfilled to protect the trade secret.
d. It is any classified or confidential information that provides an edge to an
organization over its competitors.
9
4. Host Country Laws

Host countries enact certain laws to regulate the business of foreign companies in their
economies. These laws depend upon the countrys economic objectives and its obligations
and position in relation to worldwide commerce. At times, laws are designed to allow
reciprocity with nations on good trading terms with the country. Some laws are also
discriminatory against foreign goods and businesses. In some cases, laws may be bent to
suit political needs. Laws that play a role regarding entry into foreign markets take several
forms, including tariffs, anti-dumping laws, export/import licensing, investment
regulations, legal incentives, and restrictive trading laws.
4.1 Tariffs
A tariff is a tax that a government levies on exports and imports. Tax associated with
exports is called export duty, and tax associated with imports is called import duty or
customs duty. Export duty is levied to discourage overseas selling to maintain
adequate supply at home, while import duty is levied for gaining a source of revenue
for the government, protecting the domestic industry from being out-priced by cheap
imports, etc. An import duty may be assessed on three ways on the value of the
product (called Ad Valorem); on a unit basis (called specific duty); and on both
product as well as unit basis.
Many developing countries impose high import duties as there are limited resources,
and new industries cannot compete with imports from other countries. High import
duties would help in restricting imports and in helping the domestic industries. These
help in promoting economic development in such countries. A subsidy (reverse tariff)
is also provided by many countries to local manufacturers for exporting to other
countries. It may also be provided to local products to make them competitive against
imports.
4.2 Anti-dumping Laws
Dumping is a pricing strategy used by many companies to sell products in foreign
markets below costs, or below the price charged for the same to domestic customers.
It is done to capture a larger share in a foreign market and compete with domestic
companies in foreign markets.
Dumping is not considered a condemnable practice for various reasons. In
international business, price discrimination through dumping is considered as a
normal practice as manufacturers sell their products at different prices in different
markets. The prices in various markets change due to changes in the conditions of
demand and supply. Another reason is that export prices are usually less than the
domestic prices.
Due to the above reasons, dumping is not considered illegal. However, if dumping
causes or threatens to cause problems to the domestic industry, it is subject to various
regulations. Thus, many governments passed anti-dumping laws to protect local
industries. These laws provide remedies to the domestic industry as against the injury
caused due to the practice of dumping.
10

4.3 Export/Import Licensing
Most countries have laws that call for exporters and importers to obtain licenses
before engaging in trade across national boundaries. Export licensing allows for
statistical tracking of export activities and helps in ensuring that certain goods are not
exported at all or at least not to certain countries. Import licensing helps in controlling
the unnecessary purchase of goods from other countries.
4.4 Foreign Investment Regulations
Foreign investment regulations help in limiting the influence of multinational
corporations. These regulations help in achieving a pattern of foreign investment that
contributes most effectively to the realization of the host countrys economic
objectives. Foreign investment regulations can take the following forms.
Decision making pertaining to the selection of foreign investment, control of takeovers,
prohibition or restriction of foreign investment in certain sectors and elaboration of
incentive schemes.
Taxation and regulation of financial transactions through determination of locally
taxable income to inhibit avoidance of double taxation; control of capital and profit
repatriation; incentives for profit reinvestment; regulation of local and foreign
borrowing.
Regulation of ownership, managerial control, and employment through local
participation requirement in ownership and management; limitation of expatriate
employment and local employment quotas.
4.5 Legal Incentives
In most developing countries, investments are designed to attract foreign investment.
Sometimes, the only major way the foreign investment can be regulated is through
incentive schemes. Incentives are generally given to benefit the local companies. In
certain countries, foreign investment is the main beneficiary as local companies may
not be able to qualify for the kind of investment encouraged by the incentives. There
are also some incentives that are restricted to local enterprises, joint ventures, or
enterprises with a minority foreign participation.
Based on the basic approach to investment regulation, incentives may be awarded
automatically to all enterprises meeting the conditions specified in the relevant
legislation or it may be granted for a specific performance or contribution to the host
countrys economy (such as export promotion and diversification, transfer of modern
technology, the development of backward areas, encouragement to research in host
country, and so on). Some of the incentives for the establishment of an enterprise are
income-tax holiday for several years; tax measures such as accelerated depreciation;
and fiscal incentives such as waiver of import duties on equipment and materials for
production, exemption from property tax and tax concessions.
11

4.6 Restrictive Trading Laws
These are usually referred to as non-tariff barriers to international trade. These are
adopted by most governments to restrict imports or artificially stimulate exports (in
addition to the tax incentive laws). These can be in the form of customs and entry
procedures, and import charges.
5. Conflict Resolution, Dispute Settlement and Litigation

In global markets, conflicts are inevitable as different cultures come together to buy,
sell, compete, and engage in joint ventures. Differences in legal systems, currencies,
languages, business customs, and also procedural differences in settlement of disputes
complicate litigation in foreign courts.
To avoid such problems, the parties involved should prepare a contract that
stipulates a particular legal system that is to take precedence in resolving any
contract dispute. The court to be used for the purpose should also be specified.
The company should keep in mind that to win a case in its home court is
completely different from enforcing a judgment against a foreign company. It is
difficult to enforce unless the foreign company wants to continue its business in
the country where the judgment is obtained. The company should also ensure that
the host country court would have jurisdiction to hear the case if it is necessary to
file a lawsuit in the defendants home country.
Arbitration, conciliation, mediation, and negotiations are some forms of set tling
disputes in international markets. The International Center for Settlement of
Investment Disputes (ICSID) was established in 1966 to settle disputes between
governments of host countries and foreign investors through conciliation and
arbitration. In the same year, UNCITRAL (United Nations Conference on
International Trade Law) was established by the United Nations to promote a
global set of standards to solve disputes among countries. UNCITRAL, works
along with the World Trade Organization to formulat e and regulate the
international trade.
Activity: RF Textiles Limited is a textile manufacturing company in India. The
company sells its textiles in India as well as in Japan, Singapore, Malaysia, and
South Africa. To its overseas customers, the company prices its textiles at 30% less
than the price it charges for the domestic customers. What is this strategy adopted
by the company known as? Is it an ethical strategy? Why and why not?
Answer:
12
Check Your Progress

14.
a.
b.
c.
d.
is a tax that a government levies on exports and imports.

Tariff
Excise duty
Sales tax
Inheritance tax
15. Identify the statement that holds true regarding export duty.
a. It is levied to discourage overseas selling to maintain adequate supply at home.
b. It is levied to protect the domestic industry from being out-priced by cheap
imports.
c. It is assessed based on the value of the product, on a unit basis, and on both
product as well as unit basis.
d. All of the above
16.
i.
ii.
iii.
a.
b.
c.
d.
Import duties are levied for:

gaining a source of revenue for the government.
discouraging overseas selling to maintain adequate supply at home.
protecting the domestic industry from being out-priced by cheap imports.
Only i and ii
Only i and iii
Only ii and iii
i, ii, and iii
17.
is provided by many countries to local manufacturers for exporting to

other countries or to local products to make them competitive against imports.
a. Subsidy
b. Import duty
c. Export duty
18. Which of the following is a pricing strategy used by many companies to sell
products in foreign markets below costs or below the price charged for the same
to domestic customers?
a.
Dumping
b.
Licensing
c.
Expropriation
d.
Domestication
19.
allows for statistical tracking of export activities and helps in ensuring

that certain goods are not exported at all, or at least not to certain countries.
a.
Dumping
b.
Export licensing
c.
Import licensing
d.
Legal incentives
13
6. Regulatory Environment: Role of the Government

The government plays a major role in the domestic economy. The relationship
between the government and the economy has greatly transformed since the Great
Depression of the 1930s. According to Dimock, The two most powerful institutions
in society today are business and government; where they meet on common groundamicability or otherwise-together they determine public policy, both foreign and
domestic, for a nation.
The age of Laissez Faire, also called the era of free enterprise was based on the
assumption that every individual acting as a rational being tries to get the greatest
satisfaction from life for himself and, in this process, contributes towards the greatest
possible satisfaction to the society. The classical economists believed in the principle
of non-interference with economic and business activity. However, developments
particularly those after the Industrial Revolution, changed this view. The Laissez Faire
policy led to the concentration of control and ownership of industrial empires in the
hands of a small number of people.
Practices like monopolies and exploitation of consumers and working classes by
industrial majors for private gains made the government and the economists change
their views about the role of the state in relation to economic activity. It was realized
that the state cannot continue to be a spectator in the economic scenario where
business was uncontrolled and unregulated. Laissez Faire ended with the First World
War. From then on, the government began to play a positive role in the economic
affairs of the country. It became the regulator of the economic activity in the interests
of the people and the community at large.
Though the state became the controller of the economy worldwide, the extent and
nature of control varies widely between nations. For instance, in capitalist countries,
the government regulates economic activity and the operations of business and
industries, though the ownership and control lies in private hands. In democratic
countries, the government takes over the control and ownership of certain segments of
the economy and the rest is left to the private companies, which function under the
guidelines and regulations set by the government. This pattern of economy is
popularly known as mixed economy. Most countries worldwide follow this economic
system including India.
In the mixed economy, the government plays a dual role in relation to private business
and private enterprises co-exist with government enterprises. The government
provides finance and facilities to companies. Through policies like protection and
export promotion, it tries to look after and further their interests. The government also
acts as a regulator, i.e., as a restraining force. It lays down certain guidelines, rules,
and regulations, within which companies should function. In certain cases, the
government can also take over a company or an entire industry.
In totalitarian countries, such as the erstwhile Soviet Union and other communist
countries, the government has gone to the extent of taking over complete control of
economic activity. Economic activity has been completely regimented there. That is,
even production and consumption is determined by the state.
14

6.1 Forms of Government Regulation
The government regulation of business may include a broad range of guidelines extending
from entry into the market, up to the final exit from the market. Given below are some of
the important forms of regulation of private enterprise by the government.
General direction and regulation of investment activity in private enterprise. Economic
planning at the national level and the industrial policy helps in achieving this.
Regulation of investment, location size and expansion of individual enterprises and
specific industries through industrial incensing.
Regulation of monopolies and unfair or restrictive trade practices through legislative
authority.
Regulation of price of commodities and industrial products through legislative authority.
Regulation of wages and bonus for employees in the private sector to reduce
exploitation, ensure reasonable standards of living and maintain peace and harmony in
industry.
Regulation of corporate management.
Regulation of specific forms of business activity like speculation in shares and
commodities or imports/exports.
Control and Regulation of Prices
The government has the regulatory power to control over private enterprises. It has the
power to fix, control and regulate the prices of products and services. When there is a
probable fall in the production volume in an industry or a company which is not justified,
the government can order for an investigation. Also, if there is a noticeable decrease in the
quality of the products or service, or an unfair increase in the prices, the government can
call for investigation. The government can give advice to the industry concerned to price
its products and services reasonably keeping in mind the interests of the consumers. In
India, the government enjoys the power of fixing and regulating prices of essential
commodities such as sugar, wheat, and other commodities and basic drugs.
7. Purpose of Regulations
The main aim of government intervention should be to maximize societys welfare.
According to Vilfredo Pareto, there are two ways to do this pareto efficiency and
pareto improvement. While allocating resources in a society, if there is no way to
reallocate resources to make at least a person better off without making someone else
worse off, such a situation is called a pareto efficient situation. If these resources can
be reallocated in such a way that at least one person is better off without making
someone else worse off, then such a situation is called a pareto improvement situation.
A market-based economy automatically allocates resources efficiently. The allocation may
not however be fair without government intervention. This is an idealistic situation and
gives rise to two problems society may not necessarily prefer this method, and efficiency
in resources allocation is not the only goal of any society as there are other vital social
objectives. Concentrating only on the efficiency aspect may hamper equitable distribution,
leading to not being able to satisfy the basic needs of few people.
15
Example: Tackling Childhood Obesity Issues

In recent years, many governments have been hardening their stance against food
companies that target children in their advertisements. The reason the childhood
obesity rate is said to have reached alarming proportions and to be on the verge of
becoming a global epidemic. The increasing waistlines of children were
attributed primarily to junk foods and reduced physical activity. There were
contrasting views among industry experts on whether there should be government
regulation or self-regulation on junk food advertising by companies.
Government Regulation
In 2000, the US Government made it mandatory for food companies to adhere to
strict nutritional labeling norms that would give details of the sugar and fat content
of their products. Various state governments also brought in regulations against
junk food promotions. For instance, any states like Connecticut and California
passed bills to impose restrictions on companies advertising junk food to children.
In 2003, the Australian government launched a national action agenda for Healthy
Weight 2008 Australias Future, to be coordinated by the National Obesity Task
Force. This program was targeted at children and adolescents and aimed to reverse
the trend of increase in overweight and obesity.
The UK Department of Education and Skills launched a Healthy Living Blueprint
for schools, in September 2004. It outlined initiatives to provide the required
support to schools to encourage children to eat sensibly, stay physically active, and
maintain good levels of personal health. The European Union (EU) convened a
meeting of representatives from the food industry, the advertising profession, and
Governments in January 2005; the objective was to control advertisements targeted
at children. The participants at the meeting saw a need to set up a self-regulatory
body to monitor the activities of its members.
These government initiatives were opposed by food companies. They came
together to form the Alliance for American Advertising, in January 2005, to defend
their right to advertise to children. The alliance also contended that the need of
the hour was self-regulation and not a total ban on advertising.
Self-regulation by Corporates
McDonalds faced criticism for selling food that was high in fat and calories. As
people became more aware of the downside of fast food, the company began
promoting the idea of an active lifestyle to adults as well as children. It revamped
its ads by showing its mascot, Ronald McDonald, burning calories, by working out
and playing soccer with children. It also used Olympic sportspersons to promote
health and fitness among children.
Contd
16
Contd
Kraft Foods voluntarily withdrew its ad campaigns aimed at children aged below
twelve. In early 2005, the company announced that from the year 2006, it would no
longer advertise some of its products on television, radio and in print media
vehicles that were primarily targeted at children in the age range between 6 and 11
years. The company also launched an education campaign that was aimed at
educating school students. The nutrition expert team of the company created a
program called sensible solution based on the US dietary guidelines put out by
the US Food and Drug Administration (USFDA). The program provided details of
the nutritive value of the companys food products. The company also introduced
the Kid Sense range of products that addressed the obesity issue and that had less
fat content.
Coca-Cola was criticized as being partly responsible for the rising obesity rates in
children, especially since the sugar content in its carbonated beverages was very
high. As a response to these concerns, Coca-Cola sought to provide children with
more choices and stopped promoting carbonated drinks through vending machines
at school. In the UK, the company voluntarily withdrew advertisements to children
below 12. In Australia, Coca-Cola introduced the Active Lifestyle Program to
educate and support the community to combat overweight and obesity. This
program included a sub-program named Active Factor, to support initiatives for
increasing the physical activity levels of children, by focusing on education,
participation, and inspiration. In Thailand, Coca-Cola launched a television
commercial aimed at children; this ad featured an aerobics instructor appealing to
children to participate in more physical activities and become healthier and fitter.
Coca-Cola introduced a low carbohydrate (carb) drink called C2, which it
claimed had half the sugar content of the original Coke. Coca-Cola entered into a
tie-up with McDonalds to promote C2.
Adapted from Case Study Childhood Obesity: Should Junk Food be Regulated?
IBS Center for Management Research, 2005. www.icmrindia.org.
Check Your Progress

20. Which of the following statements is true regarding the role of government in
regulating an economy?
i.
In capitalist countries, the government regulates economic activity and the

operations of business and industries, though the ownership and control lies in
private hands.
ii.
In mixed economies, the government takes over the control and ownership of
certain segments of the economy and the rest is left to the private companies,
which function under the guidelines and regulations set by the government.
iii. In democratic countries, the government plays a dual role in relation to private
business, and private enterprises co-exist with government enterprises.
17

iv.
In totalitarian countries, the government has taken over complete control of

economic activity.
a. Only i and ii b.
Only i and iv
c.
Only ii and iii
d.
Only iii and iv
21. In which of the following ways can government regulate the private enterprises?
i.
By regulating investment, location size, and expansion of individual enterprises

and specific industries through industrial incensing
ii.
By regulating price of commodities and industrial products through legislative

authority
iii. By regulating the specific forms of business activity like speculation in shares and
commodities or imports/exports
iv.
By regulating wages and bonus for employees in the private sector to reduce
exploitation, ensuring reasonable standards of living, and by maintaining peace
and harmony in the industry

Only i, iii, and iv
c.
d.
i, ii, iii, and iv
22. While allocating resources in a society, if there is no way to reallocate resources

to make at least a person better off without making someone else worse off, such
a situation is called a
situation.
a.
pareto efficient
b. pareto improvement c.
equitable distribution
d.
None of the above
8. Summary
Legal environment refers to laws that govern the setting up and operation of the
business. It differs from country to country posing many problems for firms operating
internationally.
International law may be defined as the rules and principles that states and nations
accept as binding. Legal environments can be domestic, foreign or international.
There is no international body that makes rules and ensures that the parties follow them.
In the present scenario, a business incorporated in a particular country carries the burden
of complying with the laws of both the incorporating nation and the host country.
18

Extraterritoriality refers to the state in which certain diplomatic organizations and people
operating in a foreign country are exempted from the jurisdiction of the laws in that
country.
Intellectual property refers to ideas that are translated into tangible products, writings,
and so on, and that are protected by the state for a limited period of time from
unauthorized commercial exploitation.
Intellectual property rights broadly include patents, trademarks, copyrights, and trade
secrets.
Host countries enact laws to control foreign business in their economies. These laws
depend upon the countrys economic objectives and its obligations and position in
relation to worldwide commerce.
Laws that play a role regarding entry into foreign markets take several forms, including
tariffs, anti-dumping laws, export/import licensing, investment regulations, legal
incentives, and restrictive trading laws.
In global markets, conflicts are inevitable as different cultures come together to buy, sell,
compete, and engage in joint ventures. To avoid such problems, the parties involved
should prepare a contract that stipulates a particular legal system that is to take
precedence in resolving any contract dispute.
Government plays a major role in every national economy of the world.
The extent and nature of control varies widely between nations such as capitalist
economies, mixed economies, and totalitarian economies.
Government regulation of business may include a broad range of guidelines extending
from entry into the market, up to the final exit from the market.
There are two ways in which government can intervene to maximize societys welfare.
These are pareto efficient and pareto improvement.
9. Glossary
Domestic legal environment: In this environment, the laws of the home country govern
the business.
Dumping: A pricing strategy used by many companies to sell products in foreign
markets below costs, or below the price charged for the same to domestic customers.
Extraterritoriality: It refers to the state in which certain diplomatic organizations and
people operating in a foreign country are exempted from the jurisdiction of the laws in
that country.
Foreign legal environment: As the company crosses the national border, the company
and its practices will be governed by the laws of the host country.
International law: A collection of treaties and agreements between nations that is
(more or less) legally enforceable.
International legal environment: This environment is a combination of legal systems
and laws of various nations put together.
19

Pareto efficient (to maximize societys welfare): While allocating resources in a
society, if there is no way to reallocate resources to make at least a person better off
without making someone else worse off, such a situation is called a pareto efficient
situation.
Pareto improvement (to maximize societys welfare): If the resources can be
reallocated in such a way that at least one person is better off without making someone
else worse off, then such a situation is called a pareto improvement situation.
Tariff: A tariff is a tax that a government levies on exports and imports. Tax associated
with exports is called export duty, and tax associated with imports is called import duty
or customs duty.
Trademark: A word, symbol, or device that identifies the source of goods and may
serve as an index of quality.

1.
An understanding of the legal environment in the host country and knowledge of

the international business market is necessary for those involved in any business.
Explain the characteristics of operating in an international legal environment.
What are the various issues that need to be considered while operating
internationally?
2.
Host countries enact laws in several forms to control foreign business in their
economies. What are these forms?
3.
Conflicts are inevitable in global markets. Why do conflicts occur? How can they
be resolved?
4.
Government intervenes through regulations to ensure that producers and service

providers are reliable. Explain the role played by government in the regulatory
environment of business. What are the various ways in which the government can
regulate the business of an organization?
5.
The main aim of government intervention should be to maximize societys welfare.

How can the government intervene to maximize the welfare of the society?

1.
2.
Intellectual Property Rights

<http://dipp.nic.in/ipr.htm>
3.

<http://www.ias.ac.in/currsci/jun102000/editorial.pdf>
4.
Trade Secret
<http://en.wikipedia.org/wiki/Trade_secret>
5.
Trade Secret
<http://www.wipo.int/sme/en/ip_business/trade_secrets/trade_secrets.htm>
20

6.
Tariffs
<http://en.wikipedia.org/wiki/Tariff>
7.
Tariffs
<http://economics.about.com/cs/taxpolicy/a/tariffs.htm>
8.
Anti-dumping Laws
<http://commerce.nic.in/Anti-Dum.PDF>
9.
Anti-dumping Laws
<http://www.tariffcommission.gov.ph/anti-dum2.html>
10. Export Licensing

<http://www.infodriveindia.com/Exim/Guides/How-ToExport/Ch_7_Export_License.aspx>
11. Pareto Efficiency and Improvement
<http://wilcoxen.maxwell.insightworks.com/pages/225.html>
<http://en.wikipedia.org/wiki/Pareto_efficiency>
<http://www.economics.utoronto.ca/osborne/2x3/tutorial/PE.HTM>

1.
(c) International law

International law may be defined as the rules and principles that states and
nations accept as binding. It can also be defined as a collection of treaties and
agreements between nations that are (more or less) legally enforceable.
2.
(d) Only i, iii, and iv

The field of international law is complex. The two unique characteristics of
operating in an international legal environment are -- (a) The national law is not
applicable overseas. It is binding only till the trade goes on within the state or
nation, and (b) There is no international judicial and administrative framework or
a body of law that forms the basis of a comprehensive international system.
3.
(b) Statute law is also called British law and is followed by countries like the
UK, India, and the US.
All the statements are true except statement (b). Common law is also called British
law. It is followed by about 25 countries including the UK, India, and the US.
4.
(a) Statute law

Statute law guides countries by embodying the main rules of the law in
legislative codes. Thus, under this system, the interpretations of the law are strict
and literal. It is also known as code or civil law.
21

5.
(a) Domestic legal environment

Legal environments can be domestic, foreign or international. In the domestic
legal environment, the laws of the home country govern the business. Laws can
affect both imports and exports.
6.
(c) The company and its practices will be governed by the laws of the host
country as the company crosses the national border.
Under the foreign legal environment, the company has to conform to the laws of
the host country. As the company crosses the national border, the company and
its practices will be governed by the laws of the host country.
7.
(a) Only i and ii

The international legal environment is a combination of legal systems and laws
of various nations put together. There is no international law as such that
describes acceptable and legal behavior for organizations.
8.
(c) Either ii or iii

If the parties have not included jurisdiction clause in the contract, two alternative
courses of action are possible -- settle the dispute by following the laws of the
country where the agreement was made, or resolve the dispute by applying the
laws of the country where the contract has to be fulfilled.
9.
(c) Extraterritoriality
Extraterritoriality refers to the state in which certain diplomatic organizations
and people operating in a foreign country are exempted from the jurisdiction of
the laws in that country. For instance, ambassadors, diplomatic agents, military
bases, offices of the United Nations, etc., are some entities that are under the
state of extraterritoriality.
10. (b) Intellectual property

Intellectual property refers to ideas that are translated into tangible products,
writings, and so on, and that are protected by the state for a limited period of
time from unauthorized commercial exploitation. Intellectual property rights
broadly include patents, trademarks, copyrights, and trade secrets.
11. (c) Trademark
A trademark is a word, symbol, or device that identifies the source of goods and
may serve as an index of quality. It is primarily used to differentiate or
distinguish a product or service from another.
12. (d) They protect original literary, dramatic, musical, artistic, and certain
other intellectual works.
Copyrights protect original literary, dramatic, musical, artistic, and certain other
intellectual works. In some countries, registration is required for protection of
intellectual works, while in some, copyrights protection is offered without
registration. There are also some countries which offer little or no protection for
the works of foreign companies.
22

13. (d) It is any classified or confidential information that provides an edge to an
organization over its competitors.
A trade secret refers to any classified or confidential information that provides an
edge to an organization over its competitors. Trade secrets differ fundamentally
from patents, copyrights, and trademarks with regards to the protection aspect. It
is protected for an unlimited period of time as long as the secret is maintained.
They are protected without any registration or legal formalities.
14. (a) Tariff
A tariff is a tax that a government levies on exports and imports. Tax associated
with exports is called export duty, and tax associated with imports is called
import duty or customs duty.
15. (a) It is levied to discourage overseas selling to maintain adequate supply at
home.
Only statement (a) is true regarding export duty. Statements (b) and (c) pertain to
import duty.
Statements i and iii are true, while statement ii is false. Export duty is levied to
discourage overseas selling to maintain adequate supply at home.
17. (a) Subsidy
A subsidy, also known as reverse tariff, is also provided by many countries to
local manufacturers for exporting to other countries. It may also be provided to
local products to make them competitive against imports.
18. (a) Dumping
Dumping is a pricing strategy used by many companies to sell products in foreign
markets below costs, or below the price charged for the same to domestic
customers. It is done to capture a foreign market and to damage rival foreign
national companies.
19. (b) Export licensing
Export licensing allows for statistical tracking of export activities and helps in
ensuring that certain goods are not exported at all, or at least not to certain
countries. Import licensing helps in controlling the unnecessary purchase of
goods from other countries.
20. (b) Only i and iv
Statements i and iv are true regarding the role of government in regulating an
economy. Statements ii and iii are false. In democratic countries, the government
takes over the control and ownership of certain segments of the economy and the
rest is left to the private companies, which function under the guidelines and
regulations set by the government. In the mixed economy, the government plays a
dual role in relation to private business, and private enterprises co-exist with
government enterprises.
23

The government can use all the ways mentioned above to regulate the private
enterprises. Government regulation of business may include a broad range of
guidelines extending from entry into the market, up to the final exit from the
market.
22. (a) pareto efficient
The government can maximize societys welfare using two ways -- pareto
efficient and pareto improvement. While allocating resources in a society, if
there is no way to reallocate resources to make at least a person better off
without making someone else worse off, such a situation is called a pareto
efficient situation. If these resources can be reallocated in such a way that at least
one person is better off without making someone else worse off, then such a
situation is called a pareto improvement situation.
24
Unit 10
Tax Environment
Structure
1.
Introduction
2.
Objectives
3.
General Purposes of Taxation
4.
Types of Taxation Policy
5.
Features of an Ideal Tax System
6.
Summary
7.
Glossary
8.
9.
1. Introduction
In the previous unit, we have discussed about the legal and regulatory environments.
We have discussed how the governments worldwide intervene in the business of
organizations through their legal framework, and rules and regulations. We have seen
how the governments play a vital role in ensuring that the business is carried on in a
just and equitable environment, and that there is an overall development of the
economy.
In this unit, we will discuss how taxation affects the economy and the business of an
organization. Taxation forms a crucial part of all economies, as the funds collected
through taxes are used by the governments of various countries for public welfare and
for developing their economies. In business, the understanding of taxation
environment within the country of its operation is crucial as it affects the business
both directly and indirectly. For a company, a good understanding of the implications
of the taxation policy for the business gives it a clear picture of the environment
within which the business functions.
In this unit, we will discuss the tax environment. We will first look at the purpose of
taxation. We will then move on to discuss the various types of taxation policies.
Finally, we will look at the features or traits of an ideal tax policy.
2. Objectives
understand the general purposes of taxation.
examine the types of taxation policies.
study the features of an ideal tax system.
3. General Purposes of Taxation

Tax is a compulsory contribution imposed by the government, irrespective of the
exact amount of service rendered to the tax payer in return, and not imposed as a
penalty for any legal offence. Governments impose taxes for three main purposes.
Taxes are imposed in order to raise revenues, to promote economic goals, and to
promote social groups. These purposes are common to all countries worldwide.
3.1 Raise Revenues
Taxes are imposed on individuals, organizations, products and services. These are the
most important sources of revenue to the government. The revenues earned through
taxes are used in promoting the welfare of the society.
3.2 Economic Goals
Taxes also help in promoting economic goals of the governments. These goals may be
at the national level or at the individual industry level. The government may decrease
taxes to stimulate the economic activity, while may increase taxes to slow down
excessive growth in the economy. The government may also provide tax concessions
to certain industries to encourage them to perform better. For instance, some countries
give tax concessions in order to promote research and development activities. Some
countries impose high tariffs on the manufactured goods which are imported. This is
done to promote economic goals of protecting a domestic industry from competition
from foreign companies or of discouraging the outflow of foreign exchange reserves.
3.3 Social Goals
Taxes also help in promoting social goals. The government may increase taxes to help
the people affected by natural calamities. For instance, the revenues earned through
taxes may be contributed to relief and rehabilitation programs of people who have
been affected by the floods, earthquakes, etc. Taxes may also be imposed in order to
discourage or encourage certain social behavior. For instance, heavy taxes may be
imposed on liquor and tobacco. This helps in raising revenues at one end, while
decreasing their use at the other end.
Example: Tax Problems for Cairn Energy in India
In 1996-97, crude oil production in India was around 32.90 million tonnes (mt)
while consumption of petroproducts was around 79.16 mt. Indias gross import of
crude oil and petroproducts in the year touched 54.17 mt, at a cost of Rs 341.72
billion. To reduce the increasing gap between demand and production, the
Government of India proposed a new exploration and licensing policy (NELP) in
the 1997-98 budget, which was accepted in 1998.
Under the NELP, a total of 48 exploration blocks onland, offshore and deep-water
blocks were identified. The NELP aimed to increase the exploration of oil in India and
permit private, public, or joint venture partnerships in explorations. The government
signed 90 contracts, with investment of about US$ 4.4 bn. Also, additional fiscal
concessions were proposed for companies undertaking exploration in deep waters and
frontier areas for a period of seven years. The blocks under NELP were not subjected to
any cess by the state governments as against the old policy of paying cess to the
respective state governments where the block was identified.
Contd
26
Tax Environment
Contd
Cairn Energy PLC is an independent, public oil and gas exploration and production
company based in Edinburgh, Scotland. The firm explores for and produces oil and
natural gas offshore and onshore in Bangladesh and India. In 2004, after extensive
exploration and appraisal program across its 5,000 square kilometre onshore
exploration block, Cairn Energy announced a major oil find in Rajasthan. The
British company planned to start production in 2007, and estimated that it would
produce 80,000 to 100,000 barrels per day from its Mangala and Aishwariya fields
in Barmer district in Rajasthan.
Cairn Energy received formal approval from the Government of India for a Declaration
of Commerciality in respect of its oil discoveries in Rajasthan. This approval provided
Cairn an extensive Development Area, inclusive of all development, appraisal, and
exploration rights, across 1,858 square kilometers of the Thar Desert in Rajasthan. The
Development Area was to be retained until 2020 and further extension in retention was
possible with the consent of Government of India. Cairn also started work on
developing the proposed oil sites and contemplated submitting the Field Development
Plan to the Indian government in the first half of 2005.
The Oil and Natural Gas Corporation (ONGC), a major Indian public sector
company in the petroleum industry, has a right to a 30 percent stake in any
development area resulting from a commercial discovery in the block. Cairn owned
100 percent stake in the Rajasthan block as ONGC was reluctant to exercise its
right to buy a 30 percent stake in the block, as it would become liable to pay
statutory dues of royalty for itself and Cairn. ONGC argued that what it would get
out of taking a 30 percent stake in terms of crude oil was much less than what it
would have to pay as statutory levies. After persuasion from the Indian
government, it finally agreed to take a 30 percent stake. Thus, Cairn became the
operator of the field while ONGC was the licensee.
The Petroleum Ministry asked Cairn to pay a production tax (cess) of Rs. 900 per
tonne of crude oil it planned to produce from Barmer district. But Cairn refused to
pay the cess, claiming that the Rajasthan block was a pre-NELP block where
ONGC, as the licensee, was responsible for the payment of all statutory dues such
as royalty and cess.
Finally, the Petroleum Ministry referred the case to the Law Ministry. The Law
Ministry ruled that Cairn Energy would have to pay the proposed cess on the crude oil
as it planned to produce from Barmer district. The Ministry sought a clear written
commitment from the company that it would pay up the cess. Also, the Ministry
warned that failure to pay the cess would result in the transfer of entire fields to ONGC.
The Ministry clearly stated that the production sharing contract (PSC) for the Rajasthan
block clearly mentioned only the royalty that would be paid by ONGC but not the
payment of production cess. Since Cairn and ONGC were partners, both were ordered
to pay the cess in proportion to their shareholding (ONGC was thus liable to pay a part
of the cess and also royalty). Cairn disagreed with the Law Ministry ruling too and said
that it was ONGCs liability to pay the cess. It said that it could head for an arbitration
to resolve the dispute. As of September 2009, Cairn Energy appointed an arbitrator in
London to solve the dispute with ONGC over payment of cess.
Adapted from Case Study Cairn Energy: A Tryst with the Indian Market.
The ICMR Center for Management Research, 2005. www.icmrindia.org.
27
Activity: In February 2001, the Government of India announced that a 2%

surcharge would be levied on income tax and corporate tax. The Government stated
that this was a tax-oriented relief measure that was taken up for rebuilding and
rehabilitation of Gujarat, which was badly hit by earthquake on January 26, 2001.
In the given situation, what goal does the imposition of taxes serve? For what other
purposes are taxes imposed by the Government?
Answer:
Check Your Progress

1.
Which of the following refers to a compulsory contribution imposed by the

Government, irrespective of the exact amount of service rendered to the payer in
return?
a.
Tax
b. Rebate c.
Subsidy
d.
Foreign exchange
2.
For which of the following purposes are taxes imposed by Governments?
i.
To raise revenues
ii.
To promote economic goals
iii. To promote social groups

a. Only i and ii b.
Only i and iii
c.
Only ii and iii
d.
i, ii, and iii
3.
Identify the statement that holds true regarding the taxes imposed by the
Government in order to promote economic goals.
i.
The goals may be at the national level or at the industry level.
ii.
The Government may increase taxes to stimulate the economic activity, and
decrease taxes to slow down excessive growth in the economy.
iii. The Government may provide tax concessions to certain industries to motivate them.
iv. The Government may impose high tariffs on imported goods so as to protect a
domestic industry from competition from foreign companies.
28
Tax Environment
a.
Only i, ii, and iii
b.
Only i, ii, and iv
c.
Only i, iii, and iv
d.
4.
The Governments of some countries impose high tariffs on manufactured goods

which are imported in order to
a.
promote social goals.
b.
protect a domestic industry from competition from foreign companies.
c.
discourage the inflow of foreign exchange reserves.
d.
All of the above
5.
Which of the following are the social goals served through the imposition of taxes
by the Government?
i.
To protect the domestic industry from competition from foreign companies
ii.
To stimulate the economic activity and reduce the outflow of foreign exchange
reserves
iii. To discourage the consumption of harmful products such as liquor and tobacco
iv. To contribute the revenues toward relief and rehabilitation of people affected by
natural calamities such as floods and earthquakes
a. Only i and ii b.
Only i and iv
c.
Only ii and iii
d.
Only iii and iv
4. Types of Taxation Policy

Taxation policies can be divided into direct taxes and indirect taxes.
4.1 Direct Taxes
Direct taxes are paid by the person on whom it is legally imposed. They cannot be
passed on to someone else. Income tax and inheritance tax are the examples of direct
taxes.
4.2 Indirect Taxes
Indirect taxes are paid by one individual initially, but the burden of these taxes is
passed on to another who eventually bears the burden. Direct taxes are different from
indirect taxes. Direct tax is imposed on the tax payer by the government, while
indirect taxes are collected by the intermediary. In simple sense, indirect taxes are
collected by intermediaries like retailers from customers who eventually bear the
burden of the tax. Excise tax, sales tax, customs duty, value added tax etc., are the
examples of indirect taxes.
29

Compared to direct taxes, indirect taxes have certain advantages. Indirect taxes are
imposed on products and services, and not on individuals. Indirect taxes are paid by
individuals indirectly in the form of higher prices which include the taxes levied.
Thus, it reduces the resistance in paying these taxes. Indirect taxes are easier to
collect. These taxes can be easily recorded, verified, and controlled. Indirect taxes
cannot be evaded easily as compared to direct taxes. The government uses the revenue
collected through indirect taxes to provide subsidy and other benefits to develop
industrial growth in backward areas and high priority sectors of the economy.
There are also certain disadvantages. Indirect taxes are paid by all people, whether rich or
poor. Indirect taxes are also charged on the essential goods. These taxes increase the price
of the product or the service, and the customers have to pay more to buy the product or the
service. In case of imports of capital goods, if the indirect tax (customs duty) is high, it is
difficult to attract the best technology, which may contribute to good quality products and
services. To avoid payment of high customs duty, individuals or companies may resort to
unethical and illegal practices like smuggling.
5. Features of an Ideal Tax System

An ideal tax policy should be fair, neutral, and simple.
5.1 Fair
Tax payers must contribute their fair share in taxes. However, it is difficult to
determine the fair share in taxes for the tax payer. In most countries, the ability to
pay is adopted as a measure for determining the fair share. That is, those with
greater ability (more money) should pay more taxes. In most countries, the ability to
pay is decided by considering the net income of the individual or the business.
5.2 Neutral
An ideal tax system should be neutral. Taxes should be imposed on individuals,
organizations, products, and services alike. In situations, where the tax system does
not contribute to the economic or social goal, the main aim should be to mitigate the
interference with the decisions of the taxpayers. The tax system should be designed in
such a way that it does not benefit an industry at the cost of others. It should not favor
a competitor (or a group of competitors) within an industry. It should not influence the
choice of production factors or product outputs of a firm.
5.3 Simple
A tax system should not be complex to manage. The costs involved in the collection of
taxes should be low. Individuals and firms should not be able to avoid taxes. They should
be able to comply with the provisions of the law without spending much time and money.
The tax system should be in tune with the level of development of the country.
The simplicity feature of the tax system may conflict with the equity and neutrality
features. These conflicts can be solved based on the economic circumstances prevailing in
the country at the time when the tax system was implemented. Overall, the tax system
should be designed in such a way that it contributes to the growth and development of the
country. It should also meet the requirements of the business environment of the country.
30
Tax Environment
Example: VAT in India

Value Added Tax (VAT) came into effect in India on April 01, 2005. The first few
days of its implementation saw protests from different sections of society. Even
after two months of implementation of VAT, traders were worried and confused
over whether they have to pay more tax; consumers were afraid that they will have
to pay higher prices for commodities; and companies were unsure of whether they
stand to gain or lose. Certain states in India which have implemented VAT and
those which were to take it up had a common concern whether there will be an
increase in prices of products after implementation of the new tax system. There
were thus a lot of misconceptions and misinterpretations regarding VAT.
VAT is a tax structure intended to replace central sales tax and other state taxes.
Under VAT, which is a method of indirect taxation, a tax is levied on the value
added at each stage of a product being produced and sold and not on the gross sales
price. VAT is applicable to all goods, except those whose prices are not fully
market-determined. Under VAT, there are only two basic tax rates 4% and 12.5%
and a special rate of 1% for few selected items like gold, silver, and precious
stones. The surge in taxes under the pre-VAT tax regime was expected to be
avoided under the VAT system. At each level of the value chain, the tax is levied
only on the value addition to the product at that particular level.
In the pre-VAT regime, for example, if inputs worth Rs 100 were purchased for
producing final goods (output) worth Rs 200 in a month, then the total tax worked
out to Rs 24 with input tax paid at four per cent (Rs 4) and output tax paid at 10 per
cent (Rs 20). Under the VAT regime, the tax levied on sales of final goods worth
Rs 200 would work out to only Rs 16 [output tax of Rs 20 minus Rs 4 (Rs 4 set off
from Rs 20) as it had already been paid as input tax]. Thus, the total tax paid would
amount to Rs.20 at all stages (Rs 4 in the first stage and Rs 16 in the second stage).
With this system, traders and consumers can expect paying reduced total taxes
when compared with the previous system.
However, some analysts viewed that there would be an increase in the prices of
some commodities while there would be a reduction in the prices of others. This
was because some products that were being taxed lower, say, at 5%, may now be
taxed at 12.5% while others, based on their relevance, may be taxed at a rate much
lower than earlier, say at 4% under VAT.
VAT was not a new concept. In fact, more than 130 countries worldwide had
introduced it over the past three decades. Studies from countries that had
implemented VAT successfully had revealed that there was no direct evidence
from any country of price increase due to its introduction. In April 2005, 21 out of
the 28 states in India began implementing VAT. The states had been assured by the
Union Government that they would be fully compensated for any revenue losses
incurred during the fiscal year ending March 2006 due to the implementation of
VAT. The states were therefore liberally experimenting with VAT rates and with
the list of commodities under each slab.
Contd
31

Contd
Prior to VAT, the tax being levied on a particular product by one state was different
from the tax levied on it by the other state. VAT is intended to bring about
uniformity in the tax structure throughout the country. However, as some states had
still not accepted the VAT system, the process of implementing a uniform tax
structure throughout India was getting delayed.
Some analysts felt that the benefits of the VAT system to manufacturers, traders, and
consumers needed to be communicated properly so that all sections of the society in
India will accept it whole-heartedly. According to analysts, VAT should curb tax
evasion to a considerable extent and this would result in increased revenue generation to
the Government. It was reported that State Governments that have been implementing
the VAT system from April 01, 2005, saw at least a 25 per cent increase in revenues
from the new tax system as against the erstwhile sales tax system.
Adapted from Case Study India: Before and After VAT. The ICMR Center for
Check Your Progress
6.
Which of the following is paid by the person on whom it is legally imposed, and
cannot be passed on to someone else?
a.
Sales tax
b.
Direct tax
c.
Indirect tax
d.
Customs duty
7.
Identify from the following an example of direct tax.
a.
Sales tax
b.
Excise tax
c. Inheritance tax d.
Value added tax
8.
Identify the statement that holds true regarding indirect taxes.
a.
These are paid by the person on whom it is legally imposed, and cannot be passed
on to someone else.
b.
These are paid by one individual initially, but the burden of these taxes is passed
on to another who eventually bears the burden.
c.
Income tax and excise tax are examples of indirect taxes.
d.
These taxes are imposed by the government on the tax payer.
9.
Which of the following is not an advantage of indirect taxes?
a.
These are used by the government to provide subsidy and other benefits to
promote growth in backward areas.
b.
They are imposed on all people, irrespective of their position in the society.
c.
They can be easily recorded, verified, and controlled.
d.
None of the above
32
Tax Environment
10.
is not an indirect tax.
a. Sales tax
b. Excise tax
c. Inheritance tax d.
Value added tax
11.
a.
b.
c.
d.
Which of the following is not a feature of an ideal tax policy?

Fairness
Neutrality
Simplicity
Partiality
12. Which of the following statements is true regarding the neutrality feature of an
ideal tax system?
i. Taxes should be imposed on individuals, organizations, products, and services alike.
ii. The tax system should not favor a particular competitor within an industry.
iii. The tax system should influence the choice of production factors or product
outputs of a firm.
iv. The tax system should be designed in such a way that it does not benefit an
industry at the cost of others.
a. Only i, ii, and iii
b. Only i, ii, and iv
c. Only i, iii, and iv
d.
Activity: In the Union Budget presented in July 2009, the Finance Minister of
India proposed the following taxable annual income slabs and their respective tax
rates for the female citizens applicable for the financial year 2009-10.
Taxable Annual Income Slab (Rs.)
Tax Rate (%)
Upto Rs. 1,90,000/-
Nil
Rs. 1,90,001/- to Rs. 3,00,000/-
10%
Rs. 3,00,001/- to Rs. 5,00,000/-
20%
Rs. 5,00,001/- and Above
30%
The above given system satisfies which feature of an ideal tax system? What are
the other features that make up an ideal tax system?
Answer:
33
6. Summary
Taxation forms a crucial part of all economies, as the funds collected through
taxes are used by the governments of various countries for public welfare and for
developing their economies.
In business, the understanding of taxation environment within the country of its
operation is crucial as it affects the business both directly and indirectly.
penalty for any legal offence.
Governments impose taxes for three main purposes. Taxes are imposed in order
to raise revenues, to promote economic goals, and to promote social groups.
These purposes are common to all countries worldwide.
Taxation policies can be divided into direct taxes and indirect taxes.
passed on to someone else.
Income tax and inheritance tax are the examples of direct taxes.
passed on to another who eventually bears the burden
Excise tax, sales tax, customs duty, value added tax etc., are the examples of
indirect taxes.
An ideal tax policy should be fair, neutral, and simple. Tax payers must
contribute their fair share in taxes. Taxes should be imposed on individuals,
organizations, products, and services alike. A tax system should not be complex
to manage.
7. Glossary
Customs duty: An indirect tax which is levied on the import or export of goods.
Direct taxes: These are paid by the person on whom it is legally imposed. They
cannot be passed on to someone else.
Excise tax: An indirect tax levied on the production or sale of a product and/or a
service within a country.
Income tax: A direct tax levied on the income of individuals and business
organizations.
Indirect taxes: These are paid by one individual indirectlyinitially, but the burden of
these taxes is passed on to another who eventually bears the burden. That is, indirect
taxes are collected by intermediaries like retailers from customers who eventually
bear the burden of the tax.
Inheritance tax: A direct tax that arises on the death of an individual. It is levied on
the money or the property of a person who has died.
34
Tax Environment
Sales tax: An indirect tax that is levied at the point of purchase of certain products
and/or services. It is also known as a consumption tax. The tax is included either in
the price of the product and/or service or added at the point of sale.
Tax: A compulsory contribution imposed by the Government, irrespective of the
exact amount of service rendered to the tax payer in return. It is not imposed as a
Value-added Tax (VAT): An indirect tax levied on the value added at each stage of a
product being produced and sold and not on the gross sales price.
1.
Taxes are imposed in order to raise revenues, to promote economic goals, and to
promote social groups. Explain this statement in detail.
2.
An ideal tax policy should have certain traits or features. What are these traits?
3.
Taxation policies can be divided into direct taxes and indirect taxes. What are
direct taxes and indirect taxes? Explain the differences between these two.

1.
Singhania, Direct Taxes: Law & Practice, Taxmann Allied Services Pvt Ltd,
2009.
2.
V. S. Datey, Indirect Taxes: Law & Practice, Taxmann Allied Services Pvt Ltd,
22nd Edition, 2009.
3.
Tax
<http://en.wikipedia.org/wiki/Tax>
4.
Taxation and Government Intervention

<http://personal.ashland.edu/jgarcia/Microeconomics%20232/microeconomicspo
werpt/Chap007Govt%20intervention%20Taxes.ppt>
5.
Direct Tax
<http://en.wikipedia.org/wiki/Direct_tax>
6.
Direct Tax
<http://www.economywatch.com/budget/india/direct-taxes.html>
7.
Indirect Tax
<http://en.wikipedia.org/wiki/Indirect_tax>
8.
Indirect Tax
<http://www.economywatch.com/budget/india/indirect-taxes.html>
9.
Indirect Tax
<http://www.tara.tcd.ie/bitstream/2262/21440/1/jssisiVolII1_7.pdf>
10. Direct Taxes Versus Indirect Taxes

<http://tutor2u.net/economics/content/topics/fiscalpolicy/direct_v_indirect.htm>
35

1.
(a) Tax
2.
(d) i, ii, and iii

Governments impose taxes for three main purposes. Taxes are imposed in order
to raise revenues, to promote economic goals, and to promote social groups.
3.
(c) Only i, iii, and iv

All the statements hold true, except statement (ii). The government may decrease
taxes to stimulate the economic activity, while may increase taxes to slow down
excessive growth in the economy.
4.
(b) protect a domestic industry from competition from foreign companies.

Some countries impose high tariffs on manufactured goods which are imported.
This is done to promote economic goals of protecting a domestic industry from
competition from foreign companies or of discouraging the outflow of foreign
exchange reserves.
5.
(d) Only iii and iv

Taxes help in promoting social goals. The government may increase taxes to help
the people affected by natural calamities. Taxes may also be imposed in order to
discourage or encourage certain social behavior. For instance, heavy taxes may be
imposed on liquor and tobacco. This helps in raising revenues at one end, while
decreasing their use at the other end.
6.
(b) Direct tax

passed on to someone else.
7.
(c) Inheritance tax

passed on to someone else. Income tax and inheritance tax are the examples of
direct taxes.
8.
(b) These are paid by one individual initially, but the burden of these taxes is
passed on to another who eventually bears the burden.
passed on to another who eventually bears the burden. Direct tax is imposed on
the tax payer by the government, while indirect taxes are collected by
intermediaries like retailers. Excise tax, sales tax, customs duty, value added tax
etc., are the examples of indirect taxes.
36
Tax Environment
9.
(b) They are imposed on all people, irrespective of their position in the society.
All the statements are advantages of imposing indirect taxes, except statement
(b). Statement (b) is a disadvantage. Indirect taxes are paid by all people,
irrespective of their position in the society, whether they are rich or poor.
10. (c) Inheritance tax

Excise tax, sales tax, value added tax, etc., are examples of indirect taxes.
Inheritance tax is a direct tax.
11. (d) Partiality
An ideal tax policy should be fair, neutral, and simple. A tax policy should not be
partial to any particular individual or business entity. Taxes should be imposed on
individuals, organizations, products, and services alike.
12. (b) Only i, ii, and iv
All the statements are true regarding the neutrality feature of an ideal tax system,
except statement iii. The tax system should not influence the choice of production
factors or product outputs of a firm.
37
Unit 11
Ethics in Business
Structure
1.
Introduction
2.
Objectives
3.
Definition of Ethics
4.
Importance of Ethics in Business Macro Perspective
5.
6.
Importance of Ethics in Business Micro Perspective

Ethical Code
7.
Summary
8.
Glossary
9.

1. Introduction
In the last unit, we have learnt about how taxation affects the business of an
organization. We have read that taxes are imposed by the government for various
purposes such as to raise revenue, to promote economic goals, and to promote social
goals. In this unit, we will discuss about the ethical environment of business.
In the recent years, business ethics has gained importance with the increased
awareness that it is critical to a companys success. The intensity of consumer
movements and the rising level of awareness among the corporate stakeholders have
made companies realize that they can no longer get away with undesirable business
practices, and that business ethics and transparent operations enhance the companys
image. In the highly competitive environment, the company should ensure that its
operations enhance shareholders values as well as protect the other stakeholders
interests, especially the interests of the government and the society.
This unit provides an overview of the ethical environment of business. We will first
discuss the various definitions of ethics. We will then move on to understand the
importance of ethics in the field of business from macro as well as micro perspectives.
Finally, we would be discussing ethical codes such as the Cadburys code of ethics
and the Kumar Mangalam Birla report on corporate governance, which defines the
principles of appropriate behavior in organizations.
2. Objectives
understand the meaning and scope of business ethics.
examine how the unethical behavior distorts the market system and an individual firm.
study the ethical codes such as the Cadburys code of ethics and the Kumar Mangalam
Birla report on corporate governance.
Ethics in Business
3. Definition of Ethics
Different thinkers view the concept of ethics differently. In essence, they all agree that
ethics deals with right or wrong behavior of individuals. The word ethics is derived
from the Latin word ethicus and the Greek word ethikos, meaning character or
manners. Ethics can be defined as principles of morality or rules of conduct and moral
judgment that differentiates right from wrong. It is a system of rules that governs the
ordering of values. It identifies the rules that should govern peoples behavior and the
good principles that are desirable. Values are principles of conduct like honesty,
keeping of promises, pursuit of excellence, loyalty, fairness, and integrity. Ethical
responsibilities include behaviors and the activities that are expected of business by
members in the society. Business ethics refers to a set of rules, moral principles, and
standards that explain how organizations and their employees should behave in a
given situation. It has also been defined as the process of evaluating decisions, either
before or after they are made, considering the moral standards of the cultures in the
society. Ethical behavior is vital for the success of an organization in the long run,
both from the macro (economic system) and the micro (individual firm) perspectives.
4. Importance of Ethics in Business Macro Perspective

Countries depend on the market system to allocate goods and services. They presume
that a market system is a more efficient and effective way of allocating a countrys
resources than a command system (an economic system in which a central authority
allocates the countrys resources). A market system can work effectively if the people
have the right to own or control private property, if they have the freedom of choice in
buying and selling products and/or services, and if they have access to accurate
information concerning those products and/or services. An exchange takes place only
when the private property is owned. Freedom of choice in exchange allows the forces
of competition to maintain order in the market. Accurate information enables buyers
to locate desirable goods and services in the marketplace so that they can exercise
their freedom of choice.
In a market system, the total set of goods and services available in a country is
allocated to the people based on their individual purchases. Each person buys the
goods and services that he/she believes would satisfy their needs. The goods and
services are allocated in the most effective manner possible, i.e., according to the
perceived value by the individual buyers. An item valued at equal to or greater than its
price is purchased, while an item valued at less than its price remains unsold. Thus,
the market allocation of goods and services considers how the item is valued by the
buyers. This holds good as long as there is a close correlation between perceived value
at the time of purchase and during the actual use.
The problems occur when information concerning the goods or services is incorrect,
or when either the buyers or the sellers are not free to exchange. This leads to
improper functioning of the market system. People are sometimes forced to buy items
39

that provide less satisfaction as more such items are produced and fewer of the items
that provide more satisfaction as less of them are produced. Thus, the total satisfaction
is less with this sub-optional allocation than it would be with other allocations.
4.1 Effect of Unethical Behavior
Unethical behavior distorts the market system, leading to an inefficient allocation of
resources. Such behavior can take the form of bribery, deceptive information, coercive
acts, theft, and unfair discrimination. For the market system to function effectively, it
is vital to indulge in ethical behavior. Given below are the effects of unethical
behavior viewed from a macro perspective.
Bribery
A bribe makes a choice more attractive to a decision maker by enhancing the personal
gain associated with it. The Blacks Law Dictionary defines bribery as, the offering,
giving, receiving, or soliciting of any item of value to influence the actions of an
official or other person in discharge of a public or legal duty. Usually, the decision
maker is gifted or paid money to influence the decision maker and his/her decision or
action to the fulfillment of a task. This task may in reality be a less attractive one or
may provide less satisfaction in comparison to the other tasks. The decision maker
thus gains by selecting the alternative with the bribe. Bribery reduces freedom of
choice by changing the conditions under which a decision is made. It leads to
allocation of more resources to a less desirable alternative. Most often, the overall cost
of the alternative proves to be higher, as the cost of the bribe has to be recovered.
Deceptive Information
Deceptive information creates false impressions and makes buyers purchase products
that provide less satisfaction than those which would have been purchased using
correct information. Such information may also lead to goods or services being
delivered at times other than promised. This results in production delays, which in
turn leads to high cost of output, further forcing the buyer to pay more for a less
quality product. This also distorts the system as resources will be allocated to the
delivered items and not to those which are desired.
Coercive Acts
Preventing a seller from dealing with certain customers, preventing buyers from
purchasing from certain sellers, or preventing buyers from buying certain products
and/or services, etc., are certain coercive acts. Such acts decrease effective
competition, lead to higher prices, and result in inferior products and/or services being
provided. All these, in turn, lead to a decrease in the satisfaction of buyers. Demand is
low at a higher price; this results in fewer resources being allocated to produce
products and/or services in the future.
Theft
Theft increases the cost of producing products and/or services. Losses due to theft can
be recovered by earning large profit margins. This leads to increased prices, which in
turn reduces demand, and leads to misallocation of resources in worst situations. A
huge theft leads to the exit of a product and/or service from the market.
40
Ethics in Business
Unfair Discrimination
Sometimes, buyers may purchase products and/or services from suppliers who sell
low quality products and/or services. Also, sellers may sell their products and/or
services to people who value them less than those discriminated against. This leads to
unfair discrimination, and which in turn, may lead to the purchase of inferior products
and/or services and low satisfaction.
Check Your Progress

1.
Identify the term that can be defined as principles of morality or rules of conduct
and moral judgment that differentiates right from wrong.
a.
Ethics
b.
Morals
c.
Values
d.
Behavior
2.
are principles of conduct like honesty, keeping of promises, pursuit

of excellence, loyalty, fairness, and integrity.
a.
Ethics
b.
Morals
c.
Values
d.
Behavior
3.
Identify the statements that hold true regarding business ethics.
i.
It refers to the principles of conduct like honesty, keeping of promises, pursuit of

excellence, loyalty, fairness, and integrity.
ii.
It refers to a set of rules, moral principles, and standards that explain how
organizations and their employees should behave in a given situation.
iii. It is the process of evaluating decisions, either before or after they are made,
considering the moral standards of the cultures in the society.
a. Only i and ii b.
Only i and iii
c.
Only ii and iii
d.
i, ii, and iii
4.
All the statements given below are true regarding a market system, except:
a.
Countries depend on the market system to allocate goods and services.
b.
It is considered as a less efficient and effective way of allocating a countrys

resources than an economic system in which a central authority allocates the
countrys resources.
In this, the total set of goods and services available in a country is allocated to
people based on their individual purchases.
c.
d.
It functions improperly if the information concerning the goods or services is

incorrect, or when either the buyers or the sellers are not free to exchange.
41

5.
A market system can work effectively if:
i.
the people have the right to own and control private property.
ii.
the people are forced to buy fewer items that provide more satisfaction as less of
them are produced.
iii. the people have the freedom of choice in buying and selling products and/or
services.
iv. the people have access to accurate information concerning those products and/or
services.
a.
Only i, ii, and iii
b.
Only i, ii, and iv
c.
Only i, iii, and iv
d.
6.
Which of the following factors leads to an improper functioning of the market

system?
i.
Incorrect information pertaining to the goods or services
ii.
People are forced to buy items that provide less satisfaction as more such items
are produced
iii. Buyers or sellers are not free to exchange the goods or services
iv. Unethical behavior leading to an inefficient allocation of resources
a.
Only i, ii, and iii
b.
Only i, iii, and iv
c.
d.
i, ii, iii, and iv
7.
Which of the following statements hold true regarding bribing, an unethical

behavior that distorts the market system?
i.
A bribe makes a choice more attractive to a decision maker by enhancing the

personal gain associated with it.
ii.
The choice is more attractive, and generally provides more satisfaction.
iii. Bribery enhances the freedom of choice by changing the conditions under which
a decision is made.
iv. It leads to allocation of more resources to a less desirable alternative.
a.
Only i and ii
b.
Only i and iv
c.
Only ii and iii
d.
Only ii and iv
8.
Which of the following unethical behaviors creates false impressions and makes
buyers purchase products that provide less satisfaction than those which would
have been purchased using correct data?
a.
Bribe
b.
Theft
c.
Unfair discrimination
d.
Deceptive information
42
Ethics in Business
9.
Coercive acts in the market system such as preventing a seller from dealing with
certain customers, preventing buyers from purchasing from certain sellers, or
preventing buyers from buying certain products and/or services would
i.
lead to higher prices.
ii.
decrease the satisfaction of buyers.
iii. result in inferior products and/or services.

iv. decrease the effectiveness of competition.
a.
Only i, ii, and iii
b.
Only i, iii, and iv
c.
d.
i, ii, iii, and iv
10. Which of the following statements hold true regarding the unethical behaviors of
theft and unfair discrimination in the market system?
i.
Theft increases the cost of producing products and/or services.
ii.
Unfair discrimination may arise due to the purchase of products and/or services
from suppliers who sell low quality products and/or services.
iii. Theft leads to increased prices, which in turn reduces demand, and leads to
misallocation of resources in worst situations.
iv.
Unfair discrimination may arise due to selling of products and/or services to

people who value them less than those discriminated against.

Only i, iii, and iv
c.
d.
i, ii, iii, and iv
5. Importance of Ethics in Business Micro Perspective

Ethical behavior is a vital component for developing and maintaining trust in an
individual firm. L T Hosmer defined trust as, Trust is the reliance by one person,
group, or firm upon a voluntarily accepted duty on the part of another person, group,
or firm to recognize and protect the rights and interests of all others engaged in a joint
endeavor or economic exchange.
Trust can be of two types trust as expectations of technically competent performance
and trust as expectations of fiduciary responsibilities, both that apply within and
among businesses. People hired to work are expected to be competent. They represent
the interests of the external stakeholders when they deal with them. Business is mostly
done relying on a persons word or the expected honesty and decency of the other
party. Trust in the business setting reduces costs and improves efficiency.
Trust comprises three basic elements dependability, predictability and faith.
Dependability provides assurance that one can be counted on to perform as expected.
Predictability tends to eliminate surprises, which are not usually welcome in the
business environment. Faith is the belief that one will continue to be predictable and
dependable. Trust in a person or on a firm is developed based on experience. Trust, on
43

the experience that the other person, group, or firm will honor the duty to protect
rights and interests, lowers perceived risk. Thus, trust is a risk-reducing mechanism.
Trust plays a vital role in fostering supplier, customer, and employee relations.
5.1 Trust in Supplier Relations
Suppliers are the important stakeholders of an organization. They provide inputs such
as raw materials, products, and services to an organization that enables it to carry out
its business. Organizations try to develop long term relations with their suppliers. An
exchange relationship is based on trust between both parties that each will honor
his/her commitments.
Mutual trust between the organization and its suppliers leads to cooperation and
increases efficiency as each party gains faith that the other will act in a predictable and
dependable manner. Buyer earns the suppliers trust when all commitments are
honored and when a good credit standing is maintained. Suppliers trust is lost when a
buyer engages in questionable practices such as giving up one supplier for another in
an effort to gain a price advantage. Practices such as cheating and lying in order to
lower the price also reduce trust. Exchange relationships based on trust develop when
there is firmness and fairness in negotiations.
An exchange relationship provides several benefits for the buyer. The buyer gets a
dependable source of supply. Time previously spent on frequent checks on quality and
delivery can be more productively spent elsewhere if the supplier provides goods or
services of acceptable quality and provides them on time. In periods of scarcity when
supplies are difficult to procure, a good relationship with the old suppliers gives
buyers a better chance of obtaining the scarce items. Suppliers generally give
preference to customers with whom they have established an exchange relationship
before they cater to the others.
5.2 Trust in Customer Relations
The sales force links the organization with its customers. A sales person earns a
customers trust by being honest, competent, customer-oriented and likeable.
Customers rely on suppliers to provide products and services of acceptable quality on
time. In case of products, early deliveries lead to increase in storage costs. In case of
services, early deliveries may become useless if they are required at a later time. Late
delivery may lead to stoppage in production, in turn, leading to high costs.
Customers rely on salespeople if they need information on new and existing products
and services. Salespeople must be honest and competent enough to provide the
required information. They should also be able to provide information regarding
shipping alternatives and arrival dates. Failure to do these, would lead to loss in value
and trust.
Suppliers too benefit from exchange relationships as they provide an enduring
customer base. Customers who trust suppliers continue to buy from them, and new
customers also get added to the existing customer base. Suppliers also gain from
predictable sales. A stable or growing customer base ensures a constant source of
revenue.
44
Ethics in Business
5.3 Trust in Employee Relations
A climate of trust in an organization provides improved communication, greater
predictability, dependability, and confidence among its employees. It helps in
reducing employee turnover and resistance among employees. It also enhances
openness and willingness to listen and accept criticism non-defensively. Some factors
that promote trust among employees are open communication, involving workers in
decision making, sharing of critical information and sharing of perceptions and
feelings. In a study conducted at General Motors, it was found that five factors
appeared to be correlated with trust in ones employer. These are:
Perception of honest and open communication both up and down the organizational
ladder
Shared goals and values between workers and supervisors
Faith and consistent treatment of employee groups
Autonomy from close supervision, a sign of personal trust in employees
Feedback from and to management regarding employees performance and
responsibilities.
Example: Unfair Trade Practices at Christies an d
Sothebys
In the early 2000, Christies Inc. (Christies), a famous auction house based in
London, and its rival Sothebys Holdings, Inc. (Sothebys) also based in London,
were rocked by anti-trust investigations by the US Department of Justice (DoJ) for
collusion and indulging in unfair trade practices. It was learnt that the roots of the
scandal dated back to February 1993 when the then Chairmen of both the
companies, Sir Anthony Tennant (Tennant) of Christies and Alfred Taubman
(Taubman) of Sothebys, attended to a series of one-to-one meetings. Taubman
supposedly instructed Diana D. Brooks (Brooks), Former President, Sothebys to
fix the deal with Christopher Davidge (Davidge), the then CEO, Christies but to
leave his name out of it. Brooks and Davidge met several times during the six year
period. It was in these meetings that the price-fixing deal was hatched.
In 1993, as part of its arrangement with Sothebys, Christies increased its buyers
commission. Almost immediately, Sothebys followed suit. In 1995, Christies introduced
a fixed non-negotiable fee for sellers (or sellers commission) which was again followed
by Sothebys. In June 1996, the UK Office of Fair Trading announced that it was making
informal inquiries into the business practices at Christies and Sothebys which violated
Britains Fair Trading Act of 1973 and Competition Act of 1980.
In May 1997, the DoJ became suspicious of the business practices of Christies and
Sothebys and ordered the auction houses and several art dealers to submit documents
relating to correspondence between them. In December 1999, Davidge resigned from
his post, with a US$ 7 million severance package. In January 2000, sensing that antitrust investigations and other legal hassles would be heaped on the firm, Christies
lawyers worked out an arrangement with the DoJ. The arrangement, which required
Davidges cooperation with the DoJ came under the Antitrust Divisions Corporate
Leniency program. Christies cooperated fully with the investigating agency and
provided the anti-trust lawyers with evidence of misconduct. In exchange, the company
was exempted from some penalties resulting from the case.
Contd
45

Contd
In January 2000, as part of the arrangement with the DoJ, Davidge declared that
Christies together with rival Sothebys had resorted to price-fixing. Davidge
handed over the documents and other evidence that implicated the auction houses.
Davidge sought a conditional amnesty in exchange for the evidence. It was
estimated that the auction houses price-fixing deal had earned the firms more than
US$ 400 million in illicit gains through inflated commissions.
Soon after Davidges disclosure, the clients of Christies and Sothebys filed
hundreds of civil lawsuits against the auction houses which were consolidated into
a single class-action suit. In September 2000, the auction houses agreed to a US$
512 million settlement. As per the settlement, both the auction houses agreed to
pay US$ 206 million in cash and US$ 50 million in the form of discount
certificates to their clients.
Adapted from Case Study Ethical Issues at Christies, The ICMR Center for
Activity: Kshitij Enterprises (KE) is a trading company that supplies spare parts to
automobile manufacturers. The company has good relations with the spare parts
manufacturers, and thus enjoys the advantage of getting spare parts at a discounted
price as compared to its competitors. Evolve Private Limited (EPL) is a spare parts
manufacturer that entered newly into the market. To establish its presence, it started
approaching companies like KE. Most companies rejected the products offered by
EPL quoting quality issues. However, when it approached KE, the procurement
manager of the company accepted EPLs offer. It was later found that EPL paid a
huge amount to KEs procurement manager that prompted him to accept the offer.
Name the strategy adopted by EPL to get the offer from KE? Was it an ethical
strategy? Why and why not? Explain the impact of this strategy on the individual
firm and the market system.
Answer:
Check Your Progress

11.
can be defined as the reliance by one person, group, or firm upon a

voluntarily accepted duty on the part of another person, group, or firm to
recognize and protect the rights and interests of all others engaged in a joint
a. Trust b.
Ethics
c.
Values
d.
Behavior
46
Ethics in Business
12. Match the following elements of trust with their respective descriptions.
Element of trust
Description
i.
Dependability
p. Tends to eliminate surprises, which are not usually

welcome in the business environment
ii.
Predictability
q. The belief that one will continue to be predictable

and dependable
iii. Faith
a.
i/r, ii/q, iii/p
b.
c.
i/p, ii/q, iii/r

i/r, ii/p, iii/q
d.
i/q, ii/p, iii/r
r. Provides assurance that one can be counted on to

perform as expected
13. Which of the following statements holds true regarding the role played by trust in
supplier relations?
i. Mutual trust between the organization and its suppliers leads to cooperation and
increases efficiency as each party gains faith that the other will act in a
predictable and dependable manner.
ii.
Organizations can earn the suppliers trust when all commitments are honored
and when a good credit standing is maintained.
iii. Suppliers trust is lost when a buyer engages in questionable practices such as
giving up one supplier for another in an effort to gain a price advantage.
iv. Suppliers generally give preference to customers with whom they have
established an exchange relationship based on trust before they cater to the others.
a.
b.
Only i, ii, and iii

Only i, ii, and iv
c.
d.

i, ii, iii, and iv
14. Which of the following factors promote trust among employees?

i. Open communication
ii.
Giving workers a greater share in decision making
iii. Sharing of critical information

iv. Sharing of perceptions and feelings
a.
Only i, ii, and iii
b.
c.
Only i, ii, and iv

d.
i, ii, iii, and iv
15. In what way can trust in employee relations help an organization?

i. It helps in reducing employee turnover and friction among employees.
ii.
It also enhances openness and willingness to listen and accept criticism nondefensively.
iii. It provides improved communication, greater predictability, dependability, and

confidence among its employees.
47

a. Only i and ii b.
Only i and iii
c.
Only ii and iii
d.
i, ii, and iii
16. A study was conducted at General Motors in which it was found that five factors
appeared to be correlated with trust in ones employer. Which of the following is
not a factor found in the study?
a.
Faith and consistent treatment of employee groups
b.
Shared goals and values between workers and supervisors
c.
Autonomy from close supervision, a sign of personal trust in employees
d.
Perception of honest and open communication only up the organizational ladder
6. Ethical Code
A code of ethics is a document containing a list of principles prepared for the purpose
of guiding organization members when they encounter an ethical dilemma. Most
ethical codes address subjects such as employees conduct, community and
environment, shareholders, customers, suppliers and contractors, political activity, and
technology. Code of ethics also addresses topics such as conflicts of interest,
confidentiality of corporate information, misappropriation of corporate assets, bribery,
and political contributions.
A code of ethics must be carefully designed and implemented. Employees are more
likely to accept a code if managers and others affected by it are involved in its
development. Moreover, companies should make sure that the code specifies
procedures for handling violations and that the procedures are enforced fairly. Also,
the code should be revised to reflect changes in the companys product line or
competitive practices. In this section, we discuss the highlights of Cadburys code and
the Kumar Mangalam Birla Report on Corporate Governance. These documents
provide useful insights into Business Ethics.
6.1 Cadburys Code
In May 1991, The Cadbury Committee, chaired by Sir Adrian Cadbury, was appointed
by the UK government. The main purpose of the committee was to address the
financial aspects of corporate governance. The committee laid down certain
recommendations pertaining to the boards and accounting systems of the companies in
order to reduce the risks and failures involved in corporate governance. The
committee published its report in December, 1992. Given below are some of the
recommendations given by the committee:
Decision-making power should not be vested in a single person, i.e. there should be a
separation of the roles of chairman and chief executive.
Non-executive directors should act independently while giving their judgment on issues
of strategy, performance, allocation of resources, and designing codes of conduct.
48
Ethics in Business
A majority of directors should be independent non-executive directors, i.e. they should
not have any financial interests in the company.
The term of a director should not exceed three years. This can be extended only with the
prior approval of the shareholders.
There should be full transparency in matters relating to directors emoluments. There
should be a judicious mix of salary and performance related pay.
A Remuneration committee made up wholly or largely of non-executive directors,
should decide on the pay of the executive directors.
The Interim company report should give the balance sheet information and should be
reviewed by the auditor.
The pension funds should be managed distinct from the company.
There should be a professional and objective relationship between the board and the
auditors.
Information regarding the audit fee should be made public and there should be regular
rotation of the auditors.
6.2 Kumar Mangalam Birla Report
Business ethics relates to the decisions that managers make, while corporate
governance is concerned with the rules governing the organizations structure and the
exercise of power and control of the business of an organization.
In May 1999, the Securities and Exchange Board of India (SEBI) set up a committee
on corporate governance under the Chairmanship of Kumar Mangalam Birla. The
main objective of the committee was to view corporate governance from the
perspectives of the investors and shareholders, and promote and raise the standards of
corporate governance.
The committee gave certain recommendations, primarily focused on investors and
shareholders, who are the prime constituencies of SEBI1. These recommendations
pertained to the responsibilities and obligations of the boards and the management in
instituting good corporate governance systems. The recommendations were made
considering the fact that any code on corporate governance should be dynamic, and
should change with changing context and times.
Given below are some of the recommendations given by the committee.
The board should comprise executive and non-executive directors. At least, 50%
directors on the board should be non-executive directors. The number of independent
directors depends on the nature of the Chairman of the board. In case of a non-executive
Chairman, at least one-third of the board should comprise independent directors. In case
of an executive Chairman, at least half of board should be independent.
A non-executive Chairman should be entitled to maintain a Chairmans office at the
companys expense. He/she should be allowed reimbursement of expenses incurred in
the performance of his/her duties, thus enabling him/her to discharge the responsibilities
effectively.
1
SEBI responds to three groups that comprise the market. These are -- the issuers of
securities, the investors, and the market intermediaries.
49

The board should set up a qualified and independent audit committee. This would help
in enhancing the credibility of the companys financial disclosures, and in promoting
transparency.
There should be minimum three non-executive directors in the audit committee. The
majority should be independent, with at least one director having financial and
accounting knowledge.
The Chairman of the audit committee should be an independent director; the company
secretary should act as the secretary of the committee.
The audit committee should meet at least thrice a year. One meeting must be held before
finalizing of annual accounts and one every six months. The quorum should be either
two members or one-third of the members of the audit committee, whichever is higher.
The powers of the audit committee are to investigate any activity within its terms of
reference; to seek information from any employee; to obtain outside legal or other
professional advice; and to secure attendance of outsiders with relevant expertise, if it
considers this necessary.
A remuneration committee should be set up to determine on their behalf and on behalf
of the shareholders with agreed terms of reference, the companys policy on specific
remuneration packages for executive directors, including pension rights and any
compensation payment.
Board meetings should be held at least four times in a year, with a maximum time gap
of four months between any two meetings.
The board should clearly define the role of the management.
Disclosures relating to all material, financial, and commercial transactions must be made
by the management to the board, where they have personal interest, and which may
create a conflict of interest with the company.
Shareholders have a right to participate in, and be sufficiently informed on decisions
concerning fundamental corporate changes. They should not only be provided
information as under the Companies Act, but also informed about other decisions
relating to material changes such as takeovers, sale of assets or divisions of the
company, changes in capital structure which will lead to change in control or may result
in certain shareholders obtaining control disproportionate to the equity ownership.
While appointing a new director or re-appointing a director, the shareholders must be
provided with the following information a brief resume of the director; expertise in
specific functional areas, and names of companies in which the person also holds the
directorship and the membership of committees of the board.
All shareholders are entitled to receive the half-yearly declaration of financial
performance, including a summary of the significant events in the previous six months.
A board committee under the Chairmanship of a non-executive director should be
framed to specifically look into the redressal of shareholder complaints like transfer of
shares, non-receipt of balance sheet, and non-receipt of declared dividends. Such a
committee will help focus the attention of the company on shareholders grievances and
sensitize the management to the need to redress their grievances.
50
Ethics in Business
The institutional investors should maintain an arms length relationship with
management and should not seek participation at the board level which may make them
privy to unpublished price sensitive information. Given the weight of their votes, the
institutional shareholders can effectively use their powers to influence the standards of
corporate governance.
A separate section on corporate governance should be maintained in the annual reports
of companies, with a detailed compliance report on the corporate governance code.
Non-compliance with any section of the code and the reasons thereof should be
specifically highlighted. This will enable the shareholders and the securities market to
assess for themselves the standards of corporate governance followed by a company.
Example: Code of Ethics of CSI
Given below is the code of ethics of the Computer Society of India (CSI).
A member (all categories) of the CSI shall:
organize the resources available to him and optimize these in attaining the objectives
of his organization.
not misuse his authority or office for personal gains.
comply with the Indian laws relating to the management of his organization and
operate within the spirit of these laws.
conduct his affairs so as to uphold, project and further the image and reputation of the
CSI.
maintain integrity in research and publications.
As regards his/her organization, the CSI member should:
act with integrity in carrying out the lawful policy and instructions of his organization
and uphold its image and reputation.
plan, establish and review objectives and tasks for himself and his subordinates
which are compatible with the Codes of Practice of other professionals in the
enterprise, and direct all available effort towards the success of the enterprise rather
than of himself.
fully respect the confidentiality of information which comes to him in the course of
his duties, and not use confidential information for personal gain or in a manner
which may be detrimental to this organization or his clients.
not snoop around in other peoples computer files.
In his contacts and dealings with other people, demonstrate his personal integrity and
humanity and when called to give an opinion in his professional capacity, shall, to the
best of his ability, give an opinion that is objective and reliable.
As regards the Employees, CSI member should:
set an example to his subordinates through his own work and performance, through
his leadership and by taking account of the needs and problems of his subordinates.
develop people under him to become qualified for higher duties.
Contd
51
Contd
pay proper regard to the safety and well being of the personnel for whom he is
responsible.
share his experience with fellow professionals.
As regards the Clients, the CSI member should:
ensure that the terms of all contracts and terms of business be stated clearly and
unambiguously.
not use the computer to harm other people or to bear false witness.
be objective and impartial when giving independent advice.
As regards the Community, the CSI member should:
make the most effective use of all natural resources employed.
be ready to give professional assistance in community affairs.
not appropriate other peoples intellectual output.
always use a computer in ways that ensure consideration and respect for fellow
humans.
Source: Code of Ethics <http://www.csi-india.org/code-ethics>.
Activity: Stylus is a shoe manufacturing company. It has policies that define the
standards of conduct that it expects of its employees and suppliers. For instance, for
employees, the company expects that they should not engage in the conduct of
illegal activities, and should not indulge in drinking, smoking, gambling, fighting,
etc., while on the job. It also created a toll-free line for employees to report if any
law has been violated. It mandates that every year, employees should verify that
they have read and understood the policies. What are these policies called as?
Explain their importance to an organization.
Answer:
Check Your Progress

17.
a.
b.
c.
is a document prepared for the purpose of guiding organization

members when they encounter an ethical dilemma.
Vision statement
Code of ethics
Mission statement
d.
Corporate governance report
52
Ethics in Business
18. Identify the items that are included in a code of ethics.
i.
ii.
iii.
iv.
a.
b.
c.
d.
Employees conduct
Misappropriation of corporate assets
Conflicts of interest
Confidentiality of corporate information
Only i, ii, and iii
Only i, ii, and iv
i, ii, iii, and iv
19. Which of the following is not a recommendation given by the Cadbury

committee that was created to address the financial aspects of corporate
governance?
a.
Boards should have separate audit and remuneration committees made up entirely
of executive directors.
b.
Audit committees should meet with the external auditors at least once a year and
without executive directors.
c.
The directors term of office should run for no more than three years, without
shareholders approval.
d.
Independent directors should be fully independent and free from links with the
company, except for matters pertaining to remuneration and shareholding.
20. Which of the following are the recommendations given by the Kumar Mangalam
committee set up on corporate governance?
i.
A non-executive Chairman should be entitled to maintain a Chairmans office at

the companys expense. He/she should be allowed reimbursement of expenses
incurred in the performance of his/her duties, thus enabling him/her to discharge
the responsibilities effectively.
ii.
The board should set up a qualified and independent audit committee. This would
help in enhancing the credibility of the companys financial disclosures, and in
promoting transparency.
iii. The Chairman of the audit committee should be an independent director; the
company secretary should act as the secretary of the committee.
iv. The audit committee should meet at least thrice a year. One meeting must be held
before finalizing of annual accounts and one every six months. The quorum
should be either two members or one-third of the members of the audit
committee, whichever is higher.
a.
Only i, ii, and iii
b.
Only i, ii, and iv
c.
d.
i, ii, iii, and iv
21. Identify from the following statements, the powers of the audit committee.
i.
To investigate any activity within its terms of reference
ii.
To seek information from any employee
iii. To obtain outside legal or other professional advice

iv. To secure attendance of outsiders with relevant expertise, if it considers necessary
53

a.
Only i, ii, and iii
b.
Only i, ii, and iv
c.
d.
i, ii, iii, and iv
7. Summary
Ethics can be defined as principles of morality or rules of conduct and moral judgment
that differentiates right from wrong.
Business ethics refers to a set of rules, moral principles, and standards that explain how
Ethical behavior is vital for the success of an organization in the long run, both from
macro (economic system) and micro (individual firm) perspectives.
Unethical behavior distorts the market system, leading to an inefficient allocation of
resources. Such behavior can take the form of bribery, deceptive information, coercive
acts, theft, and unfair discrimination.
Ethical behavior is a vital component for developing and maintaining trust in an
individual firm. Trust helps in fostering good relations with suppliers, customers, and
employees.
A code of ethics is a document containing a list of principles prepared for the purpose of
guiding organization members when they encounter an ethical dilemma.
Ethical codes such as the Cadburys code and the Kumar Mangalam Birla report on
corporate governance have been laid down that define the principles of appropriate
behavior in organizations.
8. Glossary
Bribe: Bribe makes a choice more attractive to a decision maker by enhancing the
personal gain associated with it. This is done by paying an unearned income.
Business ethics: A set of rules, moral principles, and standards that explain how
Code of ethics: A document containing a list of principles prepared for the purpose of
guiding organization members when they encounter an ethical dilemma.
Ethical responsibilities: Behaviors and activities that are expected of business by
members in the society.
Ethics: Principles of morality or rules of conduct and moral judgment that differentiates
right from wrong.
Trust: It is the reliance by one person, group, or firm upon a voluntarily accepted duty
on the part of another person, group, or firm to recognize and protect the rights and
interests of all others engaged in a joint endeavor or economic exchange.
Values: Principles of conduct like honesty, keeping of promises, pursuit of excellence,
loyalty, fairness, and integrity.
54
Ethics in Business
1.
Ethics identifies the rules that should govern peoples behavior and the good
principles that are desirable. Define ethics.
2.
Ethical behavior is vital for the success of an organization in the long run, both
from the macro (economic system) and the micro (individual firm) perspectives.
Substantiate this statement.
The Cadbury committee laid down certain recommendations pertaining to the boards
and accounting systems of the companies in order to reduce the risks and failures
involved in corporate governance. What were the recommendations given by the
Cadbury committee?
The Kumar Mangalam Birla committee was set up to view corporate governance from
the perspectives of the investors and shareholders, and promote and raise the standards
of corporate governance. In this regard, highlight the recommendations given by the
committee.

1.
Weiss, Business Ethics: Concepts and Cases, Thomson Business Information,

2009.
2.
Ethics
<http://en.wikipedia.org/wiki/Ethics>
3.
Importance of Ethics in Business Environment

<http://www.articlesbase.com/ethics-articles/purpose-of-ethics-in-a-businessenvironment-610589.html#>
4.
Relationship with Stakeholders

<http://www.albany.edu/~pm157/research/stakeholders.pdf>
5.
Cadbury Committee Report

<http://business.gov.in/corporate_governance/cadbury_report.php>
6.
Cadbury Committee Report

<http://www.krannert.purdue.edu/centers/CIBER/publications/pdf/99-004.pdf>
7.
Kumar Mangalam Birla Report

<http://www.sebi.gov.in/commreport/corpgov.html>

1.
(a) Ethics
The word ethics is derived from the Latin word ethicus and the Greek word
ethikos, meaning character or manners. Ethics can be defined as principles of
morality or rules of conduct and moral judgment that differentiates right from
wrong. It is a system of rules that governs the ordering of values.
55

2.
(c) Values
Ethics is a system of rules that governs the ordering of values. Values are
principles of conduct like honesty, keeping of promises, pursuit of excellence,
loyalty, fairness, and integrity.
3.
(c) Only ii and iii

Statements ii and iii hold true regarding business ethics. Statement i gives the
definition of values.
4.
(b) It is a less efficient and effective way of allocating a countrys resources

than an economic system in which a central authority allocates the countrys
resources.
All the statements are true regarding a market system, except statement b. The
market system is considered as a more efficient and effective way of allocating a
countrys resources than a command system (an economic system in which a
central authority allocates the countrys resources).
5.
(c) Only i, iii, and iv

Statements i, iii, and iv are all factors that contribute to the effective functioning
of the market system, except statement ii. People are sometimes forced to buy
items that provide less satisfaction as more such items are produced, and fewer of
the items that provide more satisfaction as less of them are produced. This
behavior distorts the market system.
6.

A market system may function improperly when information concerning the
goods or services is incorrect, or when either the buyers or the sellers are not free
to exchange. Unethical behavior also distorts the market system, leading to an
inefficient allocation of resources.
7.
(b) Only i and iv

Statements i and iv are true regarding bribery, whereas statements ii and iii are
false. A bribe makes the choice less attractive, and generally provides less
satisfaction. It reduces the freedom of choice by changing the conditions under
which a decision is made.
8.
(d) Deceptive information

Deceptive information creates false impressions and makes buyers purchase
products that provide less satisfaction than those which would have been
purchased using correct information. Such information may also lead to goods or
services being delivered at times other than promised.
56
Ethics in Business
9.

Preventing a seller from dealing with certain customers, preventing buyers from
purchasing from certain sellers, or preventing buyers from buying certain
products and/or services, etc., are certain coercive acts. Such acts decrease
effective competition, lead to higher prices, and result in inferior products and/or
services being provided. All these, in turn, lead to a decrease in the satisfaction of
buyers.

All the statements are true regarding theft and unfair discrimination. Both these
are unethical behaviors that distort the market system.
11. (a) Trust
L T Hosmer defined trust as, Trust is the reliance by one person, group, or firm
upon a voluntarily accepted duty on the part of another person, group, or firm to
recognize and protect the rights and interests of all others engaged in a joint
12. (c) i/r, ii/p, iii/q
Trust comprises three basic elements -- dependability, predictability, and faith.
Dependability provides assurance that one can be counted on to perform as
expected. Predictability tends to eliminate surprises, which are not usually
welcome in the business environment. Faith is the belief that one will continue to
be predictable and dependable.
All the statements given above are true regarding the role played by trust in
supplier relations. Suppliers are the important stakeholders of an organization as
they provide inputs such as raw materials, products, and services to an
organization that enables it to carry out its business. Organizations try to develop
long term relations with their suppliers.
All the factors given above promote trust among employees. A climate of trust in
an organization provides improved communication, greater predictability,
dependability, and confidence among its employees.
A climate of trust in an organization provides improved communication, greater
predictability, dependability, and confidence among its employees. Some factors
that promote trust among employees are -- open communication, involving
workers in decision making, sharing of critical information, and sharing of
perceptions and feelings.
57

16. (d) Perception of honest and open communication only up the organizational
ladder
In a study conducted at General Motors, it was found that five factors appeared
to be correlated with trust in ones employer. These are: perception of honest and
open communication both up and down the organizational ladder; shared goals
and values between workers and supervisors; faith and consistent treatment of
employee groups; autonomy from close supervision, a sign of personal trust in
employees; and feedback from and to management regarding employees
performance and responsibilities.
17. (b) Code of ethics
A code of ethics is a document containing a list of principles prepared for the
purpose of guiding organization members when they encounter an ethical
dilemma.
Most ethical codes address subjects such as employees conduct, community and
environment, shareholders, customers, suppliers and contractors, political
activity, and technology. Code of ethics also addresses topics such as conflicts of
interest, confidentiality of corporate information, misappropriation of corporate
assets, bribery, and political contributions.
19. (a) Boards should have separate audit and remuneration committees made
up entirely of executive directors.
All the statements are true regarding the recommendations given by the Cadbury
committee, except for statement (a). Boards should have separate audit and
remuneration committees made up entirely of independent directors.
All the given statements are the recommendations given by the Kumar
Mangalam committee on corporate governance. The main objective of the
committee was to view corporate governance from the perspectives of the
investors and shareholders, and promote and raise the standards of corporate
governance.
All the statements given above are the powers of the audit committee. These
were recommended by the Kumar Mangalam committee on corporate
governance.
58

Course Components
BLOCK I
Unit 1
Unit 2
Unit 3
Unit 4
BLOCK II
Unit 5
Unit 6
Unit 7
Trade Environment
Unit 8
BLOCK III
Unit 9
Unit 10
Tax Environment
Unit 11
Ethical Environment
BLOCK IV
Business Contracts
Unit 12
Law of Contracts
Unit 13
Special Contracts
BLOCK V
Unit 14
Unit 15
BLOCK VI
Tax Laws
Unit 16
Direct Taxes
Unit 17
Indirect Taxes
Business Environment and Law
Block
4
BUSINESS CONTRACTS
UNIT 12
Law of Contracts
UNIT 13
Special Contracts
54
Expert Committee
Dr. O. P. Gupta
Vice Chancellor
IU, Nagaland
Prof. Hilda Amalraj

IBS Hyderabad
Prof. Bratati Ray

IBS Kolkata
Prof.Marzun E Jokhi
IBS Ahmedabad
Dr. B.Padma
IBS Bangalore
Dr. Vijaya Lakshmi S

IBS Hyderabad
Dr. Vunyale Narender

IBS Hyderabad

Prof. T.S.Rama Krishna Rao
Prof. Vivek Gupta

Ms. C.Padmavathi
Ms.Pushpanjali Mikkilineni
Ms. Sunitha Suresh

Prof. Tarak Nath Sha

IU, Dehradun
Ms. Anita
Ms.Padmaja
IU, Meghalaya
Ms. Mrudula
Ms.Anurita Jois
IU, Sikkim

For a n y clarification regarding this book, the students may please write to The ICFAI University
Press specifying the unit and page number.
BLOCK 4
BUSINESS CONTRACTS
This is an introductory block on business laws. Contract law is the basic structure of
business law and every type of business involves the contracts in one form or the other. In
this block we briefly review the essential features of a contract, the various types of
contracts, the requirements of parties to the contract, and the features of special contracts
such as Guarantee contracts, Indemnity contract, the modes of performance and remedies in
case of breach of a contract.
Unit 12 outlines the general principles and rules governing contracts. This is discussed with
reference to the Indian Contract Act, 1872 which deals with the essential features of a valid
contract and the competence of parties to the contract. It also discusses the various remedies
available to the parties in the event of breach of a contract.
Unit 13 deals with features, types, rights & duties of parties in the case of special contracts
such as contract of agency, contracts of guarantee, contracts of indemnity, and employment
contracts.
It also deals with special rights available to parties in a contract. A brief discussion on the
various important clauses in commercial contracts and procedural aspects of documentation
has been discussed to fine-tune the legal skills.
UNIT 12 LAW OF CONTRACTS

Structure
12.1
Introduction
12.2
Objectives
12.3
A Contract
12.4
Legal Elements of a Valid Contract

12.4.1 Free Consent of the Parties
12.4.2 Capacity to Contract
12.4.3 Offer and Acceptance
12.4.4 Consideration
12.4.5 Intention to Create Legal Relationship
12.4.6 Lawful Object
12.4.7 Performance
12.4.8 Void Agreements
12.4.9 Legal Formalities
12.5
Classification of Contracts/Agreements
12.6
Valid Contracts and Limitations

12.6.1 Limitation as to Competence
12.6.2 Considerations and Limitations
12.6.3 Free Consent of the Parties and Limitations
12.7
Voidable Contracts
12.8
Remedies for Breach of Contract

12.8.1 Suit for Recession
12.8.2 Suit for Injunction
12.8.3 Suit for Specific Performance
12.8.4 Suit for Damages
12.8.5 Suit for Quantum Meruit
12.9
Summary
12.10 Glossary
12.11 Suggested Readings/Reference Material
12.12 Suggested Answers
12.13 Terminal Questions
12.1 INTRODUCTION
The daily life of an individual is governed by innumerable agreements such as the purchase
of a bus ticket, a cool drink, or giving a vehicle for repairs, which all involve contracts.
However, the Law of Contracts focuses not only on these simple consumer transactions but
also on more complicated commercial transactions taking place between corporates.
All these contracts as such create legal rights and obligations.
The law of contracts is considered as a part of the law of obligations. A contract creates
self-imposed obligations. It establishes the reciprocal responsibilities of the parties along
with the extent and standard of their performances. Further, a contract also facilitates the
allocation of burden of risk in case of any contingency in advance. Finally, it also makes
allowance for any loss arising out of any mishap or non-happening of any event. In this
unit we shall deal with all the important aspects of contract law.
12.2 OBJECTIVES
After going through the unit, you should be able to:
Summarize the essential elements of a valid contract;
Assess the position of a minor and a person of unsound mind in contracts;
Identify and differentiate voidable contracts from void contracts;
Determine ways by which a contract is discharged by performance; and
List out the remedies for breach of a contract.
12.3 A CONTRACT
A contract is the result of a promise to do a certain thing in exchange for a promise from
another person. Contract law assures that the promise so made is legally enforced, if any
one of the parties fails to abide by the contract.
A contract is said to create a legal bond a vinculum juris. This arises only when the
parties have intended to create a legal relationship between them. The infringement of such
obligations will make the parties liable to the extent of the loss suffered by the aggrieved
party for non-performance of the agreed act.
Non-business, religious or charitable agreements need not be contracts. Casual agreements
between friends and family or household agreements are not held as contracts. This can be
observed from the following case.
Balfour vs. Balfour: Balfour was employed in Ceylon and he promised to send his wife,
40 pounds a month so long as they had to remain separate. The wife owing to her ill health
had to stay in England and could not accompany him to Ceylon. Subsequently the husband
failed to send the money as agreed. The wife sued for breach of contract. It was held that
this agreement was not a contract enforceable in a Court of Law.
Although many variations have occurred over the years the basic concept of contract
remains the same, as evident from the following:
A contract irrespective of the content must be a binding agreement, between the parties.
Contract consists of reciprocal promises that the law will enforce.
A contract is an agreement between two or more parties that establishes an

enforceable legal relationship.
An agreement between two or more parties, which creates an obligation to do or not to

do a particular thing.
All contracts are agreements, but not all agreements are contracts.
Agreements often deal with personal or social matters that cannot be enforced by law.
If an agreement imposes a legal obligation, it results in an enforceable contract.
However, if it imposes merely a social or moral obligation, it is not a contract as it is

not legally enforceable.
Law of Contracts
All the definitions of contract refer to agreements between individuals; which are
enforceable by law. Thus, the two basic requirements of a contract are:
An agreement.
Legal enforceability.
According to Section 2(h) of the Contract Act, An agreement enforceable by law is a

contract.
According to Section 2(e) of the Act, Every promise and every set of promises, forming
the consideration for each other, is an agreement.
Section 2(b) defines a promise as: When the person to whom a proposal is made signifies
his assent thereto, the proposal is said to be accepted. A proposal when accepted becomes a
promise.
Section 2(a) defines a proposal as: When one person signifies to another his willingness to
do or to abstain from doing anything, with a view to obtaining the assent of that other to
such act or abstinence, he is said to make a proposal.
Thus, a contract is an agreement; an agreement is a promise and a promise is an accepted
proposal.
AGREEMENT
An agreement comes into being only when one party makes a proposal or offer to the other
party and that other party signifies his assent thereto. Thus, an agreement is an offer
coupled with acceptance. There emerge two essentials of an agreement which are:
Plurality of persons.
Consensus ad idem.
Plurality of Persons: Obviously an agreement is between two or more persons as a person

cannot enter into an agreement with himself or with an inanimate object.
Consensus ad idem: One of the most essential elements in the making of a contract is that
the promisor and the promisee must agree about the same thing in the same sense. There
should be a meeting of minds. The identity of minds is called consensus ad idem. This is
the theory underlying the formation of contracts. In a contract of sale of house between A
and B where A has two houses in Hyderabad and Chennai respectively; and A intends to
sell his house at Hyderabad but B intends to buy As house at Chennai, there is no
consensus ad idem between the contracting parties and hence no valid contract ensues.
12.4 LEGAL ELEMENTS OF A VALID CONTRACT

Section 10 of the Indian Contract Act, 1872 describes the requirements of a valid contract.
According to this Section, All agreements are contracts if they are made by the free
consent of parties competent to contract for a lawful consideration and with a lawful object,
and are not hereby expressly declared to be void.
Nothing herein contained shall affect any law in force in India and not hereby expressly
repealed, by which any contract is required to be made in writing or in the presence of
witnesses, or any law relating to the registration of documents.
From this definition we understand that an agreement becomes a contract when it involves
competent parties, valid consideration, free consent and legal object.
The following are the essential elements of a valid contract:
1.
Free Consent,
2.
Capacity to Contract,
3.
Offer and Acceptance,
4.
Consideration,
5.
Intention to Create Legal Relationship,

7
6.
Lawful Object,
7.
Certainty and Possibility of Performance,
8.
Not Expressly Declared Void, and
9.
Legal Formalities.
12.4.1 Free Consent of the Parties

The parties must have entered into the contract out of their own free will. Consent implies
agreeing upon the same thing in the same sense. According to Section 14 of the Act, the
consent is said to be free when it is not caused by:
Coercion, as defined in Section 15, or
Undue influence, as defined in Section 16, or
Fraud, as defined in Section 17, or
Misrepresentation, as defined in Section 18, or
Mistake, subject to the provisions of Section 20-22.
12.4.2 Capacity to Contract

One of the essentials of a valid contract, mentioned in Section 10, is that the parties to the
contract should be competent to make the contract. According to Section 11:
Every person is competent to contract who is of the age of majority according to the law to
which he is subject, and who is of sound mind, and is not disqualified from contracting by
any law to which he is subject.
Thus, the law of contract declares that a person competent to contract shall be:
a major;
of sound mind; and
not disqualified under any existing law in force.
12.4.3 Offer and Acceptance

An agreement presupposes an offer by one party which is accepted by another party.
Therefore one without the other does not bring an agreement into existence which can be
legally enforced. Mere offer does not conclude a contract unless it is accepted by the other
party to the contract. It is in this aspect that distinction is sought to be made between an
offer and an invitation to offer. Thus a proposal or offer is the starting point to initiate an
agreement which could finally lead to a contract. There must be a lawful offer and a
lawful acceptance for a valid contract. The following figure gives an outline of the
concepts covered under offer and acceptance:
Source: Smith & Keenans. Advanced Business Laws.

Figure 1
8
Law of Contracts
RULES FOR A VALID OFFER

Proposal has been used as a synonym for the term offer as used under the English Law.
Thus, the offer or proposal must be made with a view to obtain the acceptance of the person
to whom it is made. If a statement is made without this intention then it remains a mere
statement and not a valid offer. The person who makes the offer is called the offeror/
promisor and the person to whom the offer is made is called the offeree/promisee. From
the definition of a proposal as mentioned in Section 2(a) of the Indian Contract Act, the
following propositions follow:
It must be an expression of the willingness to do or abstain from doing a particular act.
The willingness must be communicated to another person.
It must be communicated with an intention to receive the assent of the other person for
such an act or abstinence. Therefore, a mere enquiry or statement of intention does not
amount to an offer.
KINDS OF OFFER
Offers can be categorized into different classes as given below:
General or Specific Offers: An offer may be made either generally, to the whole world
or specifically to an individual or group of individuals. The former is called the general
offer and the latter, specific offer. A general offer is made to the world at large or to the
general public and may be accepted by any person who fulfills the necessary conditions.
The case of Carlill vs. Carbolic Smoke Ball Co. is an instance of general offer. On the
other hand if the offer is made to a particular person(s), it may be accepted only by those
person(s). Any other person fulfilling the requisite conditions under the offer cannot
claim any reward or compensation. No right of action accrues to persons other than those
to whom the offer is made. Thus where X makes an offer to sell his library to the
College, Z alone can accept it.
Express or Implied Offers: An offer may be made either in words, spoken or written or
can be inferred from the conduct of the parties. Thus offers can be the express and implied
offers respectively. When R writes a letter to S offering to sell his car for Rs.2 lakh, it is an
express offer. If D purchases an air ticket and boards a flight to go to Delhi; it is a case of
an implied offer. The offer is made by the airlines company to take passengers to scheduled
places at scheduled fares.
Positive or Negative Offers: An offer to do something is a positive offer, whereas an offer
not to do something is a negative offer. For example, if C offers to sell his house to D, it is
a positive offer. If C offers not to interfere in Bs business if B agrees to shift his place of
business to another locality, it is a negative offer.
Counter-offer: A counter-offer is a situation wherein the offeree attempts to change the
terms of the offer initially made by the offeror. A counter-offer implies rejection of the
original offer. The consequences of a counter-offer can be seen in Hyde vs. Wrench,
involving some proposed negotiations between the defendant and the plaintiff regarding a
farm. Wrench offered to sell his farm for 1,000 pounds. Hyde offered 950 pounds, which
Wrench rejected. Hyde then informed Wrench that he accepted the original offer. Such an
acceptance is not binding as a counter-offer itself implies the rejection of the original offer.
Hence, there was no contract as the defendant did not consider himself to be bound by the
agreement and the claimant sued for specific performance. It was held, that the claimant
cannot claim as the counter-offer was a deemed rejection of the original offer to sell at 950
pounds. In Stevenson vs. Mc Lean, it was observed that a counter-offer must not be
mistaken with a request for information. A request for information can be accepted even
after the new information has been provided.
9
ACCEPTANCE
Acceptance is the next step of an offer. Unless and until an acceptance is communicated
to the offeror, it cannot be held as a valid and an effective acceptance. Acceptance takes
place only when the offeree gives his consent to the terms of the offer. Just as in case of
offer, acceptance may also be express or implied. An acceptance is said to be express
when it is communicated by words spoken or written or by doing some required Act. It is
implied when it is to be gathered from the surrounding circumstances or the conduct of
the parties. In an auction sale, the highest bidder is assumed to be the buyer of the goods
once the deal is struck.
An acceptance must be clear and unconditional. The acceptance becomes invalid if the
terms of the offer differ from the original offer, at the time of acceptance or after
acceptance. An acceptance can be valid even after the difference in terms of offer, if
the terms of counter-offer are acceptable to the original offeror. Counter-offer
terminates the original offer, if the terms of counter-offer are not acceptable to the
original offeror. A counter-offer or conditional acceptance operates as a rejection of the
offer and causes it to lapse.
In order to convert an offer into a promise, acceptance should be absolute and unqualified.
It is also essential that the acceptance is given in some usual and reasonable manner. If the
offer prescribes the manner in which the acceptance is to be given, then the acceptor should
adhere to the prescribed mode. On failure to do so, the offeror can insist that his offer will
be accepted only if it is given in the prescribed manner.
The following are the essential conditions for a valid acceptance:
It must be made by the offeree.
It should be absolute and unqualified.
It shall be in a prescribed form.
It should be within the specified time.
Communication of acceptance.
Acceptance during the course of negotiations.
Acceptance must be positive.
Lapse and Revocation of Offer and Acceptance

An offer or acceptance extinguishes in some circumstances. The figure below states the
circumstances under which an offer lapses.
Making the Contract
Termination of Offer
Revocation
General
Lapse of time
Unilateral contracts
Figure 2
10
Counter-offers
Effect of death
Law of Contracts
Lapse or Termination of an Offer

An offer may lapse under any of the following circumstances:
When the Offer is not Accepted in the Prescribed Mode: Section 7(2) of the Act lays
down that In order to convert a proposal into a promise, the acceptance must be
expressed in some usual and reasonable manner, unless the proposal prescribes the
manner in which it is to be accepted. If the proposer prescribes a manner in which it is to
be accepted and the acceptance is not made in such manner, the proposer may, within a
reasonable time after the acceptance is communicated to him, insist that his proposal
shall be accepted in the prescribed manner and not otherwise, but if he fails to do so, he
accepts the acceptance.
Thus, it is the responsibility of the offeror to intimate to the offeree/acceptor, the mode of
acceptance to be made. In case the acceptor/offeree deviates from the prescribed mode and
makes acceptance in an alternative way, and the offeror does not protest the deviation, he is
deemed to have accepted the new method of acceptance.
When it is not Accepted within the Prescribed Time: An acceptance communicated after
the time prescribed by the offeror has lapsed cannot revive the offer and hence cannot result
in a valid contract. However, if no time is prescribed, the acceptance has to be
communicated within a reasonable time. If an offer is not accepted within the specified
period, it lapses at the end of that particular specified period. In case of perishable goods
such as food, a reasonable time would likely be in terms of days. The term reasonable
time would be longer, where the subject matter of the contract is a building.
By Rejection or Counter-Offer: If the offeree has rejected the offer, the offer terminates.
The offeree cannot subsequently accept an offer so rejected. When the offeree makes a
counter-offer or gives a conditional acceptance, it amounts to implied rejection, thereby
resulting in lapse of the offer.
By Death or Insanity of Either Party to the Contract: An offer lapses if the offeror dies
or becomes insane before its acceptance and such a fact comes to the knowledge of the
offeree. Thus, an acceptance made in ignorance of the death or insanity of the offeror, shall
be a valid acceptance. In Reynolds vs. Atherton it was observed that an offer is in any event
determined by the death (or insanity) of the offeree. The personal representatives of the
offeree cannot accept it on behalf of the offerees estate. In Kennedy vs. Thomassen, it was
observed that an offer lapses if one of the parties dies before acceptance. In Bradbury vs.
Morgan, it was decided that the death of the offeror might not validate a subsequent
acceptance provided:
The offeree did not know of the death when he accepted, and
The personality of the offeror, was not vital to the contract.
By Revocation: The offer may be terminated by the offeror, if he informs the offeree that
he is withdrawing or revoking it. An offer may be withdrawn by the offeror at any point of
time before it is accepted, even though such offer is specified for a particular period. This is
known as revocation of offer.
By Subsequent Illegality or Destruction of Subject Matter: An offer lapses if the subject
matter is destroyed or becomes illegal, subsequent to making the offer but before its
acceptance.
11
On Failure to Fulfill a Condition Precedent to Acceptance: In State of Madhya Pradesh

vs. Gobardhan Dass the acceptance of a tender was to be accompanied by payment of 25%
of the amount. An omission by the successful tenderer to make the requisite payment did
not give rise to a binding contract between the parties.
Revocation of Acceptance
Section 5 of the Contract Act declares, An acceptance may be revoked at any time before
the communication of the acceptance is complete as against the acceptor but not
afterwards. Revocation of acceptance connotes the withdrawal of the acceptance to a
proposal by the offeree himself.
12.4.4 Consideration
Section 25 of the Contract Act declares that, an agreement made without consideration is
void. No right of action arises out of an agreement not supported by consideration. Ex nudo
pacto non-oritur, nobody would part with anything unless he gets a proper price. Hence, a
contract without consideration raises a doubt as to its genuineness.
In Misa vs. Currie consideration has been defined as the price for which a promise is
brought. Consideration itself means some right, interest, profit, or benefit accruing to one
party or some forbearance, detriment, loss of responsibility given, suffered or undertaken
by the other.
In other words, the return promised or the quid pro quo for the performance of the contract
is consideration. Without consideration, there cannot be a contract excepting in those cases
where it is specifically exempted. Consideration must result in some benefit to the plaintiff
or some loss to the defendant.
Indian Law: Section 2(d) of the Indian Contract Act, 1872 defines consideration as when
at the desire of the promisor, the promisee or any other person has done or abstained from
doing, or does or abstains from doing, or promises to do or abstain from doing, something,
such act or abstinence or promise is called a consideration for the promise.
Consideration means the element of exchange in a bargain, in order to satisfy the
requirements of the governing law. Consideration is necessary for the formation of a
contract. Consideration need not be adequate. It is either a benefit to the promisor or a
detriment to the promisee, negotiated for and given in exchange for a promise. It must have
the exchange value that can be measured in terms of money or moneys worth.
Illustration: A agrees to sell his house to B for 10,000 rupees. Here, Bs promise to pay the
sum of 10,000 rupees as the consideration for As promise to sell the house and As promise
to sell the house is the consideration for Bs promise to pay the 10,000 rupees.
12.4.5 Intention to Create Legal Relationship

The validity of a contract is dependent on the intention of the contracting parties.
A contract will be valid only when the parties to the contract intend to create a legal
relationship between themselves. Non-existence of such an intention will not give to a
valid contract. Agreements of social nature do not contemplate legal relationship and
hence they are not contracts.
The parties to a contract may either specifically or generally lay down that the agreement
entered is not a formal or legal agreement or in certain cases and the non-existence of an
intention to enter into a legal relationship can be implied from the agreement itself.
The test to determine the intention of the parties is objective and not subjective. Just
because the promisor contends that there was no intention to create legal relationship, he
would not be exempted from liability.
12
Law of Contracts
All contracts are agreements, but all agreements are not contracts. The basis for this
statement is that the existence of a mutual set of promises does not suffice for the courts to
accord legal recognition to such promises unless the intention to create legal relations is
clearly established. Unless the element of this intention exists the party aggrieved by the
breach of contract would not be in a position to legally enforce his rights. To don the
mantle of a contract, an agreement must give rise to a legal obligation i.e., a duty
enforceable by law. A contract is therefore a species of agreement; the latter being the
genus and a wider term than the former. Moreover agreements of moral, religious or social
nature are mere agreements and not contracts as the parties to the agreement do not intend
legal consequences to arise therefrom. The Indian Contract Act restricts the term contract
only to those agreements which give rise to legal obligations between the parties.
However, conversely, all legal relationships and obligations do not always arise out of
agreements only. There is a large area of legal obligations imposed and enforced by law.
Therefore, obligation to look after wife and children, obligation to follow the law of the
land or to comply with orders of authorities do not fall within the ambit of the Law of
Contract. Salmond had rightly observed: The Law of Contracts is not the whole law of
agreements, nor is it the whole law of obligations. It is the law of those agreements which
create obligations, and those obligations, have their source in agreements.
12.4.6 Lawful Object

Section 10 reads as follows:
All agreements are contracts if they are made by the free consent of parties competent to
contract, for a lawful consideration and with a lawful object, and are not hereby expressly
declared to be void.
Nothing herein contained shall affect any law in force in [India], and not hereby expressly
Thus, all agreements are contracts if made for lawful consideration and with lawful object.
Section 23 covers the illegality of both the object of the contract and the consideration for it.
The object of an agreement is lawful, unless it:
is forbidden by law; or
is of such nature that, if permitted, it would defeat the provisions of law; or
is fraudulent; or
involves or implies injury to the person or property of another; or
the court regards it as immoral, or opposed to public policy.
Thus, if the object or consideration of any contract falls under any of these circumstances it is
not lawful and such contracts are not valid. Section 23 clearly specifies the nature of
consideration and objects that are not lawful. The agreement is illegal if the object or
consideration of that agreement is unlawful for any of the reasons as mentioned in Section 23.
GROUNDS WHICH RENDER THE CONSIDERATION/OBJECT UNLAWFUL
Some of the reasons which make the object or consideration as unlawful are mentioned
hereunder.
The Object/Consideration is Forbidden by Law
According to Section 23, where the object of an agreement is forbidden by law, the
agreement is unlawful. Law in this connection means the law for the time being in force
13
in India and these include personal laws also. An act or an undertaking is said to be
forbidden by law when:
it is punishable by the criminal law of the country, or
when it is prohibited by the special legislation or regulations made by a competent

authority under powers derived from the legislature.
Illustration: The sale of liquor without license is illegal. The sale is void and the price is
also irrecoverable.
Object or Consideration or Performance Defeats the Provisions of Law
Where the object of or the consideration for an agreement is such that though not directly
forbidden by law, it would, if permitted, defeat the provisions of some law, such an
agreement is also void. Where the agreement is of such a character that if permitted it
would frustrate the provisions of any law, neither party is capable of enforcing such an
agreement, since no legal relations can arise from the agreement which is infringing a
statute or opposed to public policy. Defeating the provisions of law means, violation of law.
Object and Consideration are Fraudulent
An agreement made for a fraudulent purpose is void. Where the parties agree to impose a
fraud on a third person, their agreement is unlawful. For example, a scheme of fraud made
between a debtor and creditor against other creditors. Where there is an agreement between
the partners of a firm to cheat income tax authorities it is fraud and such agreement is void
as the object of the contract is fraudulent.
Object and Consideration are Injurious to any Person or Property
If the object or consideration of an agreement is injurious to the person or property of
another, it is a void agreement and is unlawful. Thus, an agreement between two persons to
injure a person or property of any person is unlawful. If the object of an agreement is such
that it involves or implies injury to the person or property of another, the agreement is
unlawful. (Section 23)
Object and Consideration are Immoral
When in an agreement the object or consideration is immoral, it cannot be enforced. Thus
all the agreements supported by immoral consideration or object, are unlawful and void.
Immoral means something against the moral principles of society or ethics. The standard of
morality depends much on time and also on courts as to how they interpret it. But by and
large there are certain sets of acts which are regarded as immoral from time immemorial.
These include generally sexual immorality, interference with marital relations, acts against
good public morals etc.
The Object and Consideration are Against Public Policy
An agreement is unlawful if the court regards it as opposed to public policy. Public
Policy is a flexible term without any exact meaning. Public policy is the principle of law
which holds that no citizen can lawfully do any act which is injurious to the public or is
against the interest of the society or the State at large. Thus in a broader sense an
agreement which tends to promote corruption or injustice or immorality is said to be
opposed to public policy.
12.4.7 Certainty and Possibility of Performance

Section 37 of the Indian Contract Act provides as follows:
The parties to a contract must either perform, or offer to perform their respective promises,
unless such performance is dispensed with or excused under the provisions of this Act, or
of any other law.
Promises bind the representatives of the promisor in case of death of such promisor before
performance, unless a contrary intention appears from the contract.
14
Law of Contracts
So, it appears from the above definition that it is the duty of each party to the contract to
perform, or offer to perform, the contract, unless the performance is excused under the
provisions of the Act or any other law. Performance may be:
Actual performance, or
Attempted performance or tender of performance.
If a party to a contract has fulfilled all his obligations under the contract, he is said to have
actually performed his promise. When both parties have performed their respective
promises, a contract is said to have been actually performed. Actual performance of the
obligations brings the contract to an end. When the promisor dies the promisee has to sue
all the heirs on whom the promisors property has devolved. If the promisee neglects to do
this, his suit is liable to be dismissed.
Persons by whom Promise is to be Performed: Section 40 of the Act provides: If it
appears from the nature of the case that it was the intention of the parties to any contract
that any promise contained in it should be performed by the promisor himself, such promise
must be performed by the promisor. In other cases the promisor or his representatives may
employ a competent person to perform it.
Obligation of Representatives of the Promisor to Perform: The second part of Section
37 provides that promises bind the representatives of the promisors in case of death of
promisors before performance, unless a contrary intention appears from the contract.
Legal representatives of the promisor may perform the contracts that do not involve any
personal skill, if the promisor dies before performance, unless a contrary intention appears
from the contract. The promisee can compel the legal representatives to perform. However,
the liability of the legal representatives is limited to the extent of the estate of the deceased
promisor, which has come to their hands.
Promisor Employs Third Persons to Perform: Section 40 provides that: in other cases
the promisor or his representatives may employ a person to perform it.
Where the contract does not show an intention that promisor alone should perform the
promise personally, he or his representatives can employ a competent person to perform the
contract. So, under some circumstances third party may also perform the promises.
DOCTRINE OF VICARIOUS PERFORMANCE
Vicarious liability means that one person is made liable for the wrongful act of another.
Vicarious liability is to be found in expediency and public policy. In civil law this kind of
liability is well established. But in criminal law, this kind of liability is not usually found.
For instance, a master is responsible for the acts of his servants done in discharge of their
duties. This is because; servants are usually weaker people and cannot pay compensation to
the injured party. Moreover, the master having placed the servant in a position where he can
do injury to others is obliged by law to assume the liability to pay for the injury.
There may be circumstances which make it permissible for a contracting party to perform
its part of the contract by getting someone else to do in a satisfactory manner the obligation
for which the contract provides. It may be observed that vicarious performance, though
loosely referred to, as an assignment of contractual liability is not an assignment in the
strict sense. A contract may be vicariously performed where it is expressly provided or
from the terms of the contract it may reasonably be inferred that it is immaterial by whom
the contract is to be performed. There can be no assignment of contractual liability by the
act of the promisor.
Section 37 shows that the promisors liability may devolve on the legal representatives on
his death. Apart from devolution on the death of the promisor, certain covenants i.e.,
promises contained in sale deeds, lease deeds etc., which relate to land pass along with the
land when the land is assigned. This is a peculiar feature of the Law of Property. Such
covenants are called covenants running with the land.
15
EFFECT OF INCOMPLETE PERFORMANCE BY A PARTY

Section 39 of the Act provides that
When a party to a contract has refused to perform or disabled himself from performing its
promise, in its entirety, the promisee may put an end to the contract unless he has signified
by words or conduct, his acquiescence in its continuance.
According to Section 39 of the Contract Act, a breach of contract by the promisor may arise
in the following ways when
He refuses to perform the contract;
He renders himself disabled to perform his obligation;
He fails to perform; and
By his conduct or action, it becomes impossible of performance.
EFFECT OF PREVENTION OF PERFORMANCE BY THE PROMISEE

Section 38 of the Act provides that
Where a promisor has made an offer of performance to the promisee, and the offer has not
been accepted, the promisor is not responsible for non-performance nor does he thereby
lose his rights under the contract.
Every offer must fulfil the following conditions:
It must be unconditional.
It must be made at a proper time and place, and under such circumstances that the
person to whom it is made may have a reasonable opportunity of ascertaining that the
person by whom it is made is able and willing to do the whole of what he is bound by
his promise to do.
If the offer is an offer to deliver anything to the promisee, the promisee must have a
reasonable opportunity of seeing that the thing offered is the thing, which the promisor
is bound by his promise to deliver.
DOCTRINE OF SUBSTANTIAL PERFORMANCE

Where the contract is substantially performed, there is authority that the injured party is
not discharged from the obligation to pay, but is protected by a counterclaim or set-off
for any loss which may have been sustained by reason of the incomplete or defective
performance. A Court will hold a contract to have been substantially performed if the
actual performance falls not far short of the required performance, and if the cost of
remedying the defects is not too great in amount in comparison with the contract price.
For instance, if the builder has acted in good faith and has completed the job in
substantial compliance with the contract, he can enforce the contract and collect the
contract price. Any damages that result from noncompliance can be collected by the
buyer or deducted from the amount of the contract price. Perfection is not required.
However this principle will not be applied where the builder has intentionally substituted
inferior materials or used other production shortcuts.
PERFORMANCE WHEN TIME IS THE ESSENCE OF THE CONTRACT
Sometimes the parties to a contract fix the time for its performance. Ordinarily it is
expected that either party will perform his obligation at the stipulated time. But if one of
them fails to do so, the question arises: what is the effect on the contract? The answer
depends upon whether the time was of the essence of the contract or not.
Section 55 of the Indian Contract Act recognizes time as an essence of the contract, which
means that in the performance of a contract the time factor will be given priority by the
16
Law of Contracts
parties. The parties intend to perform the contract exactly as per the stipulated time alone.
Such intention expressly gives a right to avoid the contract in case of default or breach by
any one of the parties. Therefore, whether the time is the essence of the contract or not
depends upon the intention of the parties.
Self-Assessment Questions 1
a.
b.
c.
A accepts Bs invitation to dinner by phone. Is this a contract?

.
.
.
Shyam advertises in a newspaper that he would pay Rs.5,000 to anyone, who finds
and returns his lost briefcase containing valuables. Does this constitute a valid
offer? Justify.
.
.
.
Ram communicates to Shyam that he will sell his car for Rs.1,50,000. Does this
constitute a valid offer?
.
.
.
12.4.8 Void Agreements

An agreement expressly declared to be void under the Contract Act or any other law, is not
enforceable and is, thus, not a contract.
Section 2(g) of the Act defines a void agreement as, An agreement not enforceable by law is
said to be void. A contract may be void ab initio (from the inception) or may be rendered
void subsequently. A valid contract may be made void by some subsequent impossibility or
when a voidable contract is made void by the aggrieved party. For instance, where the consent
of the aggrieved party was not a free consent, the contract becomes void though at the
beginning it was an enforceable contract. Following are the instances of void agreements:
Agreements by incompetent parties (Section 11)
Agreements under mutual mistake of fact material to the agreement (Section 20)
Agreements with unlawful consideration or object (Section 23):
immoral and illegal agreements

agreements opposed to public policy
Agreements unlawful in part (Section 24)

Agreements without consideration (Section 25)
Agreements in restraint of marriage (Section 26)
Agreements in restraint of legal proceedings (Section 28)
Agreement with are uncertain and ambiguous (Section 29)
Agreement by way of wager or wagering agreements (Section 30)
Agreements to do Impossible Acts (Section 56)
Figure 3: Void Agreements

17
The above agreements are explained below in detail:

AGREEMENTS BY INCOMPETENT PARTIES (SECTION 11)
One of the essentials of a valid contract, mentioned in Section 10, is that the parties to the
contract should be competent to make the contract. According to Section 11:
Every person is competent to contract who is of the age of majority according to the law to
which he is subject, and who is of sound mind, and is not disqualified from contracting by
any law to which he is subject.
Thus, the agreements entered into by the following three categories of persons are void:
A person who has not attained the age of majority, i.e., one who is a minor.
A person who is of unsound mind.
A person who has been disqualified from contracting by some law.
AGREEMENTS UNDER MUTUAL MISTAKE OF FACT MATERIAL TO THE

AGREEMENT (SECTION 20)
An agreement is void where the parties to an agreement are under the mistake of fact which
is of primary importance or subject to the contract.
Illustration: A agrees to sell to B a specific cargo of goods supposed to be on its way from
England to Bombay. It turns out that, before the day of the bargain the ship conveying the
cargo had been cast away and the goods lost. Neither party was aware of these facts. The
agreement is void.
A agrees to buy a horse from B. It turns out that the horse was dead at the time of the
bargain, though neither party was aware of the fact. The agreement is void.
AGREEMENTS WITH UNLAWFUL CONSIDERATION OR OBJECT
(SECTION 23)
If the consideration or object of an agreement is unlawful, the agreement is void.
Section 23 describes the situations where the consideration or object of a contract can be
declared as unlawful:
if it is forbidden by law, or
if the performance defeats the provisions of any existing law of India, or
if it is fraudulent, or
if it involves or implies injury to the person or property of another, or
if the court regards it as immoral or opposed to public policy.
Thus, in all of these cases the consideration or object of an agreement is said to be unlawful.
Every agreement of which the object or consideration is unlawful is void.
Illustration: A, B and C enter into an agreement for the division among them of gains
acquired or to be acquired by them by fraud. The agreement is void as its object is unlawful.
Illegal Agreements and Immoral Agreements
Immoral agreements are those whose object or consideration is immoral and/or illegal and
therefore they are void. Immoral agreements involve:
18
Illicit cohabitation or concubinage.
Sexual immorality.
Agreement to interfere with the marital relations.
Agreements to perform the acts, which are against good public morals.
Law of Contracts
Agreements Opposed to Public Policy

Agreements which are opposed to public policy mean those agreements which the court
regards them as opposed to public interest i.e., the performance of the agreement is not
detrimental to the public good. Such agreements are agreement to restrain prosecution,
agreement of maintenance and champerty, trading agreement entered with an enemy,
marriage brokerage contract and agreement tending to injure the public service, etc.
AGREEMENTS THAT IS UNLAWFUL IN PART (SECTION 24)
Section 24 of the Indian Contract Act says:
Agreements are void, if considerations and objects are unlawful in part If any part of a
single consideration for one or more objects, or any one or any part of any one of several
considerations for a single object is unlawful, the agreement is void.
Where the object or consideration is illegal in part and is not severable from the rest the
whole agreement is void. If any part of single consideration for one or more objects is
unlawful, the agreement is void. Or if any one or any part of any one of several
considerations for a single object is unlawful the agreement is void. Thus in other words,
Section 24 comes into play when a part of the consideration for an object or more than one
object of an agreement is unlawful. The whole of the agreement would be void unless the
unlawful portion can be severed without damaging the lawful portion.
Illustration: A promised to superintend on behalf of B, the manufacture of indigo, which
was legal and also certain other illegal business. B agreed to pay him a consolidated salary
of Rs.15,000. The agreement was void. A had made two promises but got one
consideration. If the salary had been promised for the two promises separately, then the
legal part would have been valid and recoverable.
AGREEMENTS WITHOUT CONSIDERATION (SECTION 25)
Any agreement which does not have consideration is void unless:
it is made on account of natural love and affection between parties standing in a near
relation to each other; or
if it is a promise to compensate wholly or in part, a person who has already done

voluntarily something for the promisor (past consideration), or
if it is a promise to pay a time-barred debt.
Illustration: If A promises to pay B Rs.100 for nothing and B neither does nor promises to
do anything in return to compensate A for the money paid by him, As promise has no force
in law.
AGREEMENTS IN RESTRAINT OF MARRIAGE (SECTION 26)
Every agreement in restraint of the marriage of any person, other than a minor, is void
(Section 26).
The agreements which restrain the freedom of marriage are discouraged by law. The
restraint may be partial or general. A party may be restrained to marry at all or marrying
only for a certain period or to a particular person etc. Thus, if such kind of restraints are
included in the contracts, they become void. The only exception is that, if the agreement is
in favor of a minor.
19
Illustration: Two widows (of the same deceased husband) agree that if any one of them
remarries, she must forfeit her right of share in the deceased husbands property. This kind
of agreement is not in restraint of marriage and has been upheld by the court, which stated
that nothing in the agreement reflected that restraint was imposed upon either of the two
widows to remarry.
AGREEMENTS IN RESTRAINT OF TRADE (SECTION 27)
According to Section 27 of the Indian Contract Act, every agreement, by which anyone is
restrained from exercising a lawful profession, trade or business of any kind, is void to
that extent.
The citizens of India are free to carry on any business or occupation or engage themselves
in any trade. This right and freedom is given by the Constitution of India under Article
19(1)/(g). Just as the legislature by means of any of its legislation cannot deprive the
citizens of their legitimate right to freedom of trade and occupation, the individuals also
cannot barter it away by agreement. The Indian public policy requires that every man is at
liberty to work for himself. So by entering into a contract with others he must not deprive
himself from choosing the suitable trade/occupation for him.
Illustration: In Madhub Chander vs. Raj Coomar, there were two rival shopkeepers in a
locality, and one of them agreed to pay a sum of money to the plaintiff if he would close the
business in that area. The plaintiff accordingly did so, but the defendant refused to give any
money to him. The court held the agreement to be void.
Exceptions to Section 27 of the Act
All the agreements in restraint of trade are void. Whether the restraint is partial or general
or specific or complete, it is void unless it falls within any of the statutory or judicially
created exceptions. There are two kinds of exceptions to the rule,
those created by statute; and
those arising from judicial interpretations of Section 27.
Statutory Exceptions: The exception mentioned in the Section 27 of the Contract Act,
relates to sale of goodwill, i.e., exception no. 1.
One who sells the goodwill of a business may agree with the buyer to refrain from carrying
on a similar business, within specified local limits, so long as the buyer or any person
deriving title to the goodwill from him, carries on a like business therein, provided that
such limits appear to the court as reasonable with regard to the nature of the business.
AGREEMENTS IN RESTRAINT OF LEGAL PROCEEDINGS (SECTION 28)
For any contract to become valid it must be enforceable by law. Therefore any clause in the
agreement restraining either of the party to enforce his agreement is void.
Section 28 of the Indian Contract Act provides that:
Every agreement,
(a)
by which any party thereto is restricted absolutely from enforcing his rights under or
in respect of any contract, by the usual legal proceedings in the ordinary tribunal, or
which limits the time within which he may thus enforce his rights; or
(b) which extinguishes the rights of any party thereto, or discharges any party thereto
from any liability, under or in respect of any contract on the expiry of a specified
period so as to restrict any party from enforcing his rights is void, to that extent.
20
Law of Contracts
Thus, Section 28 applies to the agreements which restrain enforcement of contractual

rights.
The following agreements are declared as void under Section 28:
Agreement which restricts absolutely the parties from enforcing their legal rights
under a contract, and
Agreement which limit the time within which a party may enforce his contractual rights.
Section 28 does not apply to the agreements which restrict the enforcement of legal right
partially.
This Section states that An agreement which restrains a person from enforcing his rights
absolutely void.
Illustration: A has sold certain goods to B. A has the right to realize the price and to sue for
it in a court of law.
If A and B agree that A will never realize the price by a suit in any court, that agreement is
void.
The agreement whereby the parties try to alter the time within which a suit may be filed as
per the Limitation Act, it is a void agreement.
Illustration: A has supplied goods to B. If a promises that he will not sue B after a period of
two years or if A fails to sue within 2 years he will have no right to sue. Such an agreement
is void.
Exceptions to Section 28 of Indian Contract Act
There are two exceptions to the rule that an agreement in restraint of legal proceedings is
void. These are:
reference of future disputes to arbitration; and
reference of existing disputes to arbitration.
This Section does not make such of those contracts void wherein two or more persons agree
that any dispute which may arise between them shall be referred to arbitration and also the
amount awarded in the arbitration shall only be recoverable.
AGREEMENTS WHICH ARE UNCERTAIN AND AMBIGUOUS (SECTION 29)
Any agreement the meaning of which is not certain or capable of being made certain, is
void. This provision is explained in Section 29 of the Indian Contract Act, 1872.
Illustration: A agrees to sell B 100 tons of oil. The agreement is void for uncertainty.
A agrees to sell B a white horse for Rs.500 or 1,000. This agreement is void.
In Guthing vs. Lynn A horse was bought for a certain price coupled with a promise to give
5 pounds more if the horse proved lucky. The agreement was held to be void for
uncertainty. The court had no machinery to determine what luck, bad or good, the horse has
brought to the buyer. Such cases have generally arisen in connection with the sale of goods,
bearing uncertainty as to the price.
The terms of the agreement should not be vague. The agreement where the parties fail to
express their intention clearly, is void. But where there is any possibility of making the
meaning certain, the agreement is valid. So where the price is left to be decided by a third
party, the agreement is not void. But an agreement to agree in future is void for there is no
certainty whether the parties will be able to agree or not.
21
AGREEMENTS BY WAY OF WAGER OR WAGERING AGREEMENT (SECTION 30)

Agreements by way of wager are void; and no suit shall be brought for recovering anything
alleged to be won on any wager, or entrusted to any person to abide the result of any game
or other uncertain event on which any wager is made.
AGREEMENTS TO DO IMPOSSIBLE ACT (SECTION 56)
According to Section 56 of Indian Contract Act, An agreement to do an act which is
impossible to perform is void.
Where one person has promised to do something which he knew or with reasonable
diligence, might have known that the promise is impossible or unlawful, such promisor
must make compensation to such promisee for any loss which the promisee sustains
through the non-performance of the promise.
Illustration: A agrees with B to discover treasure by magic. The agreement is void. A
already married to C contracts to marry B while polygamy is forbidden by law. A must
make compensation to B for loss caused to her by non-performance of the promise.
12.4.9 Legal Formalities

A contract may be oral or in writing. Those contracts which require to be in writing may
even require registration. Therefore, where law requires an agreement to be put in writing
or be registered, the same must be complied with. For instance, the Indian Trusts Act
requires the creation of a trust to be reduced to writing.
12.5 CLASSIFICATION OF CONTRACTS/AGREEMENTS

Contracts are of different kinds and can be classified on different bases. Classification may
be based on the validity of the contracts, the mode of formation or the extent of their
performance. It can be understood by the following figure:
Figure 4
ENFORCEBILITY
Valid Contracts
A contract which fulfills all the requirements prescribed by Section 10 of the Act is a
valid contract. In other words where an offer is made and is accepted in return by
competent parties with free consent for a lawful consideration in furtherance of a lawful
object, a valid contract is said to have been entered into. These contracts are enforceable
by law and are binding on the parties. If any of the essential elements is missing, the
contract is rendered invalid.
22
Law of Contracts
Illustration: A agrees to sell 10 bags of rice to B for Rs.10,000 by the end of May.
B accepts. This is a valid contract.
Void Contracts
Section 2(g) of the Act defines a void contract as, An agreement not enforceable by law is
said to be void. A contract may be void ab initio (from the inception) or may be rendered
void subsequently.
Voidable Contracts
According to Section 2(i) of the Act, An agreement which is enforceable by law at the
option of one or more of the parties thereto, but not at the option of the other or others, is a
voidable contract. A contract that is not enforceable by both the parties is a void contract.
But a contract that is enforceable by one and not by the other is voidable.
Unenforceable Contracts
If a contract is unenforceable, neither party may enforce the others obligations.
Illegal Contacts
The contract is illegal if the object or consideration of that agreement is unlawful for any
of the reasons such as forbidden by law, defeats the provisions of law, fraudulent,
immoral etc.
METHOD OF FORMATION
Simple Contracts
All contracts other than formal contracts are simple contracts. Based on their mode of
creation they may be classified as express contracts, implied contracts, quasi contracts,
standard form contracts and contingent contracts.
Express Contracts: Contracts which are made orally or in writing are called express
contracts. There is an express promise made in such cases. Thus the parties to the contract
offer and accept by way of words spoken or written. Thus a telegram by A offering to sell a
car at affixed rate to B and a return telegram by B accepting the same is an express contract.
Implied Contracts: A contract is said to be implied or tacit when it can be inferred from
the conduct of the parties. There is an implied offer or implied acceptance which results in
an implied promise and thus an implied contract. In other words, the promise is made
otherwise than by words spoken or written. Situations where services are rendered without
being requested to do so, at the same time something is accepted in return for the services,
and the person receiving the benefits accepts the same knowing the circumstances, they can
be termed implied contracts. Thus, keeping our belongings in the cloak room for safe
custody is an implied contract.
Quasi Contracts: These are agreements which are ascribed the nature of contract by the
law. Where no express or implied contract exists between the parties, the law creates and
enforces legal rights and obligations under certain circumstances. These obligations are
known as quasi contracts. Sections 68 to 72 of the Indian Contract Act deal with quasi
contracts. A quasi contract rests on the doctrine of unjust enrichment that a person shall not
be allowed to enrich himself unjustly at the expense of another. The obligations in a quasi
contract are not the result of an agreement; they only resemble the obligations that arise
from contracts. For example, necessaries supplied to a minor are treated as quasi contracts
so as to enable others to enter into agreements with minors. Otherwise no person shall come
forward to render any service to the minors as they would be agreements void ab initio.
23
Standard Form Contracts: Standard form contracts have printed forms of standardized
contracts containing a number of terms and conditions. The individuals entering into such
contracts can hardly negotiate and they have to accept the terms and conditions already
mentioned. Ex: Life Insurance Corporations, Railways, Unit Trust of India etc., wherein
similar nature of contracts are agreed with so many people.
Contingent Contracts: Section 31 of the Act provides for such contracts which are
collateral to do or not to do something, if some event, collateral to such contract, does or
does not happen. In Muthu vs. Secretary of State, a person was the highest bidder for a
house which was put up for sale. However, one of the conditions was that the sale could be
confirmed only if the Collector authorizes it. The Collector declined to confirm the sale. It
was held that there was no contract.
The event on which the happening of the contract is dependent should be uncertain.
Further, the event should be collateral to the contract. The event should not form part of
the consideration of the contract though the contract is made to depend upon it. Contracts
of indemnity and insurance are examples of contingent contracts. Section 32 to Section
36 specify the rules that are applied in evaluating whether a contract is a contingent
contract or not.
EXTENT OF PERFORMANCE
Executed Contract
An executed contract is a contract concluded in toto. The contract is completely performed
and nothing remains to be done by either party to the contract. A contract may be executed
at once or a later time. Thus there is no scope for the breach of the contract. For instance,
A agrees to pay B, a film actress, Rs.10,000 for an appearance at a stage show conducted by
him. A pays the amount after B makes an appearance. This is an executed contract.
Executory Contract
An executory contract is one in which both the parties may agree to do something in the
future or one of the parties has performed his part of the contract and the other party has yet
to perform his part of the promise. Thus it is a contract which has not been performed
wholly. Something remains to be done in furtherance of the contract. The contract comes
into existence from the time it is made and not from the time its performance is due. When
one side has performed and the other side has yet to perform, it is an executory contract.
OBLIGATION TO PERFORM
Unilateral Contracts
A unilateral contract is a contract where the obligation to perform remains only on one
party to the contract, the other party already having performed his part of the contract. Most
of the implied contracts are unilateral contracts. For instance where a person enters a hotel
and pays money for his lunch in advance, he has performed his promise. It is for the hotel
personnel to serve him lunch when he takes a place in the dining hall.
Bilateral Contracts
In a bilateral contract obligation rests upon both the parties to the contract to perform
their promise. The promise may be to do or refrain from doing some act. In these
contracts both can sue the other for breach of contract. This category comprises of
executed and executory contracts.
24
Law of Contracts
The Contract Law unwittingly plays a very significant role in human life. In our day to day
life we enter into innumerable contracts whether express or implied. The law of contracts
helps the individuals to protect their rights against the breach of obligations imposed by law
apart from those imposed by the parties to the contract. The Contract Act deals not only
with the consumer transactions but also with the commercial transactions of the individuals
in the society. It clearly lays down the rights and obligations of the parties to the contract. It
also provides for the remedies to the injured party in a contract.
a.
An agreement collateral to a wager. Is this agreement void?
....
b.
Agreement in restraint of carrying of trade after sale of goodwill. Can this agreement
be considered as an agreement in restraint of trade?
....
c.
Compensation for voluntary services. Is this agreement without consideration void?
....
d.
A supplied goods to B. A promises B that he will not sue B after a period of 3 years.
Is the agreement valid?
....
12.6 VALID CONTRACTS AND LIMITATIONS

A contract which fulfills all the requirements prescribed by Section 10 of the Act is a
valid contract. In other words, where an offer is made and is accepted in return by
competent parties with free consent for a lawful consideration in furtherance of a lawful
object, a valid contract is said to have been entered into. These contracts are enforceable
by law and are binding on the parties. If any of the essential elements is missing, the
contract is rendered invalid.
Illustration: A agrees to sell 10 bags of rice to B for Rs.10,000 by the end of May.
B accepts. This is a valid contract.
12.6.1 Limitation as to Competence

Section 10 of the Indian Contract Act explains that an agreement becomes a contract if it is
made between parties who are competent to contract. Section 11 explains that Every
person is competent to contract who is of the age of majority according to the law to which
he is subject, and who is of sound mind, and is not disqualified from contracting by any law
25
to which he is subject. According to the above definition the following three categories are
incompetent to contract:
a.
A person who has not attained the age of majority,
b.
A person of unsound mind, and
c.
A person who has been disqualified from contracting by any law to which he is
subject.
The above categories of incapacity to contract can be better understood with the help of the
following flow chart:
Source: Nirmal Singh. Business Laws.

Figure 5
MINORS
Generally, an infant is legally considered to lack the capacity of comprehension regarding the
implications of contracts and hence they cannot enter into contracts until they reach the age of
majority. They are not bound by agreements unless they are meant for supply of necessities.
Every person is a minor who has not completed 18 years of age according to Section 3 of the
Indian Majority Act, 1875. The following two situations stand as an exception to the age of
majority, where majority is attained at the age of 21 years and not 18 years:
Every minor for whose person or property or both a guardian has been appointed
under the Guardians and Wards Act, 1890.
Every minor whose property is under the superintendence of any court of wards
before he attains 18 years of age. However the age of majority shall be determined
according to the law to which the minor is subject to.
Section 10 of the Indian Contract Act, 1872 lays down that the contracting parties should be
competent to contract. Section 11 states that every person is competent to contract who is of
the age of majority according to the law to which he is subject and who is of sound mind
and is not disqualified from contracting by any law to which he is subject. Prior to the
landmark case of Mohoribibi vs. Dharmodas Ghose, a contract with a minor was voidable
at the option of the minor but in 1903, the Privy Council ruled in that case that the minors
contract was void ab initio.
The Indian Majority Act, 1875, regulates the age of majority. Section 3 of the Act states
that a person who is resident of India shall be deemed to have attained his majority when he
attains eighteen years of age and not before. Section 2 of the Act declares that nothing in
the Act shall affect the capacity of any person to act in matters of marriage, dower, divorce,
and adoption. An order discharging the guardian of a minor under Section 48 of the
Guardians and Wards Act, 1890, does not terminate the minority when the order obtained
26
Law of Contracts
by fraud is practiced upon the court by a third party. The law to which the contracting party
is subject determines the age of majority and the disqualification from contracting.
In Raj Rani vs. Prem Adib, a film producer entered into an agreement with a minor girl to
act in a film and the father of the minor girl signed the agreement on her behalf. The minor
sued the producer through her father as next friend for the breach of agreement. It was held
that the agreement made with the father of the minor was itself void. As the minor cannot
make a promise in law, it was held that there was no consideration. Had the consideration
moved from the father in the form of an undertaking by him that his daughter should act,
the father would have got the right to sue but could recover the damages only to the extent
he had suffered.
Effects of Minors Agreement
The law relating to minors agreements and the effects thereof can be discussed under the
following points:
No Estoppel against a Minor: There is no estoppel against a minor. Estoppel is a rule of
evidence by which a person is not allowed to go back upon his previous representations.
Section 115 of the Indian Evidence Act, 1872 lays down the law of estoppel as When one
person has, by his declaration, act or commission, intentionally caused or permitted another
person to believe a thing to be true and to act upon such belief neither he nor his
representative shall be allowed in any suit or proceeding between himself and such person
or his representative to deny the truth of that thing. This rule is not applicable to a minor.
A minor who has made an agreement by misrepresenting his age may disclose his real age
and there is no estoppel against him.
Doctrine of Restitution does not Apply against a Minor: If an infant obtains property or
goods by misrepresenting his age, he can be compelled to restore it, but only so long as the
same is traceable in his possession. This is known as equitable doctrine of restitution. In
Ajudhia Prasad vs. Chandan Lal, the court held that a minor who had taken money by
mortgaging his houses was not bound to restore the money. In Jagan Nath Singh vs. Lalta
Prasad, the court observed that he who seeks equity must do equity. The courts have the
discretion to require the minor-plaintiff to restore the advantages he has obtained under a
void agreement. Where persons who are in fact under the age induce others to purchase
property from them, they are liable in equity to make restitution to the purchasers for the
benefit they have obtained before they can recover possession of the property sold.
No Ratification on Attaining Majority: A minor cannot ratify an agreement that was
made by him during his minority on attaining majority. Ratification implies approval or
confirmation. Ratification is applicable to an existing contract, whereas in case of a minors
contract subsequent ratification cannot take place, as it is void ab initio. Similarly a
promissory note executed by a person on attaining majority in lieu of the earlier promissory
note signed by him while he was a minor in consideration of money received from the
obligee cannot be enforced in law. In Suraj Narain vs. Sukhu Akhir1, a minor borrowed a
sum of money executing a simple bond for it, and after attaining majority executed a
second bond in respect of the original loan plus interest. It was held that the suit upon the
second bond was not maintainable, as that bond was without consideration.
No Liability for a Minor in Contract or Tort Arising Out of Contract: A minor cannot
be held liable for breach or in the form of damages for tort, if the minor enters into an
agreement by misrepresenting his age. In Johnson vs. Pye2 it was laid down that an infant
who obtains a loan of money by falsely representing his age cannot be made to repay the
1
2
ILR 51 AIL.64.
(1665) 1 Sid. 258; 82 E.R.
27
amount of the loan in the form of damages for deceit. A minor is in law incapable of
giving consent and there being no consent, there could be no change in the character or
status of the parties.
Contract Beneficial to Minors: The Indian Contract Act does not prevent a minor from
becoming a promisee. A minor can enforce a contract, which is of some benefit to him.
Minority is a personal protection and only a minor can take advantage of it and bind the
other party.
Contracts by minors are valid if they are made for necessaries. A person would be entitled
to reimbursement out of the minors estate, for necessaries supplied to him or his family.
Section 68 of the Indian Contract Act imposes quasi-contractual duties on every person
incapable of entering into any contract. The quasi-contractual duties are enforceable as no
person can be allowed to enrich himself at the expense of another. Section 68 states, If a
person incapable of entering into a contract or anyone whom he is legally bound to support,
is supplied by another person with necessaries suited to his condition in life, the person who
has furnished such supplies is entitled to be reimbursed from the property of such incapable
person. The term necessaries constitute goods suitable to the condition in life of the
infant and are regarded as necessaries.
Contract of Marriage: Under the Hindu Marriage Act, 1955 minors marriage is valid for
all purposes. Otherwise children born out of such marriage would be treated as illegitimate.
However, this provision shall not provide any immunity to the parties who have performed
the marriage against the provisions of the Hindu Marriage Act.
Contracts of Service or Apprenticeship: A minor is not liable for every beneficial
contract. The Indian Apprentices Act was passed in the year 1850 to enable children to
learn trades, crafts and employment. The Act requires the contract to be made by a guardian
on behalf of the minor. The liability is only for contracts of service or apprenticeship as
they provide him education and enable him to earn his livelihood. Even in such cases the
minor is not personally liable, but only his estate is liable.
Position of Minors Parents or Guardian: Minors contracts do not impose any liability
on his parents or guardian. When a guardian enters into a contract on behalf of a minor, the
validity of the contract depends upon whether the guardian is acting within the scope of his
legal powers or not. In Mir Sarwarajan vs. Fakruddin3 the Privy Council held that a
guardians contract can neither be enforced by a minor nor be enforced against him.
Minors parents or guardians are under no obligation to honor the commitments made by
him but when the minor acts as an agent of his parents or guardian, they can be held liable
for his acts.
Surety for a Minor: A person who stands as surety for a minor can be sued though the
minor himself would not be liable. Though the original contract may be void the surety for
a minor is liable as it arises out of a different contract. Where minors debt is knowingly
guaranteed, the surety may be held liable as principal debtor. If a bank makes a loan to a
minor or allows an overdraft to a minor and an adult gives a guarantee for that transaction,
then although the loan or overdraft cannot be enforced against the minor, the adult
guarantor can be made liable for the loan amount.
Minor as an Agent: Minor can be appointed as an agent though he is not liable for any
of his acts. The principal will be held liable to the third parties for the acts of the minor
agent done in the ordinary course of dealings. But he cannot hold the minor liable for any
of his acts.
28
(1912) ILR 39 Cal. 232 (Pc).
Law of Contracts
Specific Performance: An agreement with the minor being void ab initio, there can be
nothing to be specifically performed. The guardian of a minor unless competent to do so
has no power to bind the minor by a contract for purchase or sale of immoveable property
and the minor therefore is not entitled to specific performance of the contract. A contract
can be specifically enforced by or against the minor if the contract is one which is within
the competence of the guardian to enter into on his behalf so as to bind him by it, and
further, if it is for the benefit of the minor.
Position of a Minor under other Laws:
Minor cannot enter into a partnership agreement but he can be admitted to the
benefits of partnership with the consent of all the partners. The liability of a minor is
limited to the extent of his share in the partnership unlike other partners, whose
liability is unlimited.
Minor is not a debtor under the law of insolvency because he is not liable under any
agreement. Therefore, a minor can never be adjudged insolvent either on the petition
made by the minor himself or that of his creditor.
Minor cannot become a shareholder in a company since he is incompetent to contract.

In case of inheritance a minor can become a shareholder acting through his lawful
guardian. A minor can enjoy the benefits of shareholder. A minor cannot be held
liable for payment of call money.
Minor under the Negotiable Instruments Act, 1881 may draw, endorse, deliver and
negotiate such instrument so as to bind all parties except himself.
Minor cannot become a principal or appoint an agent under a contract of agency.

Principal must be competent to contract.
PERSONS OF UNSOUND MIND

According to Section 12 of the Indian Contract Act, 1872, A person is said to be of sound
mind for the purpose of making a contract if at the time when he makes it, he is capable of
understanding it and forming a rational judgment as to its effects upon his interest. As such a
person who does not satisfy the following two conditions is a person of unsound mind:
He should be capable of understanding the contract, and
He should be capable of forming a rational Judgment about the effects of the contract
on his interest.
Unsoundness of mind may be classified into two types:
Permanent unsoundness of mind; and
Temporary unsoundness of mind.
A person of unsound mind is incompetent to contract. Mere weakness of mind is not

sufficient. Party must prove total incapacity to understand business and forming rational
judgment. Mere loss of vigour and infirmity on account of old age is not sufficient to
invalidate a contract. In order to avoid a contract on the ground of one of the parties being
of unsound mind, the question to be decided is whether that person was of unsound mind
when the contract was made. Unsoundness of mind depends largely upon the inference to
be drawn from the evidence and not on belief or skepticism of witnesses. The burden of
proof lies on the person who affirms it. In Jyotirindra Bhattacharjee vs. Sona Bala Bora4
oral evidence showed that the vendor was suffering from mental imbalance and no effort
was made to prove that the vendor at the time of execution of the deed was mentally sound
and capable of executing the sale deed.
AIR 1994 Gau 99 as per Digest of cases on Law of Contract by Ashok Soni Universal Law
Publishing Co. Pvt. Ltd.
29
Idiots
An idiot is a person who is devoid of the ability to think. An agreement with an idiot is
absolutely void. The property of an idiot can be made liable for the necessaries supplied to
him or to persons dependant upon him. An idiot can also be a beneficiary.
Lunatics
Lunatic is a person whose mental power has been damaged. Such a person is sometimes
sane and sometimes an insane. Such a person may enter into a contract when he is of sound
mind. All the agreements made by lunatics during lucid intervals are valid. In this context,
Section 12(2) of the Indian Contract Act provides that A person who is usually of unsound
mind but occasionally of sound mind may make contract when he is of sound mind.
However, agreements for necessities of life are valid. The property of the lunatic is liable
for such contracts and a lunatic cannot be held personally liable. In Johri vs. Mahila
Draupati alias Dropadi, the owner of the property was a lunatic. It was well known to the
defendant/purchaser. In view of the facts and the knowledge which the defendant admitted
in his deposition that the owner of property was a lunatic, the appellant cannot get any relief
by applying the principle laid down under Section 43 of the Transfer of Property Act, 1882.
A contract by a lunatic is void and he cannot be compelled to refund the consideration
(money). A person, who is usually of unsound mind, but occasionally of sound mind, may
make a contract when he is of sound mind. A person, who is usually of sound mind, but
occasionally of unsound mind, may not make a contract when he is of unsound mind. For
example, a patient in a lunatic asylum, who is at intervals of sound mind, may enter into a
contract during those intervals.
Idiots and lunatics come under the category of permanent unsoundness of mind. Drunkards
are categorized as temporary unsoundness of mind. The incompetent person has to make
restoration except if there are special circumstances. Special circumstances include other
party knowing or having reason to know of mental defect. If contracts made on fair terms
and other party has no reason to know of incompetency, contract ceases to be voidable
where parties cannot be restored to pre-contracting positions.
Drunkards
A person who is under the influence of intoxicating liquors or drugs is equal to that of a
lunatic. A drunkard cannot form a rational opinion as to the effect of a contract on his
interest. For example, a sane man, who is delirious from fever, or who is so drunk that he
cannot understand the terms of a contract, or from a rational judgment as to its effect on his
interests, cannot contract whilst such delirium or drunkenness lasts. In order to make a
drunkards contract void, there must be a high level of intoxication. In Gore vs. Gibson, it
was held that a contract made by a person so intoxicated as not to know the consequences
of his act is not binding on him if his condition is known to the other party. It appears,
however, that such a contract is not void but merely voidable. In Matthews vs. Baxter,
B, while drunk, agreed at an auction sale to purchase from M certain houses and land.
Afterwards, when sober, B affirmed the contract, and then repented of his bargain. When
sued on the contract, he pleaded that he was drunk at the time he made it, and to
Ms knowledge. The Court held that although B had once an option in the matter and might
have avoided the contract, he was now bound by his affirmation.
A totally drunk person also lacks the ability to consent to a contract and has the option of
avoiding a contract signed while intoxicated, provided it is done at the earliest opportunity
upon abstinence. Capacity to buy and sell is regulated by the general law concerning
capacity to contract, and to transfer and acquire property; except that where necessaries are
sold and delivered to a person who by reason of mental incapacity or drunkenness is
incompetent to contract, he must pay a reasonable price for them. Necessaries ... means goods
suitable to the condition in life of the person, and to his actual requirements at the time of the
sale and delivery.
30
Law of Contracts
CONTRACT BY THE PERSONS DISQUALIFIED BY LAW

Persons disqualified by law to enter into a contract may be divided into three categories.
They are: Alien enemy, Insolvent, and Convict.
Alien Enemy
Contracts with an alien enemy are void on the grounds of public policy as these contracts
may promote the economic interests of enemy or may prejudice the economic interests of
Indian economy. An alien enemy is the citizen of a country at war with India. An
agreement with an alien enemy is void. Such persons are disqualified from suing in Indian
courts. They can sue only after approval from the Central Government. If the Central
Government is of the opinion that the contract is against national interest, it may be
terminated or suspended temporarily. Contracts may be suspended during the war and may
be revived after the war is over, provided they are not time-barred.
Insolvent
An insolvent is a person who is unable to discharge his liabilities and therefore has applied
for being adjudged insolvent or such proceedings have been initiated by any of his
creditors. However, after the order of discharge he is competent to enter into contracts.
12.6.2 Consideration and Limitations

Section 25 of the Contract Act, 1872 declares that, an agreement made without
consideration is void. No right of action arises out of an agreement not supported by
consideration. Ex nudo pacto non oritur actio, which means nobody would part with
anything unless he gets a proper price. Hence, a contract without consideration raises a
doubt as to its genuineness.
Kinds of Consideration: Consideration may be of the following kinds:
Past Consideration: It is one which is paid for a past act or forbearance. An Act
constituting consideration which took place, is complete before the promise is made. This
kind of consideration presupposes a request by the promisor. For example, If C pays a
cheque of Rs.100 to D for returning his lost purse.
Executed or Present Consideration: It is an act or forbearance made or suffered or done in
return for a positive promise. In this case the promisor receives consideration simultaneously
with his promise. For example, in a sale by cash, consideration is present or executed.
Executory or Future Consideration: It is in return of a promise which is to be fulfilled in
future. Consideration moves at a future date. The contract is fulfilled as soon as the
promises are exchanged. For example, A agrees to sell 10 cotton bales after a week and B
agrees to pay for them after the sale.
Rules of Consideration: The general rules regarding a valid consideration are as follows:
Consideration must move at the behest of the promisor.
Consideration may move from the promisee or on the desire of the promisor, from any
other person (even a stranger).
Consideration need not be adequate for the validity of a contract.
Consideration in question must be real and not illusory.
Performance of an existing legal duty will not constitute consideration.
Exceptions to the Rules of Consideration: Consideration is a must for a valid contract to

ensue. However, the rule of ex nudo pacto non-oritur actio (an agreement made without
consideration is void) has the following exceptions:
Love and affection,
Voluntary services,
31
Time-barred debt,
Gift,
Agency, and
Charitable subscription.
Love and Affection [Section 25(1)]: An agreement made out of love and affection and
keeping in view the nearness of relationship, expressed in writing and registered under law,
is enforceable even if there is no consideration. The essential conditions required under the
Section are:
The agreement should be in writing,
It should be registered,
It is between parties who are closely related, and
It is on account of natural love and affection.
It is to be noted that nearness in relationship does not always indicate that love and affection
exist. In case of Rajlukhy vs. Bhootnath, it was held that as there did not exist any love and
affection between the parties, the agreement to pay maintenance allowance by a husband to
his wife was held to be void for want of consideration on part of the wife.
Voluntary Services [Section 25(2)]: A promise to compensate wholly or in part, a person
for an act voluntarily done is enforceable without consideration. In other words, a promise
to pay for a past voluntary service is binding. For example, if A does a favor to B, which he
acknowledges and promises to do something in return, then the promise to A is enforceable.
It is essential that:
The service should be rendered voluntarily;
The service is rendered to the promisor and nobody else. Hence, the act done should
be for a person who is in existence at the time of doing the act;
The promisor should have been capable of entering into a contract at the time of
rendering the service;
The promisor must have intended to compensate the promisee; and
The services rendered should not be immoral.
Time-Barred Debt [Section 25(3)]: A time-barred debt agreed upon by a written

agreement, signed by the debtor or his duly authorized agent, is enforceable even without
consideration. This debt must be one which would have otherwise been enforceable but for
the law of limitation. Therefore, debts unenforceable due to some other reason will not
come under Section 25(3). Thus if an insolvent debtor has been discharged under the
insolvency law, a subsequent promise by him to pay the debt cannot be enforced unless
there is a fresh consideration for the same.
Section 25(3), requires an express promise to pay the time-barred debt rather than a mere
acknowledgement of the debt. In Tulsi Ram vs. Same Singh, after the expiry of three years
from the execution of the promissory note, the defendant made an endorsement on the back
of the note stating I accept this pronote and it is valid for the next three years. It was held
that these words were only an acknowledgement of the existence of the note and did not
indicate whether the defendant intended to pay the debt. Hence, the defendant could not be
made liable on the basis of this endorsement. The validity of a time-barred debt rests on the
following conditions being fulfilled:
32
The promise should be in writing;
It should be signed by the promisor or his agent;
Law of Contracts
The debt must be a time-barred one; and
There must be an express promise to pay, either the whole or a part of the debt.
Similarly, Gift, Agency and Charitable subscriptions are exemptions to the rule of
consideration.
Unlawful Object and Consideration
The consideration of the agreement is the content of agreement as to, what is to be done
under it. For example, X lets out his house for Rs.500 to Y, for residential purpose. Y
intends to run a gambling den in that rented premises for which X does not have any
objection. The consideration in this agreement may be lawful but the object is unlawful.
Section 10 requires that both the object and the consideration must be lawful.
Section 10 reads as follows:
All agreements are contracts if they are made by the free consent of parties competent to
contract, for a lawful consideration and with a lawful object, and are not hereby expressly
declared to be void.
Nothing herein contained shall affect any law in force in [India], and not hereby expressly
Thus, all agreements are contracts if made for lawful consideration and with lawful object.
Section 23 covers the illegality of both the object of the contract and the consideration
for it.
The consideration or object of an agreement is lawful, unless it:
is forbidden by law; or
is of such nature that, if permitted, it would defeat the provisions of law; or
is fraudulent; or
involves or implies injury to the person or property of another; or
the court regards it as immoral, or opposed to public policy.
Thus if the object or consideration of any contract falls under any of these circumstances
it is not lawful and such contracts are not valid. Section 23 clearly specifies the nature of
consideration and objects that are not lawful. The agreement is illegal if the object or
consideration of that agreement is unlawful for any of the reasons as mentioned in
Section 23.
Some of the reasons which make the object or consideration as unlawful are mentioned
hereunder.
The Object or Consideration is forbidden by Law: According to Section 23, where the
object of an agreement is forbidden by law, the agreement is unlawful. Law in this
connection means the law for the time being in force in India and these include personal
laws also. An act or an undertaking is said to be forbidden by law when:
it is punishable by the criminal law of the country, or
when it is prohibited by the special legislation or regulations made by a competent

authority under powers derived from the legislature.5
Illustration: The sale of liquor without license is illegal. The sale is void and the price is
also irrecoverable.6
Referred by Nirmal Singh in the book, Business Laws, on P.no. 156 originally referred by Cf.
Pollock and Mulla, Indian Contract Act, p.138.
33
Object or Consideration or Performance Defeats the Provisions of Law: Where the

object of or the consideration for an agreement is such that though not directly forbidden by
law, it would, if permitted, defeat the provisions of some law, such an agreement is also
void. Where the agreement is of such a character that if permitted it would frustrate the
provisions of any law, neither party is capable of enforcing such an agreement, since no
legal relations can arise from the agreement which is infringing a statute or opposed to
public policy. Defeating the provisions of law means, violation of law.
Object and Consideration are Fraudulent: An agreement made for a fraudulent purpose
is void. Where the parties agree to impose a fraud on a third person, their agreement is
unlawful. For example, a scheme of fraud made between a debtor and creditor against other
creditors.7 Where there is an agreement between the partners of a firm to cheat income tax
authorities it is fraud and such agreement is void as the object of the contract is fraudulent.8
Object and Consideration are Injurious to any Person or Property: If the object or
consideration of an agreement is injurious to the person or property of another, it is a void
agreement and is unlawful. Thus, an agreement between two persons to injure a person or
property of any person is unlawful. If the object of an agreement is such that it involves or
implies injury to the person or property of another, the agreement is unlawful. (Section 23)
Object and Consideration are Immoral: When in an agreement the object or
consideration is immoral, it cannot be enforced. Thus all the agreements supported by
immoral consideration or object, are unlawful and void. Immoral means something against
the moral principles of society or ethics. The standard of morality depends much on time
and also on courts as to how they interpret it. But by and large there are certain sets of acts
which are regarded as immoral from time immemorial. These include generally sexual
immorality, interference with marital relations, acts against good public morals etc.
The Object and Consideration are Against Public Policy: An agreement is unlawful if
the court regards it as opposed to public policy. Public policy is a flexible term without
any exact meaning. Public policy is the principle of law which holds that no citizen can
lawfully do any act which is injurious to the public or is against the interest of the society or
the State at large. Thus in a broader sense an agreement which tends to promote corruption
or injustice or immorality is said to be opposed to public policy.
Interference with Course of Justice: Any agreement that obstructs or hinders the process
of justice is void and is against public policy. For example, an agreement to delay the
execution of a decree and the agreement to give false evidence are held to be void.9
Agreement to Restrain Prosecution: This includes an agreement not to prosecute an
offender or to withdraw a pending prosecution. It is against the public policy not to punish
any criminal. In Sudhindra Kumar vs. Ganesh Chandra10 the court observed: No court of
law can countenance or give effect to an agreement which attempts to take the administration
of law out of the hands of the judges and put it in the hands of private individuals.
6
7
8
Kotteswar Vittal Kamath vs. K Rangappa Balinga & co., 1969 (s) SCC255: AIR 1969 SC 504.
Alexander vs. Rayson 1936 1 KB 169.
Ram Sevak vs. Ram Charan AIR 1982 All. 177. See also Bhegie vs. Phosphate Sewage Co. 1876
QBD 679.
9 Montefiore vs. Menday Motor Components Co. Ltd. 1918 -19 ALL ER rep 1188 and Nand Kishore
vs. Kunj Beharilal, AIR 1933 All. 303.
10 1939 (1) Cal. 241.
34
Law of Contracts
Illustration: A promises B to drop a prosecution which he has instituted against B for

robbery, and B promises to restore the value of the thing taken; the agreement is void as the
object of such contract is unlawful.
Agreement of Maintenance and Champerty: Champerty is an agreement whereby a
person agrees to assist another in litigation in exchange of promise to handover a portion
of the proceeds of the action. Under the English Law such agreements are absolutely
void. Maintenance in this context is explained by Lord Haldane: It is unlawful for a
stranger to render officious by money or otherwise to another person in a suit in which
that third person has himself no legal interest for its prosecution or defense.11
The rules applied in India are as follows:
An agreement for supplying funds by way of maintenance or champerty is valid unless,
It is unreasonable so as to be unjust to the other party, or
It is made by a malicious motive like that of gambling in litigation, or oppressing other

party by encouraging unrighteous suits, and not with the bonafide object of assisting a
claim believed to be just12, or
An agreement for providing professional services is valid if it is made by way of

maintenance and with a bonafide object of assisting a claim believed to be just and
obtaining a reasonable recompense therefore. But if it is made by way of champerty, i.e.,
making the remuneration dependent to any extent whatsoever upon the result of the
suit, it is void.13
Illustration: An agreement to finance litigation will not be enforced wherein, there is a

condition that the entire share of the decreed property would go to the financier. It was held
to be extortionate and against equity and justice.14
An agreement by a client to pay his lawyer according to the result of the case is
against public policy.15
Marriage Brokerage Contract: An agreement to procure the marriage of a person in

consideration of a sum of money is called marriage brokerage contract. Where a middleman
is promised money in consideration of procuring a wife for a person or prosperous groom,
such agreement is held to be invalid and money cannot be recovered.16 An agreement to
give dowry to the parents of bride or bridegroom agreeing to the wedding is illegal and
cannot be enforced.
According to the judgments of the Punjab, Calcutta and Madras High Courts, an agreement
to pay money to the parent of a minor to induce him to give the minor in marriage is void. 17
Unfair or Unreasonable Dealings: Where the parties are not of the same economic status
and there is a wide gap in their bargaining power; where one of them is in position to
exploit and the other is vulnerable and the contract made with the other is apparently unfair,
it can under such circumstances be also regarded as opposed to public policy.
11
12
13
14
15
Nevite vs. London Express, 1910 AC 368.

Bhagwat Dayal Singh vs. Debi Dayal Sahu, 1908, 35 Calcutta 420.
Kothi Jairam vs. Vishwanth, 1925 AIR Bombay 470.
Kamrunissa vs. Pramod Kumar Gupta, AIR 1997 MP 106.
Kothi Jairam vs. Vishanath, AIR, 1925 Bombay 470; Ratan Chand Hira Chand vs. Askar Nawaz
Jung, 1991 (3) SCC 67.
16 Pitamber vs. Jagjivan, 13, Bombay 131.
17 Wazarimal vs. Rallia, 1889Punj. Rec No 128; Baldeodas vs. Mohamaya, 1911 (15) CWN 447;
Kalavangunta vs. Lakshmi Narain 1909 (32) Madras.
35
A contract creates reciprocal obligations between the parties. When those obligations come
to an end the contract is said to be discharged. The non-fulfilment of the contractual
obligations exposes the erring party to the consequences resulting from breach of contract.
When a contract is performed, as per the conditions set by the agreement for which the
parties accepted, the contract will come to an end. Parties will not have further obligation
regarding such contracts and they are free from obligations. Thus the contract is said to be
discharged by performance. This is the normal and natural mode of discharge of a contract.
12.6.3 Free Consent of the Parties and Limitations

The parties must have entered into the contract out of their own free will. Consent implies
agreeing upon the same thing in the same sense. According to Section 14 of the Act, the
consent is said to be free when it is not caused by:
Coercion, as defined in Section 15, or
Undue influence, as defined in Section 16, or
Fraud, as defined in Section 17, or
Misrepresentation, as defined in Section 18, or
Mistake, subject to the provisions of Section 20-22.
Coercion: Coercion (known as Duress under English Law) is to induce a person forcibly to
enter into a contract. Coercion must be so extreme that the person is left with no other
option but to give his assent against his will. Coercion may be by use of physical force or a
threat involving imminent danger to life or health of a person.
Illustration: A, on board an English ship on the high seas, causes B to enter into an
agreement by an act amounting to criminal intimidation.
Undue Influence: It is the use of a relationship of trust and confidence to exploit the other
party to derive some contractual advantage. This kind of relationship is also called as a
fiduciary relationship. The domination of one persons will over the other person is
quintessential to the element of undue influence.
Fraud: To constitute fraud there must exist a fact and the fact must be misstated and the
materiality of the fact must be proved, and the main factor that determines the essence of
fraud is the defendants knowledge of the falsity of his or her statement. The intention of
the defendant to deceive must also exist. In short, it is a false statement made with an
intention to deceive another person.
Misrepresentation: Misrepresentation and fraud are similar except the fact that
misrepresentation lacks scienter and intention to deceive. Professor G. Fridman states that
four conditions must be met before a court will accept that there has been fraudulent
misrepresentation:
36
That the representations complained of were made by the wrongdoer to the victim
(before the contract);
That these representations were false in fact;
That the wrongdoer, made them recklessly without knowing whether they were false
or true; and
That the victim was thereby induced to enter into the contract in question (a legal
presumption exists in this regard).
Law of Contracts
Mistake: It takes place when the parties to the contract are ignorant about the existing fact
pertaining to the transaction. A mistake may be unilateral or bilateral. Where mistake is
made by one party to the contract, it is called a unilateral mistake. Similarly, where there is
mistake on both sides of the parties there is a bilateral mistake. In Smith v, Hughes18, there
was a contract for supply of oats between the plaintiff and the defendant. The defendant has
refused to accept the shipment on the grounds that the contract was for old oats. The
words old oats were not used at any point of time in the contract. The court held that the
contract be performed as it appeared that the words old oats were never used at the
moment of meeting of minds.
The presence of fraud, undue influence etc., in the formation of the contract does not negate
the consent. There is consent but it is not freely given. The result of the consent given under
fraud, coercion etc., is that the contract becomes voidable at the option of the other party.
The party can either reject the contract or accept it. Consent must be voluntary, and if there
is any force or deception by either party to obtain agreement of the other party and the
contract may be voided by the injured party. If the agreement is induced by bilateral
mistake, the agreement is void and not voidable.
Promissory Estoppel
The doctrine of promissory estoppel is an exception to the Pinnel rule. In practice, it
neutralizes the effect of the rule in the above said case. This is similar to the rule of waiver
where parties in a contract agree not to conform to strict adherence to the terms of contract
in the performance of a contract. The principle of promissory estoppel was expressed by
Bowen L.J.19 in the following words:
If persons who have contractual rights against others induce by their conduct those against
whom they have such rights to believe that such rights will either not be enforced or will be
kept in suspense or abeyance for some particular time, those persons will not be allowed by
a Court of Enquiry to enforce the rights until such time has elapsed
The doctrine of promissory estoppel applies in the following circumstances:
where a representation is made,
of fact or law,
regarding present or future act,
which is binding,
intended to induce a person to act on it, and
such other person acts on it.
Thus, once a promise is made by the promisor not to strictly adhere to the terms of the
contract and he accepts the performance of the promisee on such terms, he cannot later on
enforce his rights under the original terms of contract. In other words, he is stopped from
retracting his words of promise. This principle was first applied in England in Hughes vs.
Metropolitan Railway Co20. In this case the landlord of a premises gave notice to the tenant
to carry out repairs to the premises within 6 months failing which he would have to vacate
the same. After a month the landlord entered into negotiations with the tenant for the sale of
the premises. But the negotiations failed and on the expiry of the 6 months time, the
landlord asked the tenant to vacate the premises. It was held that 6 months time would run
from the date of failure of the negotiations. The negotiations raised a presumption as to the
promise of the landlord to suspend the notice and the tenant had acted upon such promise.
Hence no repairs were carried out by him.
18 (1871) LR 6 QB 597.
19 Birmingham & District Land Co. vs. L. & N.W. Rly Co., (1884) 40 Ch D 268 at p.286.
20 (1877) 2 App Cas 439.
37
In India there is no scope for controversy or ambiguity in this matter. Section 63 of the Act
clearly provides that every promisee may dispense with or remit, wholly or in part, the
performance of the promise made to him, or may extend the time for such performance, or
may accept instead of it any satisfaction which he thinks fit. Where X is indebted to Y a
sum of 1000 rupees and X pays Rs.500 at the time and place where the debt was to be
discharged with the consent of Y, the debt is discharged Y having accepted it as full
satisfaction of the debt.
12.7 VOIDABLE CONTRACTS

According to Section 2(i) of the Act, An agreement which is enforceable by law at the
option of one or more of the parties thereto, but not at the option of the other or others, is a
voidable contract. A contract that is not enforceable by both the parties is a void contract.
But a contract that is enforceable by one and not by the other is voidable. Thus, if A coerces
B to enter into a contract, B can still enforce the contract if he wants, but A cannot enforce
it as against an unwilling B. Thus a voidable contract can be terminated or repudiated at the
will of one of the parties. However till it is repudiated it remains valid and binding. The
contract must be repudiated within a reasonable time. Otherwise the contract will become
enforceable. A contract is voidable when the consent of the party to a contract is obtained
by fraud, misrepresentation, coercion or undue influence. The party whose consent is so
obtained can either reject the contract or proceed with the contract at his option. He may ask
the other party to put him in the position he would have been in the absence of such fraud or
misrepresentation etc., and proceed with the contract. In such a case the contract would be
binding on both the parties.
Section 53 of the Act provides that if a party to a contract prevents the other from
performing his part of the promise the contract becomes voidable at the option of the party
so prevented.
Section 55 of the Act provides that if a party to a contract, in which time is essential, fails
to perform his promise at or before a fixed time, the contract is voidable at the option of the
other party if the intention of the parties was that time should be the essence of the contract.
Illustration: In Chikham Ammiraju vs. Chikham Seshamma21, by threat of suicide, a
Hindu induced his wife and son to execute a release in favor of his brother in respect of
certain properties which they claimed as their own. It was held by the majority judgment
that, the threat of suicide amounted to coercion within Section 15 and the release deed
was, therefore, voidable.
A voidable contract is based on the improper conduct of one party, on the vulnerability of
the other, or a combination of the two. As such the agreement is voidable at the option of
the party whose consent has been obtained by coercion, undue influence, fraud or
misrepresentation. The factors that vitiate free consent are explained hereunder:
COERCION (SECTION 15)
Coercion is defined in Section 15 of the Indian Contract Act as:
The committing, or threatening to commit, any act forbidden by the Indian Penal Code
(45 of 1860), or the unlawful detaining, or threatening to detain, any property, to the
prejudice of any person whatever, with the intention of causing any person to enter into an
agreement.
21 (1912) 16 IC 344.
38
Law of Contracts
Coercion involves committing or threatening to commit some act which is forbidden by

the Indian Penal Code. A clear illustration would be the consent obtained at the point of
pistol, or by threatening to cause hurt, or by intimidation. In Ranganayakamma vs. Alwar
Chetty22, a young widow of 13 years was forced to give her consent to the adoption of her
boy, under threat that the body of her husband (who had just died) would not be allowed
to be removed for cremation. A suit was filed to set aside the adoption. The Court held
that the consent was not a free consent, but induced by coercion as preventing a dead
body from being removed for cremation is an offence punishable under Section 297 of
the Indian Penal Code.
UNDUE INFLUENCE (SECTION 16)
Undue influence is defined by Section 16 of the Indian Contract Act, 1872. Section 16 provides
that a contract is said to be induced by undue influence where the relations subsisting
between the parties are such that one of the parties is in a position to dominate the will of
the other and uses that position to obtain an unfair advantage over the other.
In particular and without prejudice to the generality of the foregoing principle, a person is
deemed to be in a position to dominate the will of another:
Where he holds a real or apparent authority over the other, or where he stands in
fiduciary relation to the other.
Where he makes a contract with a person whose mental capacity is temporarily or

permanently affected by reason of age, illness, or mental or bodily distress.
Where a person who is in a position to dominate the will of another, enters into a
contract with him, and the transaction appears, on the face of it or on the evidence
adduced, to be unconscionable, the burden of proving that such contract was not
induced by undue influence shall lie upon the person in a position to dominate the will
of the other.
Nothing in this Subsection shall affect the provisions of Section 111 of the Indian Evidence
Act, 1872 (1 of 1872).
Agreements obtained under undue influence can also be rescinded as per Section 19-A.
This Section reads as follows:
When consent to an agreement is caused by undue influence, the agreement is a contract
voidable at the option of the party whose consent was so caused.
Any such contract may be set aside absolutely or, if the party who was entitled to avoid it
has received any benefit thereunder, upon such terms and conditions as to the Court may
seem just.
Illustration: A, a money-lender advanced Rs.100 to B, an agriculturist and by undue
influence, induced B to execute a bond for Rs.200 with interest at 6 percent month. The court
may set aside the bond, ordering B to repay Rs.100 with such interest which is justifiable.
FRAUD (SECTION 17)
Before entering into a contract, the person who makes the offer or his agent, may make any
representations so as to obtain the acceptance or consent from the other party. In the course
of these representations, many of them may be false, which the person making it may or
may not be aware. The false representation when made with an intention to deceive the
other party is called fraud.
22 (1889) 13 Mad. 214.
39
A fraud is an act of deliberate deception with the design of securing something by taking
unfair advantage of another. It is a deception in order to gain by anothers loss. It is
cheating intended to get an advantage.23 The term fraud includes all intentional or willful
misrepresentation of facts, which are material for the formation of a contract. The most
important factor involved in the fraud is the intention to mislead the other party.
According to Section 17 of the Indian Contract Act of 1872, fraud means and includes
any of the following acts committed by a party to a contract, or with his connivance, or by
his agent, with intent to deceive another party thereto or his agent, or to induce him to enter
into the contract:
The suggestion, as to a fact, of that which is not true, by one who does not believe it to
be true;
The active concealment of a fact by one having knowledge or belief of the fact;
A promise made without any intention of performing it;
Any other act fitted to deceive;
Any such act or omission as the law specially declares to be fraudulent.
Section 17 of the Act enumerates various acts which constitute fraud. According to Section
17, the following acts, committed by a party or his agent to deceive the other party amount
to fraud:
Where there is false statement of fact: When a person knowingly states a fact which is
actually not true and which even he does not believe it to be true, it is considered as fraud.
This kind of statement must be relating to a matter of fact and not of opinion.
Where a person conceals material fact: If a person intentionally takes steps to conceal a
material fact which is very important for the formation of a contract, it amounts to fraud.
Moreover, if he knows that disclosure of such concealed facts would be detrimental to his
interest, it is an act of fraud.
When a person promises without intention to perform: If a person enters into a contract
without having an intention to perform it, it is a fraud. This kind of act implies the intention
to deceive the other party.
Another acts to deceive: Any other acts which are done with an intention to deceive the
other party are defined as fraudulent. In addition to the above, all such acts that are declared
as fraudulent by law of the country also come under fraudulent acts.
MISREPRESENTATION (SECTION 18)
Misrepresentation is defined in Section 18 of the Indian Contract Act as:
Misrepresentation means and includes
the positive assertion, in a manner not warranted by the information of the person
making it, of that which is not true, though he believes it to be true;
any breach of duty which, without an intent to deceive, gains an advantage to the
person committing it, or any one claiming under him, by misleading another to his
prejudice, or to the prejudice of any one claiming under him; and
causing, however innocently, a party to an agreement to make a mistake as to the

substance of the thing which is the subject of the agreement.
23 S.P. Chengalvaraya Naidu vs. Jagannath; AIR 1994 SC 853.
40
Law of Contracts
A contract wherein the consent is taken by misrepresentation of certain facts is voidable at

the option of the deceived party. Misrepresentation is the misstatement of a fact material to
the contract. When a false statement is made with the knowledge that it is false and also
with the intention to deceive the other party to make him enter into a contract, it is called
fraud. But when the person making a false statement believes the statement to be true and
does not intend to mislead the other party to the contract, it is known as misrepresentation.
Thus, where a consent to the contract is obtained by misrepresentation, it is not a free
consent and hence the contract is voidable.
Misrepresentation thus amounts to any untrue/unwarranted statement, relating to the fact
which is material to the contract, made innocently (without the intention to deceive) by a
party to the contract, to another party. The other party believing the statement acts upon the
statement, and gives his consent and enters into a contract.
Performance of the Reciprocal Promises (Section 53)
Section 53 of the Indian Contract Act states that:
When a contract contains reciprocal promises, and one party to the contract prevents the
other from performing his promise, the contract becomes voidable at the option of the party
so prevented; and he is entitled to compensation from the other party for any loss which he
may sustain in consequence of the non-performance of the contract.
When one party to a reciprocal promise prevents the other from performing his promise, the
contract becomes voidable at the option of the party who is so prevented. Moreover the
party so prevented is entitled to compensation from the other party for any loss which he
may sustain in consequence of non-performance of the contract.
When Time is the Essence of the Contract (Section 55)
Sometimes the parties to a contract specify the time for its performance. Ordinarily it is
expected that either party will perform his obligation at the stipulated time. The contract
becomes voidable if the party fails to perform in time at the option of the other party. In
commercial transactions time is essential for the validity of a contract and a slight delay of
one party may result in irreparable loss to the other party. Thus many contracts include
stipulation as to time for the performance of the contract. When the party supposed to
perform commits default on the stipulated day, the contract becomes voidable at the option
of the promisee.
REMEDIES FOR VOIDABLE CONTRACTS
There are common remedies in cases of mistake, misrepresentation and fraud. They are:
That the party wronged can successfully defend an action against him for damages for
breach of contract.
That he can successfully defend an action for specific performance.
That he can sue to have the contract rescinded on the ground of want of real consent.
41
a.
Can a minor may enter into contract of apprenticeship? Justify?
b.
A contract where consent is obtained by coercion. Is this a void, voidable or illegal

contract?
c.
Prabhas hired the house of Sanjay to run a gambling house at a monthly rent of five
thousand rupees, on his failure to pay the rent Sanjay wants to sue Prabhas for
recovery of rent. Is the contract valid? Can Sanjay recover the amount from
Prabhas?
12.8 REMEDIES FOR BREACH OF CONTRACT

A condition is a major term of the contract. In the event of a breach, the injured party is
entitled to rescind the contract and to claim damages.24 The right to rescind is lost in the
same way as in cases of misrepresentation.
The innocent party is always entitled to affirm the contract. In such a case, he will still be
entitled to damages, but not to treat the contract as at an end.
Illustration: A hired Bs ship to carry cargo from Russia. Later, B repudiated the contract.
A delayed a decision as to whether to treat the contract as at an end or sue for damages,
hoping that B would change his mind. War then broke out between Great Britain and
Russia before the performance date, thus frustrating the contract. It was held that A had
kept the contract alive by his actions, which led to the frustration of the contract. As such
he had lost his right of action (Avery vs. Bowden).
The law has provided certain remedies to the aggrieved party in case of breach of contract
by the other parties. The important feature in the event of breach of contract is that each
party has a responsibility to mitigate its losses at a minimum possible level.
The following are the remedies provided in the Act:
The Indian Contract Act, 1872 specifies the remedies available to the parties for the
breach of contract in Sections 73, 74 and 75;
Section 73 deals with the compensation for loss or damage caused by breach of
contract;
24 Wallis sons and Webb vs. Pratt & Haynes (1910).
42
Law of Contracts
Section 74 deals with the compensation of breach of contract where penalty is

stipulated for; and
Section 75 provides that the Party who is rightfully rescinding the contract is entitled
to compensation.
Section 73 of the Indian Contract Act states that, When a contract has been broken, the
party who suffers by such breach is entitled to receive, from the party who has broken the
contract, compensation for any loss or damage caused to him thereby, which naturally arose
in the usual course of things from such breach, or which the parties knew, when they made
the contract, to be likely to result from the breach of it. Such compensation is not to be
given for any remote and indirect loss of damage sustained by reason of the breach.
Section 73 of the Act further states that, When an obligation resembling those created by
contract has been incurred and has not been discharged, any person injured by the failure to
discharge it is entitled to receive the same compensation from the party in default, as if such
person had contracted to discharge it and had broken his contract.
Explanation: In estimating the loss or damage arising from a breach of contract, the
means which existed of remedying the inconvenience caused by non-performance of the
contract must be taken into account.
A condition to perform the obligation by the parties is a major term of the contract.
When a contract is broken, the injured party has one or more of the following remedies:
Suit for Rescission,
Suit for Injunction,
Suit for Specific Performance,
Suit for Damages,
Penalty by Courts, and
Suit for Quantum Meruit.
These remedies are discussed below:
12.8.1 Suit for Rescission

When a contract is broken by one party, the other party may sue to treat the contract as
rescinded and refuse further performance. The aggrieved party may need to approach the
court to grant him a formal rescission, i.e. cancellation of the contract. This will enable him
to be free from his own obligations under the contract. Section 39 of the Indian Contract
Act extends the right to the aggrieved party to put an end to the contract. Section 64 of the
Indian Contract Act states that, when a person at whose option a contract is voidable
rescinds it, the other party thereto need not perform any promise therein contained in which
he is a promisor. The party rescinding a voidable contract shall, if he has received any
benefit thereunder from another party to such contract, restore such benefit, so far as may
be, to the person from whom it was received.
As such, when a party treats the contract as rescinded, he should restore any benefits he has
received under it. According to Section 75 of the Indian Contract Act, a person who
rightfully rescinds a contract is entitled to compensation for any damage which he has
sustained through the non-fulfillment of the contract.
Thus formal declaration of rescission clears the way for other consequences to take effect
following the breach of contract.
43
12.8.2 Suit for Injunction

Injunction is the order from a court that prohibits a party to do or refrain from doing a
certain act. This is available in contract actions in only limited circumstances. Such an
order of injunction from a court that is granted at the instance of the aggrieved party against
the person who has breached the contract acts as remedy and makes the guilty party refrain
from doing or not doing precisely the act, which is causing the breach of contract.
The guilty party may be committing a violation to certain negative terms of the contract,
which ultimately leads to some loss or injury to the aggrieved party. The order of injunction
acts as a negative relief to the aggrieved party. The positive relief is in other forms like
damages.
Illustration: R enters into an agreement with M to present an entertainment program at Ms
hotel on the eve of the New Years Day. Later, R enters into another agreement with N to
conduct the same type of performance at the same time at Ns hotel. M treats it as an
anticipatory breach of performance on the part of R and seeks for an injunction from the
court. The court may pass an injunction order against R not to present the program at Ns
hotel at that time.
12.8.3 Suit for Specific Performance

Specific performance means doing exactly what had been intended to be done by the
parties in the contract. The specific performance is the remedy granted by the courts to the
aggrieved party in equity only in cases where it is absolutely essential to grant it. Specific
performance is a rare remedy at law, but sometimes available where the subject of the
breached contract is special and irreplaceable. The courts order the guilty party to actually
perform his obligation only when monetary compensation (by way of damages) will not be
an adequate remedy. Specific remedies direct the party in default to do or to forbear the
very thing, which he is bound to do or forbear or make a declaration of rights which the
nature of the case may require.
Illustration: If A agrees to sell a house to B, B can enforce the contract specifically. So A
will be required to convey the house to B. This remedy is granted because the court finds
that the remedy of damages is not an adequate remedy in such a case.
In Indian law, the various modes of specific relief are mentioned in the Specific Relief Act,
1963, which came into force from 1.3.1964. They are:
Restoration of possession: The court orders that the disputed property is be delivered to
the rightful claimant.
Specific performance of contracts: The court can order the defendant to perform the very
act, which he has contracted to do.
Injunction: An injunction is granted to the plaintiff to prevent the breach of an obligation
existing in his favor by a mandatory injunction. The court directs the defendant to do the
requisite acts to prevent the breach of his obligation.
Declaratory relief: The court may grant a declaration as to the rights of the parties.
Other forms of specific relief are Rectification of documents, Rescission of contracts and
Cancellation of instruments.
44
Law of Contracts
12.8.4 Suit for Damages

Damages are a monetary compensation allowed to the injured party by the court for the loss
of injury suffered by him by the breach of a contract. The object of awarding damages for
the breach of a contract is to put the injured party in the same position, so far as money can
do it, as if he had not been injured i.e., place him in the position in which he would have
been had there been performance and not breach. This is called as the doctrine of
restitution (restitution in integrum). The fundamental basis of awarding damages is
compensation for the pecuniary loss which naturally arises from the breach.
The foundation of modern law of damages in contracts, both in India and England, is to be
found in the judgment in the case of Hadley vs. Baxendele25. The facts of this case were as
follows:
Hadley vs. Baxendale (The rule of remoteness and special circumstances).
A broken shaft was given to a carrier to bring it to a repair shop. The carrier was not
told that the absence of the shaft would completely stop the work of the owner. The
carrier was in breach of contract because the delivery was delayed by several days.
Admitting to damages, the defendant nevertheless argued that the loss of profit
damages were too remote.
The court said that damages should be restricted to what may fairly and reasonably be
considered either arising naturally, i.e., according to the usual course of things, from such
breach of contract itself, or such as may reasonably be supposed to have been in the
contemplation of both the parties, at the time they made the contract, as the probable result
of the breach of it. Now, if the special circumstances under which the contract was
actually made were communicated by the plaintiffs to the defendants, and thus known to
both the parties, the damages resulting from the breach of such a contract, which they
would reasonably contemplate, would be the amount of injury which would ordinarily arise
from a breach of contract under these special circumstances so known and communicated.
Section 73 of the Contract Act which deals with the compensation for loss or damage
caused by breach of contract is based on the judgment in the above case. The rules as
given in Section 73 are as follows:
When a contract has been broken, the injured party is entitled to:
such damages which naturally arose in the usual course of things from such breach.
This relates to ordinary damages arising in the usual course of things;
such damages which the parties knew, when they made the contract, to be likely to
result from the breach. This relates to special damages. But;
such compensation is not to be given for any remote or indirect loss or damage
sustained by reason of the breach; and
such compensation for damages arising from breach of a quasi-contract shall be same
as in any other contract.
In estimating the loss of damage arising from a breach of contract, the means which existed
of remedying the inconvenience caused by the non-performance of the contract must be
taken into account. In case a conflict persists between the parties after the breach, the court
has to perform the difficult task of measuring the amount of damages. In this task the court
takes into account the provisions of law and the circumstances attached to the contract. In
order to quantify the loss, the court identifies the nature of loss that has resulted in the
breach of contract and based on that factor the loss is quantified.
25 (1854)9 Ex. 341.
45
Damages can be classified under the following types based on the courts judgments and
the provisions of Section 73 of the Indian Contract Act, 1872 and also depending upon the
circumstances of the case.
General damages;
Special damages;
Exemplary or vindictive or punitive damages; and
Nominal damages.
The details of the above types of damages are discussed below:

GENERAL OR ORDINARY DAMAGES
The losses that naturally and directly arise out of the breach of the contract in the usual
course of the things are called as general damages. They would be the unavoidable and
logical consequence of the breach. The damages for such losses are called as general
damages or ordinary damages.
The general measure of damages is such sum as will put the aggrieved party as nearly as
possible into the position in which he would have been if the contract had been duly
performed. Such damages cover the loss which the aggrieved party has suffered and the
gain of which he has been deprived.
SPECIAL DAMAGES
Special damage is what arises in the peculiar circumstances of a particular case, quite apart
from the usual course of things. While making the contract, one party to the contract may bring
to the notice of the other party about the particular type of losses that he would suffer under
certain special circumstances. In case the contract is not performed properly and if the other
party still proceeds to make the contract, it is construed that the other party has expressly agreed
to be responsible for the special losses that may be caused by improper performance of his
obligation. Compensation for such special losses is called as special damages.
In accordance with the provisions of Section 73 of the Act, when a contract has been
broken, the party who suffers by such breach is entitled to receive, from the party who has
broken the contract, the compensation for any loss or damage caused to him thereby or
which the parties knew, when they made the contract, to be likely to result from the breach
of it. These damages are called as special damages.
Illustration: M told C that there should not be any delay in the performance of the contract
i.e., repairs to be made to the specified machinery, as his business would be affected and he
would incur losses for any delay by the latter and C has promised not to cause delay. This
would imply that C has agreed to become liable for the special losses that may be caused by
means of the improper performance of his obligation. Compensation for such losses are
called as special losses.
The important factor in the event of breach of contract is that each party has a responsibility
to mitigate its losses at a minimum possible level. For example, if A enters into a contract
to deliver apples to B and B refuses to take delivery (in so doing, B is in breach of
contract), A would be well advised to try to sell the fruit elsewhere to minimize any
damages that he may suffer by the breach. The law does not require a party to do
cartwheels to minimize losses, just what can be reasonably done without incurring
substantial costs. The general rule is: in a case where there is a breach of contract, the
plaintiff if he can minimize his loss by a reasonable course of conduct, he should do so,
though the onus is on the defaulting defendant to show that it could be, or could have been,
done and is not being, and has not been done.
46
Law of Contracts
Indirect Damages (Loss of Profits)

The following illustration shows the nature of the indirect damages:
A delivers to B, a courier company, a machine to be delivered overnight to As factory.
B does not deliver the machine on time, and A, in consequence, loses a profitable contract
with the Government. A is entitled to receive from B, by way of compensation, the average
amount of profit which would have been made by the working of the factory during the
time that delivery of it was delayed, but not the loss sustained through the loss of the
Government contract.
The leading case on this subject is that of Hadley vs. Baxendale26. Section 73 and various
cases clearly provide that knowledge of circumstances leading to loss of profits to the
plaintiff imposes liability on the defendant.
EXEMPLARY OR VINDICTIVE DAMAGES
The principle underlying the award of damages is compensation to the aggrieved party.
But, law generally would find it difficult to heal the mental pain or suffering or sense of
humiliation that may be caused to the aggrieved party by the breach. In two exceptional
cases, the courts award damages that can be punitive. i.e., by way of punishment. These are:
(1) Breach of promise to marry, (2) Bank dishonoring a customers cheque, though
customer has sufficient funds in his account. Damages awarded in these two exceptional
cases are called exemplary damages or vindictive damages.
Breach of Promise to Marry: An agreement to marry a person is like any other contract. If
the obligation is broken even before the marriage takes place, it would cause enormous
amount of mental agony, emotional hurt and loss of reputation in the society to the
aggrieved person. It may be very difficult for the courts to measure exactly such losses in
terms of money. Under such circumstances, the courts would award a large amount as
damages to the aggrieved party which could cause a certain degree of discomfort to the
guilty party.
Unjustified Dishonor of Cheques by Banks: Section 31 of the Negotiable Instruments
Act, 1881 stipulates the liability to the drawee of a cheque as, The drawee of a cheque
having sufficient funds of the drawer in his hands properly applicable to the payment of
such cheque must pay the cheque when duly required to do so, and, in default of such
payment, must compensate the drawer for any loss or damage caused by such default. If a
bank wrongfully dishonors a cheque that is drawn by its customer on his account when
there is sufficient money in that account to meet that cheque at the time the cheque is
presented for payment, it results in loss of reputation in the business (market) as well as a
lot of mental agony to that customer. This loss is very difficult to be measured in terms of
money or otherwise. Under such situations, the aggrieved customer shall be allowed
punitive damages by the courts.
NOMINAL DAMAGES
Sometimes the breach of a contract does not cause any loss. If the market is rising, i.e.
prices are going up, a breach by the buyer does not entail loss to the seller for the seller can
easily sell even for a higher price. Still the breach of a contract being a wrong, the seller can
recover damages in a technical sense. The damages awarded in such a case are called
nominal damages (for example, one rupee or even one pie).
26 9, Ex. 341: 96 R.R. 742.
47
Liquidated Damages
Such an amount that is specifically mentioned in the contract by the parties themselves to
be payable to the aggrieved party in case towards the breach, is also called as liquidated
damages.
Usually it is for the court to determine the quantum of damages. It is always contemplated
whether the courts would award the same amount towards the damages that the parties
themselves have specified in the contract towards the damages for breach of contract. If this
is done, the stipulated damages would be known as liquidated damages. Liquidated
damages are in the nature of ascertained damages.
In Mehata & Sons vs. Century Spinning and Manufacturing Co.27, the plaintiff claimed
damages for premature termination by the defendant company of the plaintiffs service as
Managing Agents. They claimed as damages 10% of the gross profits of the company,
(which was their remuneration as Managing Agents under the Managing Agency Contract)
for unexpired period of the contract of service.
PENALTY BY COURTS
Section 74 of the Indian Contract Act deals with the compensation to be awarded for breach
of contract where a penalty is stipulated in the contracts.
Section 74 of the Act states that, When a contract has been broken, if a sum is named in
the contract as the amount be paid in case of such breach, or if the contract contains any
other stipulation by way of penalty, the party complaining of the breach is entitled, whether
or not actual damage or loss or proved to have been caused thereby, to receive from the
party who has broken the contract reasonable compensation not exceeding the amount so
named or, as the case may be, the penalty stipulated for.
Explanation: A stipulation for increased interest from the date of default may be a
stipulation by way of penalty.
Exception: When any person who enters into any bail bond, recognizance or other
instrument of the same nature or, under the provisions of any law, or under the orders of the
Central Government or of any State Government, gives any bond for the performance of
any public duty or act in which the public are interested, he shall be liable, upon breach of
the condition of any such instrument, to pay the whole sum mentioned therein.
When an amount is named in a contract by the parties themselves towards the amount of
liquidated damages (as ascertained by them) to be paid by the breaching party, the courts
need not necessarily accept the figure named in such contract. The parties may have fixed
an excessive amount as damages so that it may operate in terrorem and counteract any
inclination to commit a breach of the contract. It is then called a penalty. The court can
grant relief against a party.
The test to be applied is to consider whether the amount really represents a reasonable
pre-estimate of the probable damage or it is an excess over the amount that is reasonably
estimated as liquidated damages. When it is known that the amount so fixed in the contract
by the parties at the time of entering into contracts is extravagant compared to the probable
loss, it would be termed as a penalty.
27 (1962) SC 1314.
48
Law of Contracts
12.8.5 Suit for Quantum Meruit

Quantum meruit means, simply, for what its worth. Quantum meruit also means
as much as he deserves. Even where there is no contract, per se, there may be a cause of
action where a person gives value to another under circumstances that would cause the first
person (if reasonable) to believe the second person will give fair market value for what he
received. Quantum meruit offers recovery of whatever the thing was worth. It is a
beautiful invention of wise judges in the past that recognized that very often there is not a
written or even a verbal contract between two persons yet an understanding exists upon the
passing of some value, that is monetary in nature, from one to the other. The law recognizes
the right of one to recover from the other for sums delivered for which no return value is
given. This right gives rise to the cause of action known as quantum meruit.
The term quantum meruit actually describes the measure of damages for recovery on a
contract that is said to be implied in fact. The law imputes the existence of a contract
based upon the situation where the service rendered by one party must have been
understood and intended to pay the compensation for it. Therefore, recovery in quantum
meruit is said to be based upon the assent of the parties and, being contractual in nature,
to recover under quantum meruit one must show that the recipient: (1) acquiesced in the
provision of services; (2) was aware that the provider expected to be compensated; and (3)
was unjustly enriched thereby.
Quantum meruit recovery is appropriate where the parties, by their conduct, have formed a
relationship which is contractual in nature, even though an enforceable contract may never
have been created. For illustration, where a written agreement between an owner and a
contractor is deemed unenforceable as a result of a technical deficiency or because it
violates public policy, the contractor may still recover in quantum meruit. As a general rule,
one should not look to recover in quantum meruit unless there have been direct dealings
between the parties that create the basis for the contract to be implied in fact.
Since specific terms in an implied contract are absent, the law supplies the missing contract
price by asking what one would have to pay in the open market for the same work. Thus the
measure of damages under quantum meruit is defined as the reasonable value of the labor
performed and the market value of the materials furnished to the project.
a.
What type of damages are awarded in case of breach of a promise to marry?

..
.
.
b.
Michel, a popular singer, enters into a contract with the manager of a theatre, to sing
at the theatre two evenings a week for the next two months and the manager of the
theatre agrees to pay him at the rate of Rs.1,000 for each performance. From the
sixth evening onwards, Michel absents himself from the theatre. In this context,
which of the following remedies is/are available to the manager of the theatre
against Michel?
..
.
.
49
c.
Govind agrees to sell a house to Arvind and a contract is entered into. However,
Govind subsequently refuses to sell. Arvind approaches the court. What type of
remedy can the court award if it finds that the remedy of damage is not adequate in
this specific case?
..
.
.
12.9 SUMMARY
A contract creates self-imposed obligations. It establishes the reciprocal responsibilities of
the parties and the extent and standard of their performances. Further a contract also
facilitates the allocation of burden of risk in case of any contingency in advance. Finally, it
also makes allowance for any loss arising out of any mishap or non-happening of any event.
The essential elements of a valid contract are Offer and Acceptance, Free Consent,
Capacity, Consideration, Lawful Object, Certainty and Possibility of Performance, a clear
term of contract.
Classification of contracts may be classified into valid, voidable, void, unenforceable and
illegal contracts based on the validity of the contracts. Contracts are classified into formal
and simple contracts based on the mode of formation. Contracts can be classified as
executed and executory contracts based on the extent of their performance.
The law has provided certain remedies to the aggrieved party in case of breach of contract
by the other parties. The important feature in the event of breach of contract is that each
party has a responsibility to mitigate its losses at a minimum possible level.
There are five remedies available for breach of contract: they are damages, specific
performance, Injunction, Quantum Meruit and Rectification. The Court awards damages in
order to put the injured party into the position he would have been in, if the contract had
been performed so far as money can make this possible.
12.10 GLOSSARY
Ab inito is a latin word that means from the beginning.
Bona fide is a good faith, honestly, without fraud, collusion or participation in wrongdoing.
Breach of Contract is a legal claim that one party failed to perform as required under a
valid agreement with the other party.
Consensus Ad Idem is a true meeting of minds between the parties on all the terms of the
contract.
Damages mean the money awarded in a law suit to one party based on injury or loss caused
by others.
Estoppel is a concept that prevents a party from acting in a certain way because it is not
equitable to do so. The concept of estoppel is applied in several areas of law.
Presumption implies an inference of the truth of a fact from other facts proved or admitted
or judicially noticed.
Privity is the doctrine of privity in English law provides that a contract cannot confer rights
or impose obligations arising under it on any person or agent except the parties to it.
Restitution means compensation for loss or injury.
50
Law of Contracts
12.11 SUGGESTED READINGS/REFERENCE MATERIAL
Ansons Law of Contract.
Prof. G C V Subba Rao, Law of Contracts I and II .
http://www.questia.com/search/contracts
http://www.barristerbooks.com
jurist.law.pitt.edu
12.12 SUGGESTED ANSWERS

a.
A legal obligation having its source in an agreement only will give rise to a contract.
The agreement A accepts Bs invitation to dinner by phone indicated is a social
agreement and does not give rise to any legal consequences.
b.
Shyam advertises in a newspaper that he would pay Rs.5,000 to anyone, who finds
and returns his lost briefcase containing valuables. This is not a valid offer. It is only
an example of invitation to offer.
c.
When Ram communicates to Shyam that he will sell his car for Rs.1,50,000. This is a
valid offer.
a.
No. An agreement collateral to a wager is not void. Only agreements by way of wager
are void and no suit shall be brought for recovering anything alleged to be won on any
wager.
b.
Public policy requires that every man should be at liberty to work for himself and an
agreement which interferes with the liberty of a person to engage himself in any
lawful trade is referred to as an agreement in restraint of trade. An exception to this
rule is the sale of goodwill. A seller of goodwill of a business may be restrained from
carrying on a similar business subject to certain conditions.
c.
No. The general rule of law is that an agreement without consideration is void. A
promise to pay for a past voluntary service is binding and is an exception to
agreements without consideration. (section 25)
d.
No. The agreement is void. Every agreement by which any party thereto is restricted
absolutely from enforcing his rights under or in respect of any contract is void and
falls under the category of Agreements in restraint of legal proceedings (section 28).
a.
Yes. A minor can enter into contract of apprentice. The Indian Apprentices Act passed
in 1850 enables children to learn trades, crafts and employment. The Act requires the
contract to be made by a guardian on behalf of the minor. The liability of the minor is
only for contracts of service or apprentiship as they provide him education and enable
him to earn his livelihood.
b.
In case of a contract where consent is obtained by coercion, the aggrieved party may
either set aside the contract or insist on its performance by the other party. In other
words, the contract is voidable at the option of the party who was coerced.
51
c.
One of the essential elements of a contract is legal object by object it is to mean the
purpose of the contract. Contracts with unlawful objects are void. Any agreement
forbidden by law or which is against the public policy is not enforceable. Hiring of
house for running gambling house is unlawful and not enforceable hence Sanjay
cannot recover the rent if he knows the object of the contract unless he can recover
the amount.
a.
Exemplary or vindictive damages are to be awarded for breach of a promise to marry.

The courts would award a large amount as damages to the aggrieved party which
could cause a certain degree of discomfort to the guilty person.
b.
He is at liberty to put an end to the contract, and also entitled to compensation for the
damages sustained by him through Michel failure to sing from the sixth evening
onwards.
c.
Where the court finds that the remedy of damages is not adequate remedy, the court
can enforce the contract specifically. Specific performance means doing exactly what
had been intended to be done by the parties in the contract. Courts grant this to the
aggrieved party in equity only in cases where it is absolutely essential to grant it.
12.13 TERMINAL QUESTIONS

A. Multiple Choice
1. Which of the following statements construe(s) an offer?
2.
3.
52
a.
Display of various varieties of silk sarees with prices marked upon them by a
cloth shop owner.
b.
A publishing company provides a catalogue with prices indicated on it for sale of

books.
c.
An auctioneer placed an advertisement in the newspaper to sell a car.
d.
Ram informs Shyam that he wants to sell his Bajaj Scooter for Rs.8,000.
e.
All of the above.
Which of the following relationships does not raise presumption of undue influence?
a.
Trustee and beneficiary.
b.
Doctor and patient.
c.
Solicitor and client.
d.
Husband and wife being Pardanashin woman.
e.
Landlord and tenant.
Which of the following agreements is/are valid?

a.
Agreement in restraint of legal proceedings.
b.
Agreement curtailing period of limitation.
c.
Agreement to stifle prosecution.
d.
Agreement by an outgoing partner with his partners not to carry on any business
within a specified period or within specified local limits.
e.
All of the above.
Law of Contracts
4.
Under which of the following modes is a contract said to have been discharged by
operation of law?
5.
a.
Performance of the contract by both the parties.
b.
Mutual consent of both the parties.
c.
Lapse of time in performance of the contract.
d.
Insolvency of either of the parties.
e.
Breach of contract by either of the parties.
The contract entered with a lunatic during the times of his sound mind is
a.
Valid
b.
Void
c.
Void abinitio
d.
Viodable
e.
Not enforceable.
B. Descriptive
1.
To be enforceable by law an agreement must consists of an offer and acceptance by

competent parties, is there any exceptions to the above principle, Explain.
2.
State the various acts which constitute fraud as set out under section 17 of the Indian
Contract Act, 1872.
3.
Describe in detail the suit for Quantum Meruit.
These questions will help you to understand the unit better. These are for your practice
only.
53
UNIT 13
SPECIAL CONTRACTS
Structure
13.1
Introduction
13.2
Objectives
13.3
Contracts of Agency
13.3.1 Creation of Agency
13.3.2 Rights and Duties of Parties
13.3.3 Termination of Agency
13.4
Contracts of Guarantee
13.4.1 Types of Guarantees
13.4.2 Liability of Surety
13.4.3 Discharge of Surety
13.4.4 Bank Guarantee
13.5
Contracts of Indemnity
13.5.1 Rights of Indemnity Holder when Sued
13.6
Letter of Credit Contracts

13.6.1 Features of a Letter of Credit
13.6.2 Parties to a Letter of Credit
13.6.3 Documents under Letter of Credit
13.7
Employment Contracts
13.7.1 The Employer-Employee Relationship
13.7.2 Checklist of Standard Clauses
13.8
Special Rights in Contracts
13.9
Documentation of Commercial Contracts

13.9.1 Important Clauses in Commercial Contracts
13.9.2 Checklist for Standard Clauses
13.10 Summary
13.11 Glossary
13.1 INTRODUCTION
In our earlier unit we have learnt the general principles and rules governing contracts.
In this unit we shall deal with contract of agency, indemnity and guarantee, and bailment
and pledge which are contracts of special type.
Contracts of Indemnity and guarantee are dealt under sections 124 to 147 of the Indian
Contract Act, 1872. Indemnity in general is the protection given against loss or a security
against or compensation for loss. The law relating to agency is dealt in sections 182 to 238.
An agent is a connecting link between the principal and third parties as it is very difficult to
Special Contracts
attend all matters personally, wherever necessary, to bring the legal relations in this
complex modern business world. Additionally, this unit also deals with essentials of
employment contracts and documentation of commercial contracts.
13.2 OBJECTIVES
Describe the different ways of creation of agency, the rights and duties of principal
and the modes of termination of agency;
Recall the different kinds of guarantee, rights of surety and discharge of suretys
liability;
Differentiate between contract of indemnity and guarantee;
Describe the conditions in an employment contract;
State the special rights enjoyed by parties in a contract; and
Document a commercial contract.
13.3 CONTRACTS OF AGENCY

Modern business is growing and becoming competitive day by day. To keep pace with this
development it is not possible for a businessman to carry on all his business transactions on
his own. This impossibility necessitates him to allow another person to work on his behalf.
This means he is delegating some of his powers to another person to carry on some of his
business transactions on his behalf. Here, the other person is an agent and the person who
delegated the powers is the principal. The contract which binds the principal and agent is
called an agency.
Illustration: X Co. engages the services of Y firm to sell its products. Here X is the
principal, Y is the agent and the contract between them is the contract of agency.
The Indian Contract Act, 1872 is the relevant statute which regulates the contract of
agency. The provisions of Sections 183 to Section 238 of the Act regulate the contract of
agency.
Section 182 of the Indian Contract Act, 1872 defines Agent and Principal as:
Agent means a person employed to do any act for another or to represent another in
dealing with the third persons and the Principal means a person for whom such act is
done or who is so represented.
Mere designation of a person as an Agent in an agreement does not by itself make him an
agent, and his position depends on the nature of legal relationship.
In a contract of agency, it is the agent who brings about a legal relationship between two
persons. It should be noted that an agent is not merely a connecting link between the
principal and a third person. The agent is also capable of binding the principal by acts done
within the scope of his authority.
An agent does not act on his own behalf but acts on behalf of his principal. He either
represents his principal in transactions with third parties or performs an act for the
principal. The question as to whether a particular person is an agent can be verified by
finding out if his acts bind the principal or not.
55
13.3.1 Creation of Agency
Any person who is of the age of majority and is of sound mind may employ an agent.
[Section 183]
Between the principal and the third persons, any person may become an agent. But no
person who is a minor and of unsound mind can become an agent. [Section 184]
No consideration is necessary to create an agency. [Section 185]
It is not essential that a contract of agency be entered into. It is sufficient if a person

acts on behalf of another and is accepted by the latter.
An agency can be created either in writing or orally. An oral appointment is a valid

appointment even though the contract of agency by which the agent is authorized has to be
in writing.
Creation of Agency
Express Agreement
Implied Agreement
Figure 1
EXPRESS AGREEMENT
An agency may be created either by Express agreement, i.e., an agreement is said to be
express when it is given by words spoken or written. (Section 187)
Under normal circumstances, an agency is created by an express agreement, specifying the
scope of the authority of agent. The agent may, in such a case, be appointed either by word
of mouth or by an agreement in writing. However, in certain cases, e.g., to execute a deed
for sale or purchase of land, the agent must be appointed by executing a formal power of
attorney on a stamped paper.
IMPLIED AGREEMENT
Implied agreement is, by inference from the circumstances of the case and things spoken or
written, or the ordinary course of dealing. (Section 187)
Implied agency comes into existence where there is no express agreement appointing a
person as agent. It arises from the conduct, situation or relationship of parties. This
means the authority to act as an agent may be inferred from the nature of business, the
circumstances of the case, the conduct of the principal or the course of dealing between
the parties.
Illustration: X who, resides in Ahmedabad, owns a shop in Hyderabad. He visits his shop
occasionally. The shop is managed by Y who orders goods from Z in the name of X for and
pays the amount out of Xs funds with Xs knowledge. This means Y has an implied
authority from X to order goods from Z in the name of X.
Types of Implied Agency
Agency by
Estoppel
Agency by
Necessity
Agency in
Emergency
Figure 2
56
Agency by
Ratification
Agency by
Operation of Law
Special Contracts
Implied Agency includes the following:
Agency by Estoppel or Holding Out: When a person, by his conduct or by

statement, leads willfully another person to believe that a certain person is his agent,
he is estopped from denying subsequently that such person is not his agent.
Agency by Necessity: Where there is no opportunity of communicating to the

concerned parties about any urgency and a person in such a situation acts as the agent
for the benefit of the other, agency by necessity is said to have arisen.
Agency in Emergency: An agent has authority in an emergency, to do all such acts

for the purpose of protecting his principal from loss as would be done by a person of
ordinary prudence, in his own case, under similar circumstances.
As per Section 189 of the Indian Contract Act, 1872, an agent has authority, in an
emergency, to do all such acts for the purpose of protecting his principal from loss as
would be done by a person of ordinary prudence, in his own case, under similar
circumstances.
Illustration: A consigns provision to B at Kolkata, with directions to send them
immediately to C, at Cuttack. B may sell the provisions at Kolkata, if they cannot
bear the journey to Cuttack without spoiling.
Agency by Ratification: Where acts are done by one person on behalf of another but
without his knowledge or authority, he may elect to ratify or to disown such acts. If he
ratifies them, the same effects will follow as if they had been performed by his
authority. The ratification may be express or implied.
Agency by Operation of Law: Promoters forming a company or partners of a firm

are considered to be agents of the principal company/firm by operation of law.
TYPES OF MERCANTILE AGENTS

As per Section 2(9) of the Sale of Goods Act, 1930 a Mercantile Agent is one who has
authority either to sell goods or to buy goods or to raise money on the security of goods.
They are of four kinds based on the nature of work they perform:
Factor: He is a mercantile agent to whom goods are entrusted for sale with wide
discretionary powers. He may sell such goods on his own name and may pledge the
goods as well on such terms as he thinks fit. Further, he has a general lien on the goods
of his principal for the general balance of account between him and the principal.
Commission Agent: He is the mercantile agent who buys or sells goods for his
principal on terms as he thinks fits and receives commission for such work done. It is
immaterial whether he possess such goods or not.
Del credere Agent: The term del credere means of entrusting. Normally the duty of
an agent is to enter into an agreement with the third person on behalf of his principal
and he is not personally liable for the defaults of third persons towards his principal.
However, del credere agent is a mercantile agent, who for additional consideration or
extra commission from his principal, undertakes to perform the financial obligations
of such third person in case such third person fails to fufill the same. Thus, he
occupies the position of surety as well as of an agent.
57
In case a del credere agent is made to pay an amount to his principal on default of
such third person, he cannot recover this amount from such third person later. His
compensation is the extra commission that he was getting.
Thus, the difference between the del credere agent and an ordinary agent is that the
former acts also as a guarantor of the solvency of the third person while the latter acts
only as a contracting link between the principal and the third person.
Broker: He is the mercantile agent who is employed to negotiate and make contracts
for the purchase and sale of goods. He has neither control nor possession of goods. He
serves as a connecting link and tries to bring out a business contract between the
principal and the third party. In case the deal materializes then he receives the
commission called brokerage.
Auctioneer: He is an agent entrusted with the possession of goods for sale to the
highest bidder in public competition and authorized only to deliver the goods on
receipt of the price. Further he has implied authority to sign a contract or
memorandum of sale on behalf of the vendor and the purchaser.
A sub-agent is a person appointed by an agent to work for the business of agency. He acts
under the control and supervision of an agent. That means the agent acts as a principal for
the sub-agent (Section 191).
13.3.2 Rights and Duties of Parties

DUTIES OF AGENT
An agent is bound to conduct the business of his principal according to the directions
given, or in the absence of directions, according to the custom which prevails in doing
business of the same kind at the place where the agent conducts such business.
A, was instructed to warehouse some drapery goods for P, at a particular place. He
warehoused a portion of them at another place where they were destroyed by fire
without any negligence on the part of A. Held, A was liable to P for the value of
the goods destroyed.
In case the agent does not follow the instructions of the principal or in case there are
no instructions, he departs from the commonly established practice, he will be liable
to compensate the principal for any loss incurred because of the departure.
If the agent adheres to the instructions given by the principal he cannot be made liable
if consequences turn out to be different from those contemplated by the principal.
An agent is under no obligation to follow instructions which are unlawful. However,
he will be liable if:
He sells goods at a rate below than that fixed by the principal;
He fails to insure goods as instructed by his principal and the goods are lost;
He warehouses goods at a place different from that directed by his principal and
the goods are destroyed; or
He purchases a larger quantity than directed to do so.
An agent is bound to conduct the business of the agency with as much skill as is
generally possessed by persons engaged in similar business unless the principal has
notice of his want of skill.
The following illustration aptly discusses this:
A, an agent for the sale of goods, having authority to sell on credit, sells to B on
credit, without making the proper and usual inquiries as to the solvency of B. B, at
the time of such sale is insolvent. A must make compensation to his principal in
respect of any loss thereby sustained.
58
Special Contracts
An agent is bound to render proper accounts to his principal, and has duty, irrespective
of any contract to that effect, to produce vouchers by which items of disbursement are
supported as part of the obligation to render proper accounts to the principal on
demand. (Section 213)
The agent is not discharged from his duty by merely submitting accounts. His duty
also consists in explaining them wherever necessary.
It is the duty of an agent, in cases of difficulty, to use all reasonable diligence in

communicating with his principal and seeking to obtain his instructions (Section 214).
If an agent deals on his own account in the business of the agency, without first
obtaining the consent of his principal and acquainting him with all material
circumstances which have come to his own knowledge on the subject, the principal
may repudiate the transaction, if the case shows, either that any material fact has been
dishonestly concealed from him by the agent, or that the dealings of the agent have
been disadvantageous to him. (Section 215)
In an emergency situation, the agent should exercise reasonable diligence and sound
discretion and adopt a course which appears best to him under the said circumstances.
He will be justified in this and shall have discharged his duties, though subsequent
events may demonstrate that some other course would have been a better option.
A transaction made by an agent wherein he sells his own property to the principal is
not ipso facto void for failure to disclose a material fact. It is only voidable at the
option of the principal. But a transaction which places the agents duty in conflict with
the principals interest will be presumed to be disadvantageous to the principal.
An agent should not set up an adverse title to the goods which he receives from the
principal as an agent.
An agent is duty bound to pay sums received to the principal on his account.
However, the agent can deduct his lawful charges i.e., expenses properly incurred by
the agent and the remuneration if any.
The principal cannot recover money received by the agent on behalf of the principal in
cases where,
The contract of agency itself is illegal.
The agent has lawfully repaid the money to the third person from whom he
received it.
The principal cannot sue the agent for recovery of money until the latter has received
the same. However, if the agent does not account for a reasonable time, it will be
presumed that he has received the money. Demand may not be necessary to claim the
money, though it is required if the principal wants to claim the interest thereon.
An agent should protect and preserve the interests of the principal in case of his death
or insolvency.
An agent must not use confidential information entrusted to him by his principal for
his own benefit or against the principal.
The agent must not make secret profit from the extract agency. He must disclose any
extra profit that he may make.
An agent must not allow his interest to conflict with his duty. For example, he must
not compete with his principal.
59
An agent must not delegate his authority to a sub-agent. This rule is based on the
principle Delegatus non-protest delegare A delegate cannot further delegate
(Section 190). The exception to this rule is when delegation is allowed by the
principal or the trade custom or usage sanctions delegation or when delegation is
essential for proper performance or where emergency renders it imperative or where
nature of the work is purely ministerial and where the principal knows that the agent
intends to delegate.
RIGHTS OF AGENT
The agent has a right to retain any sums received on account of the principal in the
business of the agency, all moneys due to himself in respect of his remuneration and
advances made or expenses properly incurred by him in conducting such business.
The agent has a right to receive remuneration. It is relevant to discuss the following
case in this regard.
An agent who does not conduct his business in a proper manner, cannot claim
remuneration in respect of that part of the business affected by his misconduct.
Right of Lien: In the absence of any contract to the contrary, an agent is entitled to
retain goods, papers and other property, whether movable or immovable, of the principal
received by him until the amounts due to himself from commission, disbursements, and
services in respect of the same has been paid or accounted for to him.
The lien exercised by an agent can be either a particular lien or a general lien. The
right of lien cannot be exercised where goods have been secured by misrepresentation
or where the agent has obtained the goods without the authority of the principal.
The property on which lien is claimed should belong to the principal.
The property on which lien is claimed should have been received by the agent in
his capacity as an agent and not otherwise.
The agent should be holding the property for and on behalf of the principal and
not a third party.
The right of lien is lost if:
The agent parts with the goods voluntarily;
He waives or abandons his lien or takes another security;
The principal repays the amount due; or
The agent enters into an agreement which is inconsistent with the lien.
The employer of an agent is bound to indemnify him against the consequences of all
lawful acts done by such agent in exercise of the authority conferred upon him. The
following cases discuss this in detail:
i.
The agent has a right to receive compensation for injuries sustained due to
neglect or want of skill on part of the principal.
Section 225 provides that an agent can claim compensation under this Section
only if he proves:
60
That some injury was caused to him.
The injury was caused because of the negligence of the principal.
The agent cannot recover compensation from the principal if the injury
has been caused because of the nature of his employment.
Special Contracts
ii.
Right of stoppage of goods in transit: This right is available to the agent in the
following two cases:
Where he has bought goods for his principal by incurring a personal

liability, he has a right of stoppage in transit against the principal, in
respect of the money which he has paid or is liable to pay;
Where he is personally liable to the principal for the price of the goods
sold, he stands in the position of an unpaid seller towards the buyer and
can stop the goods in transit on the insolvency of the buyer.
RIGHTS OF PRINCIPAL
Right to Repudiate the Transaction
An agent in a fiduciary position, is duty bound to transact the agency work in the interest of
his principal business and not otherwise. That means he is not entitled to do anything for
his personal benefit out of his principal business.
The principal may repudiate such agents transaction if he can prove that:
A material fact has been dishonestly concealed from him; or
The dealing of the agent has been disadvantageous to him.
Illustration: X appoints Y to sell her estate at Ahmedabad. Subsequently, Y discovered a

mine in her principals estate. Without disclosing this fact to her she buys the estate for
herself. The principal may repudiate the transaction.
To Claim any Resulted Benefit from Agency
If an agent, without the knowledge of his principal, deals in the business of the agency on his
own account instead of on account of his principal, the principal is entitled to claim from the
agent any benefit which may have resulted to him from the transaction. (Section 216)
The agents relationship with the principal is fiduciary in nature. That means he shall
perform his agency work in absolute good faith and thereby shall not make any secret profit
out of his agency business. Secret profit means any advantage obtained by the agent over
and above his agreed remuneration in the course of his agency business.
Knowledge acquired by an agent in the course of his agency business and applied for his
own benefit does not result into any secret profit unless he uses the principals property or
makes any diversions of his principals business opportunities to obtain such benefit.
Thus, the principal has every right to obtain an account of secret profits and recover them
and resist a claim for remuneration.
Right to Recover Damages
If the principal suffers any loss due to disregard by the agent of the directions by the
principal, or by not following the custom of trade in the absence of directions by the
principal, or where the principal suffers due to lack of requisite skill, care, or diligence on
the part of the agent, he can recover damages accruing as a result from the agent.
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To Resist Agents Claim for Indemnity

Where the principal can show that the agent has acted on his own behalf and not on the
behalf of the principal, he can resist the agents claim for indemnity against liability
incurred.
Duties of Principal
To indemnify against consequences of all lawful acts of agent: The principal is

bound to indemnify the agent against the consequences of all lawful acts done by such
agent in exercise of the authority conferred upon him. (Section 222)
Illustration: X employs Y to enter into contract with Z for purchase of 100 rice bags
for her. Subsequent to the contract entered with Z by Y, X refuses to take the delivery
of such rice bags from him. Z sues Y against such refusal. Y is made liable to pay
Z and X is made liable to pay Y towards damages, costs and expenses incurred on
such refusal.
However, where a person (principal) appoints an agent to do a criminal act then the
principal is not liable to the agent, either upon an express or an implied promise, to
indemnify him against the consequences of that act (Section 224). The liability here
refers only to the liability existing between the principal and agent i.e., the liability to
indemnify. This does not preclude the principal from liability under other Acts.
To indemnify the agent against consequences of acts done in good faith: The
principal is required to indemnify the agent against the consequences of acts done in
good faith. According to Section 223 of the Contract Act, where one person employs
another to do an act and the agent does the act in good faith, the employer is liable to
indemnify the agent against the consequences of that act though it causes an injury to
the rights of third persons.
Thus, Section 223 entitles the agent to claim compensation in respect of acts done in
good faith though they cause injury to the rights of third persons.
To pay compensation against agents injury: The principal must make compensation
to his agent in respect of injury caused to such agent by the principals neglect or want
of skill. (Section 225)
Every principal owes to his agent the duty of care not to expose him to unreasonable
risks.
To pay the agent the commission or other remuneration agreed.
13.3.3 Termination of Agency

According to Section 201, an agency is terminated by:
62
by an agreement between the parties, or
by the principal revoking his authority; or
by the agent renouncing the business of agency; or
by the business of agency being completed; or
by either the principal or the agent dying or becoming of unsound mind; or
by the principal being adjudicated an insolvent under the provisions of any Act for the
time being in force for relief of insolvent debtors.
Special Contracts
Thus an agency may be terminated by Agreement, Revocation of authority by the Principal

and by operation of Law.
Agreement: The relation of principal and agent like any other agreement may be
terminated at any time and at any stage by the mutual agreement between the principal
and the agent.
Revocation of Authority by the Principal: Section 203 provides that a principal may
revoke the authority of the agent any time before the authority has been exercised so
as to bind the principal. However, where the agent has himself an interest in the
property which forms the subject matter of the agency, the agency cannot, in the
absence of an express contract, be terminated to the prejudice of such interest.
Where the authority given to the agent has been partly exercised, it cannot be revoked
with regard to acts already done in the agency [Section 204].
Where there is an express or implied contract that the agency should be continued for
a fixed period of time, the principal must make compensation to the agent or the agent
to the principal, as the case may be, for any previous revocation or renunciation of the
agency without sufficient cause [Section 205].
By Operation of Law: There are certain circumstances where agency is terminated

by operation of law such as:
On performance of the contract. Where an agent is appointed to perform a

specified transaction, his authority comes to an end on the completion of the said
transaction.
On expiry of time.
When the agent or the principal dies or becomes of unsound mind. The death of
the agent terminates his authority.
The death of one of the joint agents will terminate the agency only as far as he is
concerned, while it will continue to be valid as regards the other surviving agents
in the absence of a contrary intention.
On the insolvency of the principal.
On the destruction of the subject matter.
On the principal becoming an alien enemy.
On the dissolution of a company.
On termination of sub-agents authority.
EXCEPTIONS
Irrevocable Agency
When an agency cannot be put an end to, it is said to be irrevocable agency. An agency is
irrevocable where the agent himself has an interest in the property which forms the subjectmatter of the agency. Such an agency cannot, in the absence of an express contract, be
terminated to the prejudice of such interest.
Illustration: A gives authority to B, to sell As land, and to pay himself, out of the
proceeds, the debts due to him from A. A cannot revoke this authority, nor can it be
terminated by his insanity or death.
When agent has incurred a personal liability the agency becomes irrevocable.
The principal cannot revoke the authority given to his agent after the authority has been
partly exercised, so far as regards such acts and obligations as arise from acts already done
in the agency. (Section 204)
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Time when Termination takes Effect

The termination of the authority of an agent does not, so far as regards the agent, take effect
before it becomes known to him. As regards third persons, it terminates when it comes to
their notice.
a.
Amit, a duly appointed agent of Bharat, insures the goods of Bharat without his
authority. Later on, Bharat satisfies with the act of Amit and pays the premium.
Examine the type of agency created.
.....
.....
.....
b.
Mr. Mukarjee employs Pravin as his agent in selling his used car.
Pravin is
instructed to sell the car for a price not less than Rs.50,000. Pravin buys the car
himself and hands over Rs.50,000 to Mukarjee, who is quite satisfied with the price
and does not ask for the name of the buyer. A few days later Pravin sold the car for
Rs.1,00,000 to Anil as knowing the fact Mukarjee wants to recover the excess profit
of Rs.50,000 from Pravin. Can Mukerjee succeed in recovering the excess profit?
.....
.....
.....
13.4 CONTRACTS OF GUARANTEE

Section 126 deals with Contract of Guarantee. As per this Section contract of guarantee
is a contract to perform the promise, or discharge the liability of a third person in case of
his default. The person who gives the guarantee is called the surety, the person in
respect of whose default the guarantee is given is called the principal debtor, and the
person to whom the guarantee is given is called the creditor. A guarantee may be either
oral or written.
The purpose of a contract of guarantee is to provide additional security to the creditor in the
event of default by the principal debtor. In a contract of guarantee, there are three parties
i.e., the creditor, the debtor and the surety. Also, there are three contracts in a contract of
guarantee (i.e., between the creditor and the debtor, between the creditor and the surety and
between the debtor and the surety).
It should also be noted that a contract of guarantee presupposes the existence of a debt. If
there is no existing liability, there cannot be a guarantee. Therefore, if the debt to be
guaranteed is already time barred, guarantee given will not be valid and the surety will be
discharged from his liability.
13.4.1 Types of Guarantees

A guarantee may be specific or continuing.
SPECIFIC GUARANTEE
A specific guarantee covers only one transaction or objective, is limited to a certain sum of
money and is limited as to time. Any amount paid towards the advance by the borrower in
his debt account with the creditor will go to reduce the guarantors liability.
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Special Contracts
CONTINUING GUARANTEE
A continuing guarantee is defined in Section 129 of the Indian Contract Act. It covers a
series of transactions; subject to the limit as mutually agree upon, irrespective of the
payments towards the advance and irrespective of the fluctuations of the balance in the
debtors account between debit and credit. Whether a guarantee is a continuing guarantee or
not depends upon the construction of the document. If there are several documents covering
a debt and guarantee, all the documents must be read as whole. In case of ambiguity in the
contract, the nature of the contract is to be determined basing upon the surrounding
circumstances.
In Nottingham Hide Co. vs. Bottrill1 it was held that the following words used in a
guarantee made the guarantee a continuing one: Having every confidence in him, he as but
to call on us for a cheque and have it with pleasure for any account he may have with you
and when to the contrary we will write to you.
Methods of Revocation of Continuing Guarantee: A continuing guarantee may be
revoked in two ways:
by the surety giving notice oral or in writing to the creditor as to future transactions
(Section 130), and
in the absence of a contract to the contrary, by the death of the surety as to future
transactions, (Section 131).
It should be noted that the notice of revocation must be given according to the terms of the
contract. If the contract of guarantee requires three months notice, the surety must give a
three months notice. In Wali Muhammed vs. Ganpat2, it was held that a notice revoking a
guarantee given just a day before the performance of the contract is not illegal. If there are
more than one surety, the notice must be given by or on behalf of all the co-sureties.
Notices by one co-surety do not determine the guarantee.
The death of the surety terminates his guarantee as to future transaction in the absence of a
contract to the contrary. His estate is, however bound to all transactions entered into before
the death of the surety. In several court decisions it has been held that if the consideration
for the continuing guarantee is one and whole, in that case the guarantee does not come to
an end by the death of a surety, and the estate of the deceased surety continues to be liable
for future transaction as well (Ma Moo Zim vs. Ma pwa3; Kandhaya vs. Manki4). Where two
sureties give joint and several continuing guarantee, the death of one of them does not
terminate the liability of the survivor Beeket vs. Addyman5. The lunacy of the surety
terminates the guarantee as to future advances Bradford Old Bank vs. Sutcliffe6.
13.4.2 Liability of Surety

According to Section 128, the liability of the surety is co-extensive with that of the
principle debtor, unless otherwise provided by the contract.
The liability of the surety is normally to the same extent as that of the principal debtor. The
surety cannot however, be made liable beyond what he had earlier contracted to. The surety
may however, limit his liability to a part of the entire debt. The extent of liability of a surety
assumes importance when the principal debtor is declared insolvent.
1
2
3
4
5
6
(1873) L.R.8 C.P 694

52 All. 1014
1921 U.B.25
31 All 56 etc
(1882) 9 QBD 783)
(1918) KB 833).
65
A reduction in the liability of the principal debtor (for example, after the creditor has
recovered a part of the sum due from him out of his property) will result in a proportionate
scaling down of the suretys liability.
It has been specifically provided in the contract that the suretys liability arises only when
the principal debtor is made liable, the surety continues to be liable in the given
instances:
Death of the principal debtor;
Discharge of the principal debtors liability by operation of law;
Creditors failure to sue the principal debtor within the period of limitation; and
Release of one of the co-sureties by the creditor.
13.4.3 Discharge of Surety

By Revocation
A continuing guarantee can be revoked by the surety any time by giving notice to the
creditor. A notice given, discharges the liability of the surety with respect to all future
transactions. However, the surety will remain liable for those transactions prior to the
revocation.
By death of the surety so far as future transactions are concerned. However, the
suretys liability will not be discharged even on his death, in case there is a contract to
that effect.
By Novation where a new contract substitutes the old contract by which the liability
under the old contract stands canceled.
By Conduct of the Creditor
Any variance made without the suretys consent, in the terms of the contract between
the principal debtor and the creditor, discharges the surety as to transactions
subsequent to the variance.
The validity of a contract of guarantee will not be affected in case there is a written
contract of guarantee and there is no variance of the same in writing.
Where the creditor enters into an agreement with the principal debtor releasing him
from his liability, the surety stands discharged.
The following illustration aptly discusses this:

A gives guarantee to C for goods to be supplied by C to B. C supplies goods to B,
and afterwards B becomes embarrassed and contracts with his creditors (including Cs) to
assign to them his property in consideration of their releasing him from their demands.
Here, B is released from his debt by the contract with C, and A is discharged from his
suretyship.
It has already been discussed that as per Section 128 the liability of a surety is
co-extensive with that of the principal debtor. Hence, if the principal debtor is discharged
from his liability by virtue of an agreement between him and the creditor, then the surety
also will stand discharged.
66
Special Contracts
Another explanation for the discharge of the surety is as follows:

As per Section 140, the surety can claim reimbursement from the principal debtor after
making payment to the creditor. If the principal debtor is no more liable, then the remedy of
the surety will be affected. This would result in a discharge of his liability.
When the creditor compounds with principal debtor giving him time to pay his debt
the surety stands discharged.
According to Section 135, the following circumstances will lead to a discharge of

suretys liability.
When the creditor compounds with the principal debtor.
When the creditor agrees not to sue the principal debtor: A contract between the
creditor and the debtor, wherein the creditor agrees not to sue the debtor will
discharge the surety from his liability.
Where the creditor, by his act or failure to perform his duty to the surety impairs the
remedy available to the surety against the principal debtor, the surety is discharged.
Also, any act of the creditor which by implication releases the principal debtor from
liability, will discharge the surety from his liability. In Hewison vs. Rickets, goods
were given on hire purchase basis. The payment of the installments was guaranteed by
a third person. When the debtor failed to make payment, the creditor determined the
agreement, seized the goods and sued the surety on his guarantee. It was held that as
the creditor had determined the agreement, the surety cannot be held liable.
Where the creditor loses or disposes off, without the consent of the surety any security
pledged with him, the surety stands discharged to the extent of value of the security so
lost or disposed.
By Invalidation of Contract
A guarantee obtained by means of either misrepresentation or concealment of material

fact which the creditor was aware of, at the time of entering into the contract,
invalidates the guarantee and discharges the surety.
Where there is no consideration between the creditor and the principal debtor, the
surety is discharged.
Where a person gives guarantee on the condition that the creditor shall not act upon it
until another person joins in as co-surety, the guarantee is not valid if that other person
does not join.
13.4.4 Bank Guarantee
A bank guarantee is a guarantee given by a bank to a third person, usually a creditor,

to pay him a certain sum of money on behalf of the banks customer, when the
customer fails to fulfill any contractual or legal obligations towards the third person.
For example, A bank enters into an undertaking on behalf of X, who is the customer
of the bank, to pay Y, the seller/creditor from whom X has purchased goods. The
Bank issues this bank guarantee document to the seller who can produce the same
before the bank and receive payment of the goods sold to X, where X has committed a
breach of contract.
67
A bank guarantee has much commercial significance. It is considered as an important

financial instrument. Where a creditor feels that the debtor has committed a breach of
contract, he can invoke the bank guarantee and encash the amount immediately
without indulging in legal dispute.
A bank guarantee is independent and in no way related to the main contract between
the customer/debtor and the creditor. It is a contract involving two parties i.e. the bank
and the creditor/beneficiary.
Examples of bank guarantee:
A bank guarantee may be given by a buyer to a seller as a guarantee for the

future payment.
A bank guarantee may be given by the contractor as a guarantee for any amount
advanced.
Types of bank guarantees:
Financial Guarantee.
Performance Guarantee.
Deferred Payment Guarantee.
Statutory Guarantee.
The creditor in whose favor the guarantee is issued can be prevented from invoking
the same, by an injunction under the Civil Procedure Code, 1908, or the Specific
Relief Act, 1963. The creditor can be restrained from invoking the guarantee by the
debtor when he proves:
Fraud committed by the creditor/beneficiary,
Irreparable harm or injustice to himself.
ORDINARY GUARANTEE VS. BANK GUARANTEE
An ordinary guarantee is governed by Section 126 of the Indian Contract Act, 1872.
Whereas, a bank guarantee is not directly governed by Section 126 of the Indian
Contract Act, 1872.
An ordinary guarantee consists of three parties and three agreements involving the
surety, the debtor and the creditor. On the other hand, a bank guarantee is a contract
involving two parties i.e. the bank and the creditor.
In an ordinary guarantee, the contract between the surety and the creditor arises as a
addition to the contract between the creditor and the principal debtor. The bank
guarantee is independent of the main contract.
In an ordinary guarantee, the inter se disputes between the debtor and the creditor
affect the suretys liability. However, the bank guarantee is independent of the
disputes, arising out of the contract.
An ordinary guarantee does not mention any time limit before which the debt has to
be claimed. Bank guarantees generally specify a specific time within which they can
be enforced.
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Special Contracts
13.5 CONTRACTS OF INDEMNITY

According to Section 124 of the Indian Contract Act, 1872 a contract by which one party
promises to save the other from loss caused to him by the conduct of the promisor himself
or by the conduct of any other person, is called a contract of indemnity.
A contract of insurance is an example of a contract of indemnity according to English Law.
In consideration of a premium the insurer promises to make good the loss suffered by the
assured on account of the destruction by fire of his property insured against fire. The person
who promises or makes good the loss is called the indemnifier (promisor) and the person
whose loss is to be made good is called the indemnified or indemnity holder (promisee).
However, a contract of life insurance does not come under the category of a contract of
indemnity. This is because, in the case of life insurance, the insurer agrees to pay a certain
sum of money either on the death of a person or on the expiry of a stipulated period of time.
The question of having suffered a loss does not arise. Moreover, as the life of a person
cannot be valued, the whole of the sum assured becomes payable and for that reason also it
is not a contract of indemnity.
The contract of indemnity in a real sense is a contingent contract. It must have all essentials
of a valid contract. It can be expressed or implied. It is relevant to discuss the following
cases in this regard.
The definitions given in Section 124 and Section 125 of the Contract Act are not exhaustive
of the law of indemnity as it does not include implied promises to indemnify and cases
where loss arises from accidents and events not depending on the conduct of the promisor
or any other person.
Certain rights have been granted to the indemnity holder under Section 125.
13.5.1 Rights of Indemnity Holder when Sued

The promisee in a contract of indemnity, acting within the scope of his authority, is entitled
to recover from the promisor:
All damages within the scope of the terms of the indemnity;
All costs which he may be compelled to pay in any such suit if, in bringing or
defending it, he did not contravene the orders of the promisor, and acted as it would
have been prudent for him to act in the absence of any contract of indemnity, or if the
indemnifier authorized him to bring or defend the suit;
All sums to be paid under the terms of any compromise of any such suit, provided
the compromise is not contrary to the orders of the indemnifier, and should be
authorized by him.
Though the Indian Contract Act does not grant specific rights to the indemnifier, we can
however, as in English Law, draw the rights of the indemnifier to be the same as those of
the surety which are detailed in the foregoing paras.
The Indian Contract Act does not specify the time of commencement of the indemnifiers
liability. Different courts have been following different rules with regard to this. Some
courts contend that the indemnifiers liability will begin only when the indemnity holder
actually suffers a loss. On the other hand, some have held that an indemnity holder may
compel an indemnifier to fulfill his promise even before actually incurring the loss.
Buckley L J in Richardson, ex parte etc. has made the following observation: Indemnity is
not given by repayment after payment. Indemnity requires that the party to be indemnified
shall never be called upon to pay.
69
a.
Suresh a surety, in a contract of guarantee requiring three months notice, revokes

guarantee just a day before performance of contract. Is such a revocation illegal?
b.
A promises B to compensate the loss caused to B either by him or by another person.

What type of contract is this?
13.6 LETTER OF CREDIT CONTRACTS

Letters of credit are generally used in international transactions to ensure payment. Due to
the nature of international dealings that include factors such as distance, differing legal
systems of each country and difficulty in knowing each party personally, the use of letters
of credit has become a very important aspect of international trade. The device used by the
Bankers to effect payment is called the Bankers Commercial Credit or Letter of Credit.
13.6.1 Features of a Letter of Credit
70
It is generally used in long-distance and international commercial transactions.
A letter of credit is a document issued by a bank to a customer allowing him to draw

up to a predetermined amount of money, from the issuing bank, its branches, or other
associated banks or agencies on complying with specific requirements.
It is a legal document issued by the buyers bank, requesting that any person or any
specifically named person, usually the seller/exporter, to advance money or goods on
credit to a person holding the document or to a person whose name appears therein.
Where the Letter of Credit is used, in the sense that credit is given to the bearer of the
instrument, and the buyer defaults his payment or is unable to pay, the repayment of
such debt is confirmed by the (sellers bank) issuing bank that it will make payment to
the seller/exporter/beneficiary. However, the bank will pay only when the seller/
beneficiary presents/submits the documents as mentioned in the Letter of Credit.
It is an assurance to the seller/beneficiary that he will receive payment on time and for
the correct amount for any goods which he sells to the buyer/customer.
It is not a negotiable instrument and hence cannot be transferred or exchanged.
A bank issues a Letter of Credit on the request of the buyer/customer and on the basis
of ones financial position and reputation in the society.
It is often abbreviated as LOC or L/C, and is also referred to as a documentary

credit.
The seller need not worry about the import regulations of the buyers country nor
about the currency fluctuations.
The buyer or the issuing bank need not pay money in advance to the seller.
Special Contracts
13.6.2 Parties to a Letter of Credit

Applicant-Buyer-Importer-Opener: is a person who intends to purchase goods or
avail services for which payment is to be made and hence applies to a bank to open a
Letter of Credit.
Issuing Bank: The bank which opens a Letter of Credit on the request of the applicant/
Buyer is referred to as an Issuing/operating/Importers Bank.
Beneficiary-Exporter-Seller: A person who has the right to receive payment or to draw
bills and receive payment as per the terms of the Letter of credit is known as the
Beneficiary/Exporter/Seller.
Advising Bank: It is a bank which forwards the Letter of Credit to the beneficiary. It is
located in the Beneficiarys/Exporters country. It may also be termed as a Notifying Bank.
Negotiating Bank: A bank in the beneficiary/Exporter country which makes payment on
the bills drawn by the seller and accepts the documents is called as a Negotiating bank. The
name of the Nominated/Paying Bank may be specified in the Letter of Credit.
Confirming Bank: Where the advising bank in addition to advising credit to the
beneficiary confirms such credit, such an Advising Bank shall be deemed as a
Confirming Bank.
Reimbursing Bank: It is a bank appointed by the issuing bank to reimburse the
Negotiating, Paying or Confirming Bank.
13.6.3 Documents under a Letter of Credit

The issuing bank is bound to certify that the documents submitted by the seller/beneficiary
are as per the instructions of the applicant/buyer. The documents that generally accompany
a Letter of Credit are:
Bill of Exchange
Invoice
Transport Documents
Bill of lading
Airway bill
Post parcel receipts and courier receipts
Insurance documents
Other documents.
UNIFORM CUSTOMS AND PRACTICE FOR DOCUMENTARY CREDITS

UCPDC 500
The Uniform Customs and Practice for Documentary Credits are the conditions according
to which bankers issue or act on commercial credits. Being first formulated in 1933 by the
International Chamber of Commerce (ICC), they underwent several revisions with the latest
which came into force on January 1st 1994. They are called the UCP 500. The UCP 500 are
incorporated in the Letter of Credit as one of the terms of Letter of Credit hence they are
contractually binding on all the parties to the Letter of Credit. They generally govern all
Letter of Credit transactions.
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13.7 EMPLOYMENT CONTRACTS

Employer-employee relationship has acquired a new meaning and significance with the
phenomenal rise of globalization, market economy and free trade. Employers can no longer
dictate terms to employees. Employees have become the equal partners and players in the
economic sector. In fact, the positive role being played by both the employer and the
employee in all sectors of activity Public and Private, is immensely contributing towards
achieving peace, prosperity and happiness of the humankind. Efficient corporate
governance is recognized as the key to progress.
13.7.1 The Employer-Employee Relationship
The employer-employee relationship is primarily determined by the terms of the

employment contract, which can be either oral or written.
The contract should specify a job description, wages, employee rights and duties, and
other specific terms and conditions of employment.
A contract for employment is generally presumed to be at will unless otherwise

specified.
An employer or employee can terminate an at will employment relationship at

any time, and for any reason, unless the law provides a specific exception to this
general rule.
The employer-employee relationship is contractual and gives rise to reciprocal obligations

of rights and duties:
Duties of Employee: There are two types of duties of employees
Those that arise from tort law or agency law; and
Those that arise from contract law.
Under agency law (tort law), there are three kinds of duties that an employee owes towards
his employer:
Duty of Loyalty Obligation to act only in the interest of ones employer and not to
compete with ones employer. Even if one is working on ones own computer and
equipment, the project may constitute a breach of loyalty if it competes in the same line of
business as that of the employer.
Duty of Obedience The obligation to obey all reasonable orders of ones employer. The
act of insubordination is a violation of this duty.
Duty of Care Lack of performance is a violation of this duty.
CONDITIONS IN CONTRACTS
Employment at Will
The doctrine of employment at will gives free hand to both as the employee can
quit, and the employer can fire an employee at his will, at any time and for any reason
and without any prior notice.
The doctrine of employment at will is a default rule of contract law, thus it applies
whenever the employee and employer have not agreed on something else or an
alternative.
Express Contract
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An express contract can be either in writing or in oral. An employer might want to

have in an express contract a statement that:
The employee can be fired or otherwise disciplined only for just cause or
reasonable cause or some such general language.
Special Contracts
Termination
Before the employee is discharged or disciplined, he has to be given an opportunity to

explain or have some kind of hearing.
Discipline will be progressive. For example, there should be a warning (rather than
immediate discharge) for the first offense. If the employee is to be laid off, there must
be advance notice and severance pay.
An employer would include in an express contract the following conditions:
An agreement not to compete (non-competition agreement).
An agreement not to use the employers trade secrets, customer lists, and so on.
An agreement to arbitrate disputes rather than taking them to court.
Collective Bargaining
A collective bargaining agreement, or CBA, can be an effective exception to the doctrine of
employment at will. As it is simply a contract between an employer and gives significant
job protection to the employee. A CBA will override the employment at will doctrine.
CBA contains the following key job-protection provisions:
An employee can be discharged or otherwise disciplined (for example, by suspension

or demotion) only for just cause.
An employee who is disciplined can file a grievance, or have the union file a grievance.
If the grievance is not settled satisfactorily, the union can require it to be decided by
an arbitrator.
The arbitrator will hold a hearing and then issue a decision that is final and binding.
Liquidated Damages
When the parties to a contract agree to the payment of a certain sum as a fixed and agreed
upon satisfaction for not doing certain things particularly mentioned in the agreement, the
sum is called liquidated damages.
The damages considered as liquidated are:
When the damages are uncertain and not capable of being ascertained by any
satisfactory or known rule whether the uncertainty lies in the nature of the subject
itself or in the particular circumstances of the case.
When, from the nature of the case and the tenor of the agreement, it is clear that the
damages have been the subject of actual and fair calculation and adjustment between
the parties.
An agreement for liquidated damages can only be when there is an engagement for the
performance of certain acts that if not done would injure one of the parties or to guard
against the performance of acts that would be injurious if done.
Generally the sum fixed upon will be considered either liquidated damages or a
penalty according to the intent of the parties. The use of the words penalty,
forfeiture, or liquidated damages, will not be decisive of the question if the
instrument, taken as a whole, discloses a different intent.
Data Privacy
Data privacy refers to the evolving relationship between technology and the legal right to,
or public expectation of privacy in the collection and sharing of data. Privacy problems
exist wherever uniquely identifiable data relating to a person or persons are collected and
stored, in digital form or otherwise. Improper or non-existent disclosure control can be the
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root cause for privacy issues. The most common sources of data that are affected by data
privacy issues are:
Health information,
Criminal justice,
Financial information,
Genetic information.
The challenge in data privacy is to share data while protecting the personally identifiable
information. Consider the example of health data which are collected from hospitals in a
district; it is standard practice to share this only in the aggregate. The idea of sharing the
data in the aggregate is to ensure that only non-identifiable data are shared. The legal
protection of the right to privacy in general and of data privacy in particular varies greatly
around the world.
Anyone processing personal data must comply with the eight enforceable principles of
good practice, hence the data must be:
fairly and lawfully processed;
processed for limited purposes;
adequate, relevant and not excessive;
accurate;
not kept longer than necessary;
processed in accordance with the data subjects rights;
secure;
not transferred to countries without adequate protection.
Confidentiality
Under contract law, there are confidentiality agreements, and restrictive covenants.
Confidentiality Agreements
Two restrictions are non-use and non-disclosure and an agreement should have both. An
example of confidentiality breach might be disclosing the identity of the former employers
customers to the new employer. There are three levels of confidentiality. The lowest level is
public domain information, followed by confidential information, and finally by trade
secrets, the highest of the three.
Restrictive Covenants
The four types of restrictive covenants are:
non-competition;
non-disparagement;
non-interference; and
non-solicitation.
Reasonable notice is an implied term of the contract and is either written by an express
notice provision, if there is an express notice provision in the employment contract, then
that clause is binding unless it is expressly or impliedly no longer in effect, or it is
unlawful, in which case the contract may be terminated upon a reasonable notice.
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Special Contracts
The law of employment establishes minimum statutory requirement for compensation for
individual terminations:
For periods of employment greater than 3 months, the employer must pay severance to
the employee, or satisfy that obligation by giving a written notice of termination.
Group terminations (those of 50 or more) have additional requirement under the law.
First, the employer must give written notice to the Minister, to the employee being
terminated and to the Union. This notice must specify the number of employees being
terminated and dates of terminations and the reason for termination.
Non-Disclosure of Information Concerning Business

Employee will not at any time, in any fashion, form, or manner, either directly or indirectly
divulge, disclose, or communicate to any person, firm, or corporation in any manner
whatsoever
any information of any kind, nature, or description concerning any matters affecting or
relating to the business of employer including, without limitation, or
the names of any of its customers, or
the prices at which it obtains or has obtained goods, or
prices at which it sells or has sold its products, or
information concerning the business of employer, or
manner of operation of business, or
its plans, processes, or
other data of any kind, nature.
The parties hereby stipulate that, as between them, the foregoing matters are important,
material, and confidential, and gravely affect the effective and successful conduct of the
business of employer, and its goodwill, and that any breach of the terms of this section is a
material breach of this agreement.
INDEMNIFICATION
Indemnity is a legal exemption from the penalties or liabilities incurred by any course of
action.
Indemnification is a promise, usually as a contract provision, protecting one party from
financial loss by the other. By way of indemnification it protects one party at the expense of
the other. Indemnification can either by direct payment or reimbursement for the loss,
however indemnification clauses cannot usually be enforced for intentional tortious conduct
of the protected party.
Corporate officers, board members and public officials often require an indemnity clause in
their contracts before they perform any work. In addition, indemnification provisions are
common in intellectual property licenses in which the licensor does not want to be liable for
misdeeds of the licensee. Such a license would protect the licensor against product liability
and patent infringement.
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13.7.2 Checklist of Standard Clauses
Commencement of employment,
Job title,
Salary,
Place of posting,
Hours of work,
Leave/Holidays,
Nature of duties,
Company property,
Borrowings/accepting gifts,
Termination,
Confidential information,
Notices,
Applicability of company policy,
Governing Law/Jurisdiction,
Acceptance of offer.
a.
Seenu is an office boy in a corporate office. At the time of appointment there was an
agreement between him and the employer that Seenu can be terminated at any time
without mentioning any cause. In the light of the given situation, can Seenu be fired
at any time?
b.
Safin owes certain amount to Robin. Mary promises Safin to save him from
indebtedness. Robin wants Safin to repay the debt with interest. On the failure of
Safin to repay, Robin filed a suit against Safin. What kind of contract has Mary and
Safin entered into?
13.8 SPECIAL RIGHTS IN CONTRACTS

LIEN
Lien is the right of a person (usually the creditor) to retain the possession of the goods and
securities belonging to another person (the debtor) till the amounts due to him from such
owner are fully realized. The lien can be defined as the right to retain the lawful
possession of the property of another until the owner fulfills a legal duty to the person
holding the property, such as the payment of lawful charges for work done on the property.
A mortgage is a common lien.
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Special Contracts
A lien has judicially been defined as a right in one man to retain that which is in his
possession belonging to another until certain demands of the person in possession are
satisfied.
Illustration: The transporter of goods retains the possession of the goods that he has carried
to the destination till the amount of freight is paid to him.
The right of exercising Lien may arise in three ways:
By express contract in between the parties;
From implied contract in accordance with the general or particular usage of trade; and
By legal relation between the parties.
In order to create a valid lien, the following factors are essential:
The party who acquired the property should have the absolute title of ownership over
that property;
That the party claiming the lien should have an actual or constructive possession of
property or goods with the assent of the party against whom the claim is made; and
The lien should arise upon an agreement, express or implied and not be for a limited
or specific purpose inconsistent with the express terms or the clear, intent of the
contract; e.g., when goods are deposited to be delivered to a third person or to be
transported to another place.
In general, the right of the holder of the lien is confined to the mere right of retainer. But
when the creditor has made advances on the goods of a factor, he is generally invested with
the right to sell. In the absence of express contract a lien does not of itself carry
(subject to a few exceptions) a right of sale of goods/property on the part of the lienee
(the person who exercises the right). However, when such right of sale is incorporated as a
matter of special contract in between the owner and the lienee, the lienee will have to
closely observe the contractual rights given to him and should be careful to serve any
notices of his intention to sell the goods/property according to the terms of the contract and
he should follow the necessary procedures stipulated by the contract meticulously.
There are two kinds of lien; particular lien, and general lien.
Particular Lien
A person claims the right to retain property in respect of money or labor expended on such
particular property. This right is known as particular lien. In Indian law, particular lien is
available to all the classes of people other than those mentioned in Section 171 of the
Indian Contract Act.
The creditor with a particular lien can retain the possession of the goods only till the dues
from the debtor for a particular debt for which the securities were handed over have been
satisfied. He can not retain them for any dues from the debtor on other accounts.
Example: A, the goldsmith is given the gold by B, the owner to convert it in the form of
golden ornaments. He can retain the possession of the ornaments only till the service
charges for making those ornaments are paid by the owner, but not for any other liability to
be discharged by the owner of the golden ornaments.
General Lien
A general lien is one which the holder thereof is entitled to enforce as a security for
the performance of all the obligations, or all of a particular class of obligations, which
exist in his favor against the owner of the property.
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A general lien is a lien in respect of all monies owed to the lienee. A particular lien is
limited to monies owed to the lienee in respect of the goods over which the lien is
sought to be exercised.
Illustration: X has borrowed from the bank in the form of two types of loans, one is
the agricultural loan for cultivation of crop and the other is a personal loan against the
security of his gold ornaments to meet his personal expenditure The agricultural loan
has become due for repayment. If there is no specific agreement in between the bank
and the borrower in consistent with the lien, when the personal loans is repaid, the
bank can exercise the right of general lien by retaining the possession of golden
ornaments after the borrower repays the entire liability in his personal loan till the
dues accrued in the agricultural loan are repaid. But, the bank cannot exercise the right
of lien when the agricultural loan is not due for repayment at the time when the
personal loan is closed.
Bankers Lien
Section 171 of the Indian Contract Act, 1872 authorizes bankers, in the absence of a
contract to the contrary, to retain, as a security any goods bailed to them. However,
this does not entitle third persons to retain goods as security bailed to them unless they
have entered into an express contract to that effect.
It is a right of the banker to retain in custody the securities or properties in order to get
the debts discharged.
No agreement or contract is required for its creation.
It can be exercised over securities or properties (all bills, cheques, and money paid or
entrusted) which he has received as a banker. However, in order to exercise his lien on
such properties or securities, a banker is required to prove his diligence, good faith
and that he had no notice of the defect in the title. Where a banker has received a
notice of defect in title or of assignment of money or securities in his custody, he
cannot claim lien on subsequent advances. A general lien may be excluded by an
express contract. It covers goods bailed as security for a general balance of account. A
right of lien cannot be exercised on money deposited in a bank account. The money in
a bank account is subject to be set-off.
In Indian law, the general lien is available only to a select class of people. Section 171 of
the Indian Contract Act provides, that bankers, factors, wharfingers, attorneys of a High
Court and policy brokers may, in the absence of a contract to the contrary, retain, as a
security for a general balance of account, any goods bailed to them.
Accordingly, the bankers can retain the goods and securities which come into their
possession in the course of their dealings as bankers for a general balance due from the
customers, provided there is no arrangement inconsistent with the lien. No agreement is
necessary for the creation of the lien.
Set-off Bankers Right
The bankers right of set-off is also known as the right to combine accounts. A banker is
authorized to set-off a debt which he owes to a customer against a debt which the customer
has to pay the bank. For example, a customer has two accounts. He borrows a sum of
money from the bank and the bank also owes him some amount. In such a case the bank
can set-off its due towards the customer by combining the funds of one of his accounts into
the other. It is a type of a security, a remedy, a right for the banker. It is an attractive
security because its realization does not involve the sale of an asset to a third party.
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Special Contracts
Essentials of Set-off
Existence of mutual debts between the banker and the customer in the sense that both
of them should owe the payment of money to each other.
It must be for a liquidated sum of money which was determined by the parties.
The surplus left in the hands of a banker after the sale of a security for a advance to a
borrower can be set-off against any other debt of the borrower unless there is no other
charge on the security.
A partners personal account and his debit balance in a partnership firms account can
be combined because of the joint and several liability of the partners.
A future debt can be set-off against money owed to a company in liquidation.
Personal account of a customer cannot be combined with the joint account held by
him with other person. Where the joint account is in the name of the husband and
wife, and it is proved that the money in the joint account belongs to the husband, such
a joint account can be combined with the husbands personal account.
The personal account of a guarantor can be set-off to adjust the guarantors liability
when the guarantor defaults his payment and the guarantor is required to pay.
When an account is stopped due to the insolvency or mental incapacity of the

customer, the banker can exercise his right of set-off in the absence of any agreement
to the contrary or notice of trust.
Money held by a customer in an account in his fiduciary capacity cannot be set-off

against a personal debt or overdraft due from him.
The liability of a customer/debtor in respect of a bank guarantee cannot be set-off by

the bank against his credit balances since the liability is not fixed or certain and can be
determined only when the customer defaults.
Where there is an agreement to the contrary, the accounts of a customer cannot

be combined.
13.9 DOCUMENTATION OF COMMERCIAL CONTRACTS

13.9.1 Important Clauses in Commercial Contracts
Agreements representing the various conditions agreed to by the parties and mentioned in
the form of certain clauses form the foundation of rights and liabilities of the parties. The
significance of these clauses is explained below:
DESCRIPTION OF PARTIES
Any format of an agreement opens with the usual heading of description of the deed clearly
describing the name of the transaction which they evidence, such as, THIS DEED OF
SALE or THIS DEED OF LEASE etc. The description is followed by the date on which
the said DEED is executed. After these two, the names and description of the parties to the
deed are mentioned.
The Parties: The description of the parties to an agreement names the individuals and the
full details thereof. Thus, in the case of living persons, the particulars of the parentage, age,
occupation and residence including municipal or survey number, street and city and in the
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case of resident of a rural area, the village, sub-division, tehsil and/or development block
are generally regarded as sufficient to identify a person. If there is any other description of
the party, which is sufficient, the same may be adopted.
Party A Juridical Person: One of the parties or both the parties happen to be juridical
person(s), such as, a company, or an association or body of individuals (Section 5 of the
Transfer of Property Act, 1882), or an idol or a corporation sole or aggregate, or, in fact,
any juridical person capable of holding property and entering into contracts. A court is not
a juridical person capable of holding property or entering into contracts, and security bonds,
which are given to courts, must, therefore, be made in favor of a named officer of the court
and not in favor of the court. Care should be taken that companies, associations and
corporations are described by their correct names. It is better also to refer to the Act under
which they are registered or incorporated thus:
(name), a company within the meaning of the Companies Act, 1956, and having its
registered office at
Party An Idol: In the case of an idol, as it has to act through some natural person, the
name of the latter should be disclosed, thus:
the idol of (name) installed in the temple at (place), acting through
its(name), son of ..(name) of
Persons under Disability: As persons under disability namely, minors, persons of unsound
mind and persons disqualified from contracting by any law to which they are subject,
cannot enter into a contract. In such cases, the representatives on their behalf could enter
into agreements, as per the law in that regard.
RECITALS OF SUBJECT
A recital means the account of the subject-matter of a deed of agreement. Recitals are of
two types:
Narrative recitals, which relate the background history of the subject-matter and set
out facts and other related particulars to show the relation of the parties to the subjectmatter of the deed; and
Introductory recitals, which explain the motive for the preparation and execution of
the deed.
Narrative Recitals: Apart from furnishing the full account of the subject-matter of the
deed of agreement, narrative recitals must recite the special circumstances, if any, as to how
the parties are placed in their respective positions, keeping in view of the disputes that
might arise at a later date.
Introductory Recitals: Among the introductory recitals, which come after the narrative
recitals, the chief one is of the agreement, which the deed is intended to give effect to. If
the agreement is in writing, it is not necessary to give particulars of the date and place of
such agreement but it may be expressed in brief and general terms. Any other recitals,
which may be necessary to connect the narrative recitals with the rest of the deed by
showing why and how, the state of things previously existing is about to be altered by the
deed should also be entered.
Precautions: Recitals should be inserted with abundant caution because they may control
the operative part of the deed if the same is ambiguous, and may operate as estoppel by
preventing the parties and their representatives from showing the existence of a different
state of things from that stated in the recitals. Hence, persons drafting should, therefore,
80
Special Contracts
exercise utmost care and caution to avoid unnecessary recitals and to ensure that all recitals
are both correct and judicious.
The deed should contain all the material facts leading to the agreement along with the
terms and conditions settled between the parties.
The intention of the parties should be made clear by plain and simple reading of the
document as a whole and there should be no ambiguity or inconsistency between
paragraphs or clauses of the deed.
The words and expressions should be used in their primary, natural and grammatical
meanings and the same words and expressions should have the same meaning throughout.
The recitals should be kept at the minimum and drafted in consonance with the
operative part, otherwise some recital may be interpreted to control the operative part.
Order of Recitals: In case there are numerous and lengthy recitals, they should be
mentioned in a chronological order. Facts and events contained in the introductory recitals
also should be inserted in the sequence in which they have occurred.
Form of Recitals: Generally, recitals begin with the word Whereas, but where there are
several recitals, one can either repeat the word before every one of them by beginning the
second and subsequent ones with the words And Whereas, or divide the recitals into
numbered paragraphs with the word Whereas at the top.
CONSIDERATION
As agreements are necessarily for some consideration (Section 10 of the Indian Contract
Act, 1872), it is mandatory to express the consideration, except where it is not required by
the Act (for example, in the case of a gift). It is necessary in many cases of transfer for
ascertaining the stamp duty payable on the deed as Section 27 of the Indian Stamp Act
requires that the consideration should be fully and truly set forth in the deed. Failure to
do so will attract fine as per the Stamp Act.
Consideration7 is a legal detriment suffered by the promisee that is requested by the
promisor in exchange for his promise. A valid contract requires consideration by both
parties. As a general rule, in a bilateral contract, one promise is valid consideration for the
other. In a unilateral contract, the agreed performance by the offeree furnishes the necessary
consideration and also operates as an acceptance of the offer.
Consideration can consist of a promise; an act other than a promise; a forbearance from
suing on a claim that is the subject of an honest and reasonable dispute; or the creation,
modification, or destruction of a legal relationship. It signifies that the promisee will
relinquish some legal right in the present or restrict his or her legal freedom of action in the
future as an inducement for the promise of the other party. It is not substantially concerned
with the benefit that accrues to the promisor.
Love and affection are not consideration. A promise to make a gift contains no
consideration because it does not entail a legal benefit received by the promisor or a legal
detriment suffered by the promisee. Since a promise to give a gift is freely made by the
promisor, who is not subject to any legal duty to do so, the promise is not enforceable
unless there is promissory estoppel. Promissory estoppel is a doctrine by which a court
enforces a promise reasonably expected by the promisor to induce action or forbearance on
the part of a promisee, who justifiably relied on the promise and suffered a substantial
detriment as a result of it.
http://www.answers.com/topic/contracts-legal
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COVENANTS AND UNDERTAKING

In some cases, where the parties to the agreement enter into covenants, it is necessary that
such covenants should be entered as such. While drafting covenants, regard should be had
to the statutorily implied covenants, which operate subject to any contract to the contrary.
For instance, Section 55 (Sale), Sections 65 and 67 (Mortgage), Section 108 (Lease) of the
Transfer of Property Act should be kept in mind.
Where several covenants follow each other, they may run on as one sentence, each being
introduced with the words and also or by the words First, Secondly, etc. or they may
be sent out in paragraph form with the heading:
The vendor hereby covenants with the purchase as follows:
It is desirable to place the covenants of the respective parties separately, including those
covenants entered into mutually. Care should be taken to see that they are not mentioned
wrongly under those of the other party.
Sometimes, where the terms and conditions of a transfer cannot be conveniently separated
into the respective parties, it would be better to include all the covenants under one heading
as those of the parties thus: The parties aforesaid hereto hereby mutually agree with each
other as follows:
SIGNATURES AND ATTESTATION
After all the important clauses of a deed of agreement have been duly incorporated in the
order of their precedence, the important part of the deed that concludes it is the
testimonium, which sets forth the fact of the parties having signed the deed. Usually, it
concludes thus:
In witness whereof, the parties hereto have signed this deed on the date first above
written.
This is followed by the signatures of the parties, being the executants of the deed, and those
of the attesting witnesses, who testify as to the fact of such execution by the former.
Where the executant is not competent to contract or is a juristic person, the deed must be
signed by the person competent to contract on his or its behalf. Thus, if the deed is
executed
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on behalf of a minor or a mentally ill person, the natural guardian or where a guardian
has been appointed by a competent court/authority, then by such guardian;
by a firm, then by any partner or partners of the firm, on behalf of the firm;
by a corporation, such as, a university or a local authority or other statutory

corporation, then by a person or the persons authorized in this behalf;
by a company or cooperative society or a society registered under the Societies

Registration Act, 1860, then by a person authorized in this behalf by or under the
statute incorporating such body;
by a trust or mutwalli, then by such person describing himself as such;
by an attorney, then by such person describing himself as such and mentioning the
date of the deed of the power of attorney;
by the Government, then by the person authorized in this behalf under Article 229 of
the Constitution of India, by and on behalf of the President or the Governor, as the
case may be, specifying the official designation and preferably notification or
government order under which the authority is conferred.
Special Contracts
Affixing Signature: The word sign means to write ones name on, as in acknowledging
authorship. Section 3(56) of the General Clauses Act, 1897, extends its meaning, with
reference to a person who is unable to write his name, to include mark. The document
must be signed by a person in such a way as to acknowledge that he is the party
contracting, and it is not very material in what part of the document the signature appears.
Attestation: Attestation should be by at least two witnesses, who should have seen the
executant sign the deed or should have received from the executant personal
acknowledgement of his signature but it is not necessary that both the witnesses should
have been present at the same time (see definition of attested in Section 3 of the Transfer
of Property Act and also in Section 63 of the Indian Succession Act).
There are no particular forms of attestation but it should appear clearly that a witness
intended to sign as an attesting witness.
Illiterate person not able to sign may either put his pen mark or thumb mark. The modern
practice allows the thumb mark only as the recognized form of signing a deed. For
instance, a thumb mark is more satisfactory for identification purposes.
ENDORSEMENT AND SUPPLEMENTAL DEEDS
Where a deed or agreement becomes necessary in pursuance of, or in relation to a prior
deed, it is effected either by endorsement on the prior deed when a short writing would be
sufficient, or by a separate deed described as supplemental or intended to be read as
annexed to the prior deed, in which case, detailed recitals of the prior deed are
unnecessary.
The provision of endorsement and supplemental deeds is purely as a matter of convenience,
but mostly in contracts with the government, a supplemental deed becomes necessary either
because a new term of agreement is sought to be added or because modification of the
existing terms has been subsequently agreed upon.
Endorsements, which are of a general use and for which no supplemental deed is
necessary, relate to part payment or acknowledgement of a debt by a debtor. It is
necessary for such an endorsement that the intention of the parties should be expressed
by use of specific words.
Endorsements are a common feature in negotiable instruments or transfer of a bill of
exchange or a policy of insurance or Government Securities. Here also the form is of no
significance. What is required is that the words should clearly show the transfer of interest
in favor of a particular person.
Endorsement may begin either by saying
This deed made on this day of between the within named and the within
named or directly thus: The parties to the within written deed hereby agree as
follows.
The operative part of the deed follows, usually without any recitals unless any recital is also
absolutely necessary in order to make the deed intelligible.
Form of Supplemental Deed: The form shall be the usual form of deed or agreement in
which after the names of parties should be inserted the words
Supplemental (or intended to be read as annexed) to a deed of datedand made
between the Parties hereto (or, betweenand.) hereinafter called: Principal deed.
If the particulars of the principal deed are somewhat lengthy, it is more convenient to refer
to the principal deed in the first recital and to say that this deed is supplemental to that
deed, thus,
Whereas this deed is supplemental to a deed of sale made, etchereinafter called the
Principal Deed.
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If the supplemental deed is supplemental to several deeds each should be mentioned

specifically. Then should follow such recitals as reconsidered absolutely necessary in order
to make the deed intelligible for facts leading to the execution of the supplemental deed, but
recitals about the contents of the principal deed are not necessary.
STAMP DUTY
The law on affixing stamps to various documents is governed by the Indian Stamp Act,
1899 as amended in its application to various states by local amendment Acts. The Stamp
Act extends to the whole of India except the state of Jammu and Kashmir. The main
purpose of the Stamp Act is to raise revenue by means of stamp duty on certain documents.
Stamp duty payable on instrument is determined by the inclusion of document either in
Central or State Government list. Stamp duty on demand promissory notes, usance bills of
exchange money receipts, proxies and transfer of shares comes under the central list and is
same all over the country. The stamp duty payable on other documents comes under the
state list and varies from state to state.
REQUIREMENTS OF VALID STAMPING
Time of Stamping: Stamp duty is leviable on the instrument at the time of execution of the
instrument. Unless the document comes within the charging section it is not liable to duty:
Instruments should be stamped before or at the time of their execution (Section 17).
Every instrument (other than bill of exchange or promissory note) which is executed out
of India may be stamped within three months after it has been first received in India.
The first holder of bill of exchange or promissory note drawn out of India shall affix
proper stamps and cancel the same (Section 19). When a document is required to be
executed by two persons in different states in India, it must bear the stamp duty of that
state where it is signed first. It is then to be sent to the second state for the signature of
other person. If in that state the duty on the document is higher than in the first state
the excess amount will have to be paid before the person in the second state signs it.
Any instrument required to be stamped if not stamped duly is invalid. Two categories
of documents are specified to determine the effect of insufficient stamping or
unstamping.
The first category consists of the following documents which if unstamped or

inadequately stamped are not at all admissible as evidence.
Demand promissory note.
Usance bills of exchange.
Acknowledgement of debt (Section 35).
Except the above documents all other documents fall in the second category. Such
documents are admissible in evidence even if they are inadequately stamped by paying
penalty at the discretion of the Collector:
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Where a single sheet of paper is insufficient to write the full document, Rule 7 of
Stamp Rules 1925 provides that additional sheets (unstamped) can be used with a
substantial portion of such instrument written on each sheet.
Adhesive stamps affixed should be duly cancelled so that they shall not be reused
again (Section 12).
Revenue stamps should be cancelled by executant/payee. If the stamps are not

cancelled they are treated as unstamped (Section 12).
Special Contracts
Where several instruments are executed for single transaction like mortgage, sale or
settlement, only principal instrument is chargeable with prescribed duty (Section 4).
Where an instrument comes under more than one description for charging duties,
highest duty is to be charged (Section 6).
TYPES OF STAMPS USED FOR DOCUMENTS

Revenue Stamps: Documents like demand promissory notes, cash receipts, acknowledgement
of debt should be stamped with adhesive revenue stamps of appropriate value before
execution.
Special Adhesive Stamps: Printed agreements/xerox copies of printed blank documents
should be affixed with special adhesive stamps. These stamps are cancelled by appropriate
authority before execution of documents.
Other Documents: Share transfers, notarial acts, bills of exchange made out of India.
Embossed/Engraved Stamps: Stamps can also be embossed or engraved by the

stamp authorities on banks standard forms.
Non-judicial Stamp Paper: Non-judicial stamp paper carries the stamp duty
embossed on the paper itself and as such stamped paper of requisite value may be
purchased from local stamp vendors.
Only one instrument is made on a stamp paper (Section 14).

ADJUDICATION FOR DEFICIENCY
Collector is empowered to determine the proper stamp duty payable in case of dispute
by executants (Section 31). The registration officer can refer the subject matter of an
instrument to the Collector for determination of market value of such property in case
of doubt (Section 47-A).
All duties, penalties and other sums required to be paid under the Stamp Act can be
recovered by the Collector by distress sale or any process of land revenue recovery in
force (Section 48).
Collectors are also empowered to refund the stamp duty for inadvertent misuse, forms
out of use, or spoiled (Section 51 to Section 55).
Section 29 of the Stamp Act provides which party, in the absence of and agreement to the
contrary, will bear the stamp duty payable on an instrument. This may be kept in view
while drafting a deed.
STAMP DUTY ON ENDORSEMENTS AND SUPPLEMENTAL DEEDS
All endorsements or supplemental deeds should be stamped according to the nature of

the transaction, which they evidence, e.g., if it is for receipt of money, it should be
stamped as a receipt; if it is an agreement, it should be stamped as an agreement.
Some documents if endorsed on prior deeds are exempt from stamp duty, e.g., receipt
of mortgage money endorsed on mortgage deed, or transfer of a bill of exchange or
policy of insurance or securities of Government of India endorsed on those papers.
85
REGISTRATION
The preliminary note to each deed shows whether a deed is required to be compulsorily
registered (Section 17, Registration Act):
Some documents though do not require registration may be voluntarily got registered
(Section 18).
Section 49 provides that an unregistered document of the nature requiring compulsory

registration may be used in evidence for certain collateral purposes, though not as
evidence of the transaction itself.
Section 60(2) provides that the Sub-Registrars endorsement while registering a

document is admissible in evidence for proving the facts mentioned therein.
APPLICABLE LAW
The interpretation of a written contract involves the ascertainment of the words employed by
the parties and the determination, subject to any rule of law, of the legal effect of those words.
The object sought to be achieved in construing any contract is to ascertain what the
mutual intentions of the parties were as to the legal obligations, each assumed by the
contractual words in which they sought to express them.
There is no intention independent of the meaning of the words they have used. The
proper construction of contract is a question of law.
However, the ascertainment of the meaning of a particular word is a question of fact.

The general presumption is against implying terms into written contracts. The more
detracted and apparently completed the contract, the stronger the presumption.
The contract must be construed as a whole and no clause should be taken in isolation.
The court will not for the purpose of construction correct a mistake as to the legal effect
of a written contract. However, such a mistake can be corrected by rectification.
The materials available to the courts for the purpose of construing a contract are
documents to be construed, consideration of deleted words to construe the words that
remain, antecedent agreements, drafts and preparatory negotiations along with
expressly incorporated terms.
LEX FORI IS THE LAW

It means the law of the forum. It signifies that the proper law applicable in enforcing
contracts is deemed to be the law of the country according to whose laws the contracting
parties wish to be governed. If such intention does not exist the applicable law is objectively
determined as the law of the country with which the contract is primarily concerned.
FORCE MAJEURE
It is a common clause in contracts, which decides the rights and liabilities of the contracting
parties and relieves them of their duties accordingly on the happening of certain events
during the course of executing the terms of a contract.
Force majeure (French for greater force) is a common clause in contracts, which
essentially frees one or both parties from liability or obligation when an extraordinary event
beyond the control of the parties, such as war, strike, riot, crime, and act of God (e.g., flood,
earthquake, volcano) prevails on one or both parties from fulfilling their obligations under
the contract.
86
Special Contracts
Time critical contracts may be drafted to limit the shield of this clause where a party does
not take reasonable steps (or specific precautions) to prevent or limit the effects of the
outside interference, either when they become likely or when they actually occur. Note
also that a force majeure may work to excuse all or part of the obligations of one or both
parties. For example, a strike might prevent timely delivery of goods, but not timely
payment for the portion delivered.
Under International Law it refers to an irresistible force or unforeseen event beyond the
control of a State making it materially impossible to fulfill an international obligation.
Force majeure precludes an international act from being wrongful where it otherwise
would have been.
NOTICE
Notice is the legal concept describing a requirement that a party be aware of legal process
affecting their rights, obligations or duties. It may be described as an official
communication of a legal action or ones intent to take an action. In a contract, notice has
some legal implications. The parties to the agreement, by mutual consent, agree to
incorporate the clause of Notice, whereby, either party could issue a notice to the other
party, in case of breach or as to any change in the subject-matter of the contract.
If one of the parties to the agreement fulfils the obligations under the contract, or fails to
perform them, then either party could act accordingly and determine the same in the former or
issue notice to the other party, in the latter case, it is cautioning him as to the further course of
action for specific performance or to pay damages, as per the terms of the contract.
Notice is also an important requirement in ending legal relationships. For example, a
notice to quit is a written notification given either by the tenant to the landlord, or
vice-versa, indicating that either the tenant intends to surrender possession of the
premises on a certain day or that the landlord intends to regain possession of the premises
on a certain day. Many kinds of contracts require that similar notice be given to either
renew or end the contractual relationship.
ARBITRATION CLAUSE
The advantages for including arbitration clauses in commercial agreements are that it is
prompt, and therefore, inexpensive, way of resolving business disputes and suitable for
present day commercial transactions. Arbitration assures that the dispute is decided by a
person, who is familiar with the commercial context in which the dispute arose.
ARBITRATION AGREEMENT
When parties to a contract, agree to incorporate the arbitration clause as a machinery to
redress the grievances, if any, which may arise while fulfilling the contractual obligations,
such an agreement is called an arbitration agreement.
Section 7 of the Arbitration and Conciliation Act, 1996 defines an arbitration agreement
thus:
1.
In this Part, arbitration agreement means an agreement by the parties to submitted

arbitration all or certain disputes which have arisen or which may arise between them
in respect of a defined legal relationship, whether contractual or not.
2.
An arbitration agreement may be in the form of an arbitration clause in a contract or in

the form of a separate agreement.
3.
An arbitration agreement shall be in writing.

87
4.
An arbitration agreement is in writing if it is contained in

a.
b.
A document signed by the parties;

An exchange of letters, telex, telegrams or other means of telecommunication
which provide a record of the agreement; or
c.
An exchange of statements of claim and defence in which the existence of the

agreement is alleged by one party and not denied by the other.
5.
The reference in a contract to a document containing an arbitration clause constitutes

an arbitration agreement if the contract is in writing and the reference is such as to
make that arbitration clause part of the contract.
a.
A gives a water heater for repair to an electric appliances shop. He says that he will
take the water heater only when it is completely repaired. The electric appliances
shopkeeper repairs the water heater and refuses to hand over the water heater until
he is paid for his services. Can the shopkeeper retain the heater? If yes, under what
right can he do so?
b.
The concluding part in the deed of agreement,

In witness whereof, the parties hereto have signed this deed on the data first above
written followed by signatures of parties, is referred to as _____________.
13.9.2 Checklist for Standard Clauses
88
Preamble
Parties
Definitions
Offer and Acceptance
Obligations
Conditions
Indemnification and Exoneration
Environmental Responsibilities
Security
Delivery
Insurance
Risk of Loss
Price and Currency Indexes
Force Majeure and Hardship Clause
Special Contracts
Default
Termination and Expiration
Assignment
Options
Confidentiality and Non-compete
Penalties and Liquidated Damages
Delay
Non-waiver Clause
Notice Clause
Publicity Clause
Language Clause
Required Activity
Choice of Law and Venue.
13.10 SUMMARY
Agency may be created either by implied or express agreement. An agreement is said to
be express when it is given by words spoken or written. Implied agreement is by
inference from the circumstances of the case and things spoken or written, or the ordinary
course of dealing.
Commercial agreements represent the conditions agreed by the parties and contain certain
clauses which form the basis of the rights and liabilities of the parties. The clauses in
corporate and commercial agreements include the description of the parties, the subject
matter of the agreement, the consideration paid by the promisor, statutorily implied
covenants, the signatures of the parties to the agreement, attestation by witnesses, and if
required, endorsements to the agreements or supplemental deeds.
The employment contract between an employer and employee can be either oral or written
specifying the job description, wages, employee rights and duties, and other specific terms
and conditions of employment.
13.11 GLOSSARY
Agency is a contract of a business or service authorized to act for others.
Del Credere Agent is an agent that guarantees his or her principal that the third parties
involved in the transaction will pay or perform.
Estoppel is an impediment that prevents a person from asserting or doing something
contrary to his own previous assertion or act.
Guarantee by which one person assumes responsibility for paying anothers debts or
fulfilling anothers responsibilities.
Indemnity is a security against loss or damage or injury. It is a contractual agreement made
between different parties to compensate for any damages or losses.
Lien is an encumbrance or legal burden upon property.
Pledge is something given or held as security to guarantee the payment of a debt or
fulfillment of an obligation.
89
Principal is a person who empowers another to act as his or her representative.

Ratification means making something valid by formally ratifying or confirming it.
Surety is a security for payment or performance on behalf of another in the event of a
default.
Dr. Avtar Singh. Law of Contract and Specific Relief. 8th Edition (2002) Eastern
Book Company.
Beatson J. Ansons Law of Contract. 28th Edition, Oxford University Press.

a.
Agency by ratification: Where acts are done by are person on behalf of another but
without his knowledge or authority, he may elect to ratify or to disown such acts. If he
ratifies them, the same effects will follow as if they had been performed by his authority.
The ratification may be express or implied, this is known as agency by ratification. In
the given case also Bharat can ratify the act of insuring his goods by Amit.
b.
As per the provisions of law of agency. The agent must not make secret profit from
the Instrument of agency. He must disclose any extra profit that he makes. In the
given case also Pravin (agent) is not allowed to make any secret profit. Mukarjee
(principal) can recover the excess profit made by Pravin.
a.
If a contract of guarantee requires three months notice the surety must give a three
months notice. However, in the case of Wali Muhammed vs Ganpar, 52 ALL.1014, it
was held that a notice revoking a guarantee given just a day before the performance of
the contract is not illegal.
b.
A contract by which one party promises to save the other from loss caused to him by
the conduct of the promisor himself, or by the conduct of any other person, is called a
contract of indemnity.
a.
Seenu is an office boy in a corporate office. At the time of appointment there was an
agreement between them that Seenu can be fired at any time without mentioning any
cause. Therefore Seenu can be terminated without showing any cause. This kind of
agreement is called, as employment at will, where the employer and the employee
agree with each other to terminate the relationship just by giving a notice of fixed
period of time.
Employment at Will
The doctrine of employment at will gives free hand to both as the employee can
quit, or the employer can fire an employee at his will, at any time and for any reason
and without any prior notice.
The doctrine of employment at will is a default rule of contract law, thus it applies
whenever the employee and employer have not agreed on something else or an
alternative.
90
Special Contracts
b.
Safin owes certain amount to Robin. Mary promises to Safin to save from the
proceedings which Robin may take against Safin in respect of due amount. The
contract between Mary and Safin is called contract of indemnity, which is defined
under section 124 of the Indian Contract Act, 1872.
According to Section 124 of the Indian Contract Act, 1872 a contract by which one
party promises to save the other from loss caused to him by the conduct of the promisor
himself or by the conduct of any other person, is called a contract of indemnity.
a.
A gives a water heater for repair to an electric appliances shop and says that he will
take back the water heater only when it is completely repaired. The electric appliances
shopkeeper repairs the water heater and refuses to hand over the water heater until he
is paid for the same. This right of shopkeeper is called lien.
b.
The concluding part of the deed is referred to as testimonium.

A. Multiple Choice
1.
2.
3.
4.
Which of the following agents are treated as non-mercantile agents?

a.
Factors.
b.
Auctioneers.
c.
Brokers.
d.
Del-credere agents.
e.
Insurance agents.
In which of the following cases an agency is terminated other than by operation of

Law?
a.
On performance of the contract.
b.
By mutual agreement.
c.
On the insolvency of principal.
d.
On the destruction of subject matter.
e.
On termination of sub-agents authority.
Who enjoys the right of subrogation in a contract of indemnity?

a.
Creditor.
b.
Principal debtor.
c.
Indemnifier.
d.
Indemnified.
e.
Both (a) and (b) of the above.
General Insurance is a
a.
Voidable Contract
b.
Wager
c.
Contract of Guarantee
d.
Contract of Indemnity
e.
None of the above.

91
5.
A continuing guarantee can be revoked by

a.
Novation
b.
Death of surety
c.
Discharge of principal debtor
d.
Loss of security
e.
All of the above.
B. Descriptive
1.
What is a Bank Guarantee? Distinguish a Bank Guarantee from an Ordinary

Guarantee.
2.
What are the features of a Letter of Credit? How do the parties to a letter of credit use
these letters of credit during the conduct of business?
3.
What is the meaning of the word lien? What are the different kinds of lien?
These questions will help you to understand the unit better. These are for your
practice only.
92
Special Contracts
NOTES
93
NOTES
94

Block Unit
Nos.
I
Unit Title
THE SOCIO-POLITICAL ENVIRONMENT OF BUSINESS
1.
2.
3.
4.
II

5.
6.
7.
Trade Environment
8.
BUSINESS
III
9.
10.
Tax Environment
11.
Ethical Environment
IV
BUSINESS CONTRACTS
12.
Law of Contracts
13.
Special Contracts
LAW RELATING TO CORPORATE BUSINESS ENTITIES

14.
15.
VI
TAX LAWS
16.
Direct Taxes
17.
Indirect Taxes
Block
5
UNIT 14
Formation and Organization of Company
UNIT 15
36
Expert Committee
Dr. O. P. Gupta
Vice Chancellor
IU, Nagaland
Prof. Hilda Amalraj

IBS Hyderabad
Prof. Bratati Ray

IBS Kolkata
Prof.Marzun E Jokhi
IBS Ahmedabad
Dr. B.Padma
IBS Bangalore

IBS Hyderabad

IBS Hyderabad

Prof. Vivek Gupta

Ms. C.Padmavathi
Ms. Sunitha Suresh


IU, Dehradun
Ms. Anita
Ms.Padmaja
IU, Meghalaya
Ms. Mrudula
Ms.Anurita Jois
IU, Sikkim

BLOCK 5
LAW RELATING TO CORPORATE

BUSINESS ENTITIES
This block provides a detailed discussion on the law that specifically governs corporate
business entities. The Companies Act, 1956, is the fundamental law that regulates the
formation, functioning, financing and winding up of corporate form of organizations. The
Act has been amended from time to time in response to the changing business environment.
The administration of the Act is vested with the Central Government. The Central
Government through the Ministry of Corporate Affairs, Offices of Registrar of Companies,
Company Law Board, Official Liquidators, and Public Trustee administers this Act.
Unit 14 outlines the legal and regulatory provisions pertaining to various forms of corporate
entities, the features of a company, procedural aspects of incorporation of companies, the
powers of company, the rights, duties of owners of a company, raising of capital and other
relevant provisions.
Unit 15 contains provisions pertaining to powers, duties, responsibilities and liabilities of
directors, the different types of meetings held to conduct the affairs of the company, the
procedures to be followed in conducting meetings, provisions concerning reconstruction
and amalgamation, types of winding up and the circumstances leading to winding up of
companies.
UNIT 14
FORMATION AND
ORGANIZATION OF COMPANY
Structure
14.1
14.2
14.3
14.4
14.5
14.6
14.7
14.8
14.9
14.10
14.11
14.12
14.13
14.14
14.15
14.16
14.17
Introduction
Objectives
Salient Features of a Company
14.3.1 Independent Corporate Entity
14.3.2 Limited Liability
14.3.3 Separate Property
14.3.4 Perpetual Succession
14.3.5 Transferability of Interest
14.3.6 Can Sue and be Sued
Corporate Veil and Limitations
14.4.1 Judicial Interpretations
Types of Companies
14.5.1 Limited Company
14.5.2 Unlimited Company
14.5.3 Government Company
14.5.4 Foreign Company
14.5.5 Private Company
14.5.6 Public Company
Incorporation of a Company
14.6.1 List of Documents Required to Incorporate a Company
Doctrine of Ultra Virus
Doctrine of Indoor Management
14.8.1 Exceptions to the Doctrine of Indoor Management
Raising of Capital from Public
14.9.1 Prospectus
Share Capital
14.10.1 Share Certificate
14.10.2 Share Capital
14.10.3 Buy-Back of Securities
Dividend Payment
Transfer and Transmission
14.12.1 Transfer of Shares
14.12.2 Transmission of Shares
Summary
Glossary
Suggested Answers
Terminal Questions
14.1 INTRODUCTION
Every individual who wishes to start a business should have a basic understanding of the
regulatory requirements needed to set up a business. A company form of business is the
most popular form of business organization. In our earlier unit, we have dealt with the
general and specific laws of contracts entered into by individuals and business entities.
In this unit, we shall deal with the laws governing corporate form of business entities.
A company is a voluntary association of persons formed for the purpose of doing business,
having a distinct name and limited liability. It is a juristic person having a separate legal
entity distinct from the members who constitute it, capable of rights and duties of its own
and endowed with the potential of perpetual succession.1
Companies are those business entities that are incorporated under separate enactments.
They have a distinct legal personality, separate from the persons constituting it. The word
corporation or the word body corporate is defined in Clause (7) of Section 2 of the
Companies Act, 1956:
Body corporate or Corporation includes a company incorporated outside India but does
not include
A corporation sole;
A co-operative society registered under any law relating to co-operative societies; and
Any other body corporate not being a company which the Central Government may,
by notification in the Official Gazette, specify in this behalf.
14.2 OBJECTIVES
State the meaning, nature and characteristics of a company;
Explain the concept of lifting or piercing of corporate veil;
Classify companies on the basis of incorporation, liability, control;
Summarize the various aspects of Incorporation of a company and the important

documents required to be filed;
State and assess the doctrines of ultra vires and indoor management;
State the meaning of share capital and classify the various kinds of shares; and
Explain the requirements of prospectus and list its contents.
14.3 SALIENT FEATURES OF A COMPANY

Section 3(1) of the Companies Act, 1956 defines a company as a company formed and
registered under this Act, or an existing company as defined under Section 3(1)(ii) which
lays down that an existing company means company formed and registered under any
previous Company Law.
The company is an independent entity that is required to operate with defined bodies.
These are:
The general assembly;
The board;
The managing director.
The following are the characteristic features of a company:
14.3.1 Independent Corporate Entity

One of the important features of a company is its separate legal entity once it is
incorporated or registered under the Companies Act.
The case of Salomon vs. Salomon & Co. Ltd., is noteworthy in the light of this discussion.
Salomon was a prosperous leather merchant who converted his company into a limited
company named as Salomon & Co. Ltd. The company so formed consisted of Solomon, his
1
Soloman vs. Soloman Co. Ltd (1997) A.C.22.
Formation and Organization

of Company
wife and five of his children as members. The company purchased the business of Salomon
for 39,000, and the purchase consideration was paid in terms of debentures worth 10,000
conferring a charge over the companys assets, and 20,000 shares of 1 each fully paid-up.
The balance was contributed in cash. The company in less than one year ran into difficulties
and liquidation proceedings commenced.
It was held by the House of Lords that the business belonged to the company and not to
Salomon.
14.3.2 Limited Liability

The case of Salomon vs. Salomon & Co Ltd. also recognized the principle of limited
liability. No member can be called upon to pay anything more than the unpaid value of the
shares held by him or the amount guaranteed by him.
But, in the case of companies formed with unlimited liability of members, the liability of
the members in such cases is not limited only to the extent of the face value of their shares
and the premium, if any, unpaid thereon but members will also be required to contribute
further to meet the debts of the company in the event of winding up.
14.3.3 Separate Property

The wealth of the shareholders and the wealth of the company are separate. A member does
not even have an insurable interest in the property of the company. An incorporated
companys wealth is clearly distinguished from that of its members.
The income received by the shareholders in the form of dividends from the company is not
similar to the income of the company itself.
14.3.4 Perpetual Succession

A company once incorporated will never die. Being an artificial person it cannot be
incapacitated by illness and it does not have an allotted span of life. Also, as the company is
distinct from its members, the death, insolvency or retirement of its members leaves the
company unaffected and will continue to be the same entity with the same privileges and
immunities, estates, and possessions.
14.3.5 Transferability of Interest

The Companies Act provides that the shares or other interests of any member in a company
shall be movable property, transferable in the manner provided by the articles of the
company. A member may sell his share in the market without having to withdraw the
capital from the company.
14.3.6 Can Sue and be Sued

Once the company is incorporated or registered under the Companies Act, it exists as an
independent legal person and has its own entity distinct from the persons who constitute it.
The company enjoys rights and liabilities, which are not the same as that of its members.
Being a distinct legal entity, the company has the capacity to sue and be sued.
14.4 CORPORATE VEIL AND LIMITATIONS

As it can be seen from the case of Salomon vs. Salomon & Co Ltd., a company is given a
distinct legal entity in comparison to the individuals who are managing the affairs of the
company. This provides a veil for the persons who run the incorporated company as its
arms and heads. The courts generally consider themselves bound by the principle of
separate legal entity and adopt a cautious approach while piercing a corporate veil.
7
However, there have been instances where the courts lift the corporate veil of an
incorporated company either to expose the ingenuous persons behind the company or to
find out the real purpose of incorporating it. The corporate veil is said to be lifted or pierced
when the court ignores the company and concerns itself directly with the members or
management.
The circumstances under which the court may lift the corporate veil can be broadly grouped
under two heads: Statutory provisions, and Judicial interpretations.
The Companies Act, 1956 expressly provides for the following provisions pertaining to the
lifting of the corporate veil:
i.
Reduction of Membership: Section 45 specifies that If any time the number of

members of a company is reduced, (a) in the case of a public company, below seven,
(b) or in the case of a private company, below two, and (c) the company carries on
business for more than six months while the number is so reduced, every person who
is a member of the company ... and is cognizant of the fact ... shall be severally liable
for the payment of the whole debts of the company contracted during that period. In
this case, the privilege of limited liability of shareholders is lost and the law pierces
the corporate veil making persons behind the company personally liable despite their
limited liability. It must be noted that Section 45 provides for a grace period of six
months for bringing back the number of members to the required number.
ii.
Failure to Refund Application Money (Section 69(5)): If the directors of the

company fail to comply with the deadline for refunding the application money with
interest to unsuccessful applicants, then they are severally and jointly liable. This is
provided by the SEBI guidelines also. The deadline is of 130 days from the day of
opening of the issue.
iii.
Mis-description of Company Name (Section 147): The person(s) signing a contract

on behalf of the company would be held liable if the companys name is not fully and
properly indicated as required. The contract may be any contract, bill of exchange,
hundi, promissory note, cheque or order for money.
iv.
Misrepresentation in the Prospectus (Section 62): In case of misrepresentation in a

prospectus, every director, promoter and every other person, who authorizes the issue
of such a prospectus incurs liability towards those who subscribe for shares on the
faith of the untrue statement.
v.
Fraudulent Conduct (Section 542(1)): If it appears in the course of winding up of

the company that some business of the company has been carried on with intent to
defraud creditors, then the courts may declare that any persons who were knowingly
parties to the carrying-on of the business in this way are personally responsible
without any limitation of liability.
vi.
Holding and Subsidiary Companies: A subsidiary company is considered as a

separate legal entity in the eyes of law without any affiliation to the parent company;
except under certain circumstances. This viewpoint is reaffirmed by the decision in
the case of Freewheel (India) Ltd vs. Dr. Veda Mitra (1969). A company with a 52%
stake of the parent company, offered to issue further capital to the existing holder of
equity shares. The holding company objected and sought for subsidiary to be
restrained from going ahead with the issue, as it would deprive the holding company
of its controlling interests and would also result in depreciation in the value of shares.
The Court refused to issue the injunction following the principle of corporate veil.
However, a holding company is required to disclose to its members the accounts of its
subsidiaries. Sections 212 and 214 provide that every holding company shall attach to
its balance sheet, the balance sheet, profit and loss account, directors reports and cash
flow statement and auditors report, etc., in respect of each of subsidiary companies.

of Company
14.4.1 Judicial Interpretations

The decisions of the courts have always been intended to provide opportunities for an
incorporated company to retain its identity. However, certain circumstances compel the
courts to divert from the Salomon principle only to restrict any unjust result. While
exercising discretion, the courts rely on the underlying social, economic and moral factors
associated with the corporation. Some of the cases where the veil has been lifted are
discussed below, throwing light on the interpretation of this particular clause by the Courts:
i.
Protection of Revenue: The courts have pierced the veil of corporate entity where it
has been used for tax evasion or to circumvent tax obligations. A noteworthy case in
this point is that of Dinshaw Maneckjee Petit, Re (1927). Here the assessee who was
receiving huge dividend and interest income, diverted his investments to four private
companies formed for the purpose of reducing the tax liability. The companies did not
do any business but were created as legal entities to ostensibly receive the dividends
and interest and to hand them over to the assessee as pretended loans. It was held that
as the company was formed by the assessee purely and simply as a means of avoiding
super-tax, the company was nothing more than the assessee himself.
ii.
Prevention of Fraud or Improper Conduct: Where the machinery of incorporation

has been used for some fraudulent purpose like defrauding creditors or defeating or
circumventing law, the courts have resorted to piercing the corporate veil and looking
into the realities of the situation.
In case of PNB Finance vs. Shital Pd. Jain (1983), the person borrowed money from
the company and invested it in shares of three different companies in all of which he
and his son were the only members. The lending company was permitted to attach the
assets of such companies as they were created only to hoodwink the lending company.
In the case of Gilford Motor Company vs. Horne (1933), Horne had been employed by
the company under an agreement that he shall not solicit the customers of the
company or compete with it for a certain period of time after leaving its employment.
However, Horne started a company that carried on a similar business and solicited the
customers of his erstwhile company. It was held that the formation of the company
was a mere cloak or sham to enable him to break his agreement with the plaintiff and
was restrained from such solicitation.
Similarly, one other instance where the corporate veil had to be lifted in order to
prevent fraud was that of Jones vs. Lipman (1962). Lipman formed a company with a
capital of 100 to specifically sell a certain land to it, so that he need not perform an
earlier contract of selling the land to Jones. The company had Lipman and a clerk of
his solicitors as the only members. It was held that the specific performance of the
contract cannot be resisted by Lipman by transferring of the land to the company
which was a mere facade for avoidance of the contract of sale to Jones.
In Jyoti Limited vs. Kanwaljit Kaur Bhasin (1987), a similar undertone is evident in
avoiding legal liabilities. A firm of two partners agreed to sell two floors in a building
to certain parties but cancelled the agreement. Litigation followed and the High Court
restrained the firm from selling the property to any other party. In the meantime, a
private company was floated by these two partners who being the only two
shareholders became the Chairman and Managing Director respectively and the
property was transferred to the company. The company sold off the two floors and the
partners of the firm took the plea that the sale had been made by the company and
therefore the firm had not disobeyed the courts order. The courts disregarded the use
of corporate entity by the partners to avoid their personal legal obligations and
proceed with the assumption that no company had existed.
9
iii.
Determination of the Character of the Company: To an extent the nationality of

the company would not be determined on the basis of the nationality of its members
and also the company being an artificial person cannot be an enemy or friend.
However, the courts have lifted the veil in order to determine whether the company is
in de facto control of the persons who reside in an enemy country.
In case of Daimler Co. Ltd. vs. Continental Tyre & Rubber Co. Ltd. (1916), a
company was incorporated in London for the purpose of selling tyres manufactured in
Germany by a German company. Its majority shareholders and all the directors were
Germans. On declaration of war between England and Germany in 1914, it was held
that since both the decision-making bodies, the Board of Directors and the general
body of shareholders were controlled by Germans, the company was a German
company and hence an enemy company. The suit filed by the company to recover a
trade debt was dismissed on the ground that such payment would amount to trading
with the enemy and hence against public policy.
A similar decision was given in Cannos Bros. vs. Cannors (1940), a case with similar
factors. In this context, courts have resisted lifting of corporate veil in order to
determine whether the company is controlled by the government or not. In case of LIC
of India vs. Escorts Ltd (1986), the Supreme Court refused to hold the Life Insurance
Corporation as an instrumentality of state when it was exercising its ordinary right as a
majority shareholder in a company for removing the existing management and
reconstituting the board of directors.
iv.
Where a Company is used to Avoid Welfare Legislation: Formation of companies

in order to avoid the amount to be paid by way of bonus to workmen or to avoid other
statutory welfare measures, is also one of the factors that make the courts lift the
corporate veil.
In the case of Workmen of Associated Rubber Industry Ltd. vs. Associated Rubber
Industry Ltd. (1986), the company transferred its investments to a dummy company
which was formed specifically for the purpose of not including the dividend earned in
the Profit and Loss account of Associated Rubber Industry Ltd. This resulted in
reduction of profits and in turn decreased the amount that would be paid as bonus to
the workers. The Supreme Court over-ruling the decisions of the High Court and the
Industrial Tribunal held that the new company was created with no business or income
of its own, served no purpose whatsoever except to reduce the gross profits of the
company. It was held that the amount of dividend received by the dummy company
was, therefore, to be taken into account in computing the profits of Associated Rubber
Industry Ltd.
v.
10
For Determination of the Technical Competence of the Company: The case in

reference is that of New Horizons Ltd. and Another vs. Union of India (1994). The
Department of Telecommunications, Hyderabad district, invited printing, binding and
supply of telephone directories from companies which have experience in supplying
such directories to telephone systems with a capacity to more than 50,000 lines. One,
New Horizons Ltd., responded to the tender but could not be accepted partly on
grounds of technical flaw. NHL pleaded that its Indian collaborators had experience in
the related field. The High Court (sticking to the Salomon principle) dismissed NHLs
plea on the ground that NHL had no experience. However, the Supreme Court
(piercing through the corporate veil) held that as both groups of joint venture had
contributed towards the resources of the venture in the form of machines, equipment
and expertise, the experience of the company would include the experience of the
constituents of the joint venture as well.

of Company
14.5 TYPES OF COMPANIES

There are different types of companies such as the following:
14.5.1 Limited Company

A company can limit its liability either by shares or by guarantee:
Companies Limited by Shares [Section 12(2)(a)]: In this type of company, the liability of
the members is limited to the amount remaining unpaid on the shares. Hence, holders of
shares that are fully paid-up, cannot be called upon for any further contribution. The
liability of the members holding partly paid-up shares exists even if the company is in the
process of winding up.
Companies Limited by Guarantee not having Share Capital: In this type of company,
the memorandum limits the members liability. It is limited to such amount as he may have
undertaken by the memorandum of association to contribute in case of winding up.
The form of memorandum and articles of a company limited by guarantee and not having
a share capital is contained in Table C of Schedule I of the Companies Act, 1956. This
form may be adopted either in toto or as near thereto as circumstances warrant. The
proviso to Section 29 states that a company is permitted to include additional matters in
its articles provided it is not inconsistent with the provisions contained in Table C. In P
C Arvindhan vs. M A Kesavan, it was held that a provision in the articles of a guarantee
company that prevented its members from participating in the annual general meeting
was illegal and void.
Companies Limited by Guarantee having Share Capital: If the company is limited by
guarantee while having its own share capital, the liability of members would be towards
guarantee as specified in the memorandum of association and in addition any sums
remaining unpaid on the shares held by him.
The form of memorandum and articles of a guarantee company having share capital can be
found in Table D of Schedule I of the Companies Act. The memorandum of such a
company should also specify the amount of share capital with which the company is to be
registered and the amount of each share.
14.5.2 Unlimited Company

Unlimited companies do not have any limit on the extent of liability of its members. The
liability of each member extends to the whole amount of the companys debts and
liabilities. However, the members cannot be sued upon directly by the companys creditors.
This is in contrast to the liability of the partners in a partnership firm where partners can be
sued directly. In case of winding up, the official liquidator may call upon the members to
discharge the debts and liabilities without limit.
The articles of association of a company must state the number of members with which the
company is registered and the amount of share capital (if any) [Section 27].
14.5.3 Government Company

Section 617 defines a government company as any company which has at least 51% of the
paid-up share capital held either by the Central Government, or by any State Government or
Governments or partly by the Central Government and partly by one or more State
Governments. As the concept of Government Company has been introduced in the
Companies Act, 1956, it follows that a Government company will mean a company
registered and incorporated under the Companies Act, 1956.
The legal status of a company does not change by virtue of majority holding by the
government. Hence no special privileges or exemptions are granted to Government
Companies.
11
14.5.4 Foreign Company

As per Section 591, a foreign company means a company incorporated outside India but
having a place of business in India. Thus, if a company is incorporated outside India, but
employs agents in India without establishing a place of business here, it cannot be
considered as a foreign company. In Deverall vs. Grand Advertisement Inc., it was held that
a company shall be said to have a place of business in India if it has a specified or
identifiable place at which it carries on business such as an office, storehouse, godown or
other premises having some concrete connection between the locality and its business.
14.5.5 Private Company

A private company should have at least two persons (Section 12) to subscribe their names
to Memorandum and Articles of Association. Section 26 provides that a private limited
company must have articles of its own.
As per Section 3(1)(iii), a private company means a company which has a minimum
paid-up capital of one lakh rupees or such higher paid-up capital as may be prescribed, and
by its articles,
a.
Restricts the right to transfer its shares, if any;
b.
Limits the number of its members to fifty not including

i.
Persons who are in the employment of the company; and
ii.
Persons who having been formerly in the employment of the company, were
members of the company while in that employment and have continued to be
members after the employment ceased;
c.
Prohibits any invitation to the public to subscribe for any shares in, or debentures of
the company.
d.
Prohibits any invitation or acceptance of deposits from persons other than its
members, directors or their relatives.
However, where two or more persons hold one or more shares in a company jointly, they
shall, for the purposes of this definition, be treated as a single member.
Every private company, existing on the commencement of the Companies (Amendment)
Act, 2000, with a paid-up capital of less than one lakh rupees, shall within a period of two
years from such commencement, enhance its paid-up capital to one lakh rupees.
Section 3(6) indicates that where a private company or a public company fails to enhance
its paid-up capital in the manner as stated above, such company shall be deemed to be
defunct company within the meaning of Section 560 and its name shall be struck off from
the register by the Registrar.
12
a.
Restriction on Transfer of Shares: A private company is normally a closely knit

company with a very few members. Hence free transferability of shares is restricted. It
should be noted that it is a restriction imposed and not prohibition. The articles usually
provide that directors may in their absolute discretion and without assigning any
reason thereof decline to register a transfer of any share whether fully paid or partly
paid. The articles may also provide that a member wanting to dispose of his holding
should first offer them to the existing shareholders at a price determined according to
the articles. Only when no existing member agrees to buy his holding, can the member
sell them to an outsider. This restriction is not applicable in case of a company
incorporated as a pure guarantee company.
b.
Limitation on the Number of Members: The number of members of a private

company is to be compulsorily limited by its articles to fifty. The membership will be
arrived at by considering joint holders as single member.

of Company
Also, present employees who are members and former employees who had become
members during their employment and continued to be members even after they have
ceased to be employees will be excluded.
Regarding the question as to whether directors can be considered as employees for the
purpose of arriving at the maximum limit, it has been held in Normandy vs Ind
Coope & Co. Limited. (1908) that for the purposes of counting the membership of a
private company, directors will not be considered as employees.
In Lee vs. Lees Air Farming Limited (1960), it was held that though a managing
director may be treated as an employee for purposes connected with labor,
employment and taxation, legislation, etc., he will not be considered as an employee
for counting the membership of a private company.
It is worthnoting that in case of a private company, it is only the number of members
that is required to be limited to fifty. This rule does not apply to debentures. Hence,
a private company may issue debentures to any number of persons. However, the
only restriction would be that an invitation to the public to subscribe to debentures
is disallowed.
c.
Restriction upon issue of Prospectus: As per Section 3(1)(iii)(c), a private company

cannot issue a prospectus inviting the public to subscribe for shares in or debentures
of, the company. However, there is nothing to prevent a private company from
soliciting investment in its shares or debentures by private means. Investment by
private approach would mean giving opportunity of investment to the person
approached and not to others through him if those others are likely to be members of
the general public rather than a restricted circle of known persons such as his relatives.
d.
Privileges Enjoyed by Private Companies: As there are restrictions on raising

money and maximum number of members in a private company, there is not much
public accountability. Therefore a private company need not be subjected to such a
rigorous surveillance as in the case of a public company. The exemptions enjoyed by a
private company are mentioned below.
EXEMPTIONS
i.
A private company is exempted from following the norms of offering rights issue
whenever there is an expansion of capital. Hence, the shares of a private company
need not be first offered to the existing shareholders (Section 81).
ii.
A private company need not have more than two directors as against minimum three in
the case of a public company (Section 252). Directors of a company need not be
appointed by a resolution per each director as in case of public limited companies. They
may be appointed by a single resolution (Section 255). Also, directors of a private
company are not required to retire by rotation unlike a public company where 2/3rds of
the directors must retire by rotation at each annual general meeting (Section 256).
iii.
A private company need not hold any statutory meeting or file a statutory report
(Section 165).
iv.
Quorum required for the general meeting in the case of private company is two
persons as against five persons in the case of public company (Section 174).
v.
A private company, by virtue of restriction on the public participation, is exempt from

all the requirements of the Act relating to the prospectus (Section 70).
vi.
The restrictions on the commencement of business contained in Section 149 do not

govern private companies.
13
14.5.6 Public Company

According to Section, 3(1)(iv) of The Companies Act, 1956, public company means a
company which,
a.
is not a private company.
b.
has a minimum paid-up capital of five lakh rupees or such higher paid-up capital, as
may be prescribed.
c.
is a private company which is a subsidiary of a company which is not a private

company.
Every public company, existing on the commencement of the Companies (Amendment)

Act, 2000, with a paid-up capital of less than five lakh rupees, shall within a period of two
years from such commencement, enhance its paid-up capital to five lakh rupees.
However, a company registered under Section 25 of the Companies Act, 1956 before or
after the commencement of the Companies (Amendment) Act, 2000 shall not be required to
have the minimum paid-up capital as specified above.
1. Requires minimum two members.
Requires minimum seven members.
2. Maximum limit of fifty members.
No maximum limit.
3. Minimum paid up capital Rs.1 lakh.
Minimum paid up capital Rs.5 lakh.
4. Atleast two directors required.
Atleast three directors required.
5. Consent of directors need not be filed

with the Registrar.
Consent of Directors is to be filed with the

Registrar.
6. Raises capital by private arrangement,

public subscription is not allowed.
Raises capital by inviting public subscription

or by private arrangement.
7. Raises deposits privately only from its

members, directors or their relatives.
May raise deposits from public as well.
8. Shares are not transferable except for

the provisions in the Articles.
Shares are freely transferable, and may be

even quoted on a Stock Exchange.
9. No restriction on managerial
remuneration.
Restrictions on total managerial

remuneration.
10. The words Private Limited are added

to the companys name.
The word Limited is added to the

companys name.
Table 1: Differences between Private and Public Companies

CONVERSION OF A PRIVATE COMPANY INTO A PUBLIC COMPANY
A private company is converted into a public company in either of the circumstances
mentioned below. Whatever may be the circumstances under which a private company is
converted into a public company, it will cease to enjoy all the privileges that are allowed to
a private company.
Conversion by Default (Section 43)
Any private company making a default in compliance with the statutory requirements as
laid down in Section 3(1)(iii) of the Act will be automatically converted into a public
company. The Central Government, under specific circumstances, may grant relief from
any of the consequences that may arise in case of conversion by default. A departure from
the conditions of Section 3(1)(iii) attracts penalty applicable to a public company for
contravention of the provisions of the Companies Act. This section does not specify any
fixed time limit or impose any special penalty.
14

of Company
In case a company contravenes or does not comply with the conditions laid down by
Section 3(1)(iii), a petition for relief may be filed in case such contravention was accidental
or due to inadvertence. Such a petition should be made to the Central Government and
accompanied by the following documents:
i.
Copy of memorandum and articles of association.
ii.
Copy of document showing that the default has been committed in complying with the
conditions laid down in clause (iii) of Subsection (1) of Section 3.
iii.
Affidavit verifying the petition.
iv.
Bank draft evidencing payment of application fee.
v.
Memorandum of appearance, shall be filed in Form 5.
Inapplicability of Section 43A

The Companies (Amendment) Act, 2000 has inserted Sub-sections (2A) and (11) in Section
43A. According to Sub-section 2A, a public company (referred to in Sub-section (2) of
Section 43A) becomes a private company on or after the commencement of the Companies
(Amendment) Act, 2000 and shall inform the Registrar, who has to substitute the word
private company for public company and shall make the required changes in the
certificate of incorporation issued to the company and in its memorandum of association
within 4 weeks from the date of application of the company. However, the Companies
(Amendment) Act, 2000 does not specify the time period within which the company shall
inform the Registrar that it has become private company.
The Sub-section (11) of 43A specifies that nothing contained in this section, except Subsection (2A), shall apply on and after the commencement of the Companies (Amendment)
Act, 2000. This implies that a private company can no longer automatically become a
public company on account of shareholdings or turnover. With the insertion of the Subsection (11), the provisions of Section 43A will become inapplicable after the
commencement of the Companies (Amendments) Act, 2000.
Conversion by Choice (Section 44)
Finally, there is always a choice for the company to convert itself into a public company.
Conversion of a private limited company into a public limited company by choice will
necessarily involve a change in the name of the company. Any change in the name will
require the passing of a special resolution as provided by Section 21.
In addition to the passing of a special resolution, the following requirements will have to be
fulfilled:
a.
The company will have to alter its articles so as to delete the provisions of clause (iii)
of Subsection (1) of Section 3. On the date of such alteration, the company will cease
to be a private company.
b.
c.
The company shall within thirty days from the passing of the resolution, file a
prospectus or a statement in lieu of prospectus with the Registrar.
If the number of members is less than seven, such number should be raised to at least
seven.
d.
The number of directors should be raised to not less than three in case it is less than
three.
15
Conversion of a Public Limited Company into a Private Limited Company

Proviso to Section 31(1) and (2A) provides that no alteration made in the articles which
has the effect of converting a public company into a private company shall have effect
unless such alteration has been approved by the Central Government. Every such company
after obtaining the approval of the Central Government has to file a printed copy of the
altered articles with the Registrar within 30 days of receipt of the approval.
Approval of the Central Government must be obtained through an application within three
months from the date when the special resolution altering the articles was passed. The
application should be in Form IA or in any other form as near thereto as circumstances
warrant.
a.
List down the circumstances in which the court ignores the company and concerns
itself directly with the members or the management.
b.
Mr. A diverts his investments to three private companies to receive the dividends and
interest. One of the companies was in the name of his spouse and two on his name.
Preliminary investigation reveals that Mr. As purpose was to circumvent tax
obligations. Discuss the legality of above act with reference to case laws.
c.
A company was incorporated at Mumbai with a paid up capital of 5 crore. 25% of

paid up capital held by the Maharastra Government and 30% of paid up capital held
by the Central Government. Identify the type of company.
14.6 INCORPORATION OF A COMPANY

For incorporation of a company, the promoters have to inter alia decide on the following
aspects:
16
Type of the company.
Name of the company.
Filing of the following documents with the Registrar:
Memorandum of Association
Articles of Association
List of Directors

of Company
Declaration stating that all requirements of the Companies Act have been
complied with
Preparation of other documents.
Payment of the required fees.
Obtaining the Certificate of Incorporation.
Obtaining the Certificate of Commencement of Business.
14.6.1 List of Documents required to Incorporate a Company

Following are the list of documents required to incorporate a company:
i.
Declaration of compliance in Form No.1 by an advocate of the Supreme Court or a

High Court, an attorney or a pleader entitled to appear before a High Court or a
Secretary or a Chartered Accountant, in whole-time practice in India who is engaged
in the formation of a company, or by a person named in the Articles as a director,
manager or secretary of the company that all the requirements of the Companies Act,
1956 and the rules thereunder have been complied with in respect of registration and
matters precedent and incidental thereto.
ii.
The stamped and signed copy of the Memorandum and Articles of Association.
iii.
Notice of the situation of the registered office of the company in Form No.18.
iv.
Particulars in favor of one of the subscribers to the memorandum of association or any

other person authorizing him to file the documents and papers for registration and to
make necessary corrections, if any. This should be executed on non-judicial stamp
paper of the requisite value.
v.
Any other agreement, if referred to in the Memorandum and Articles of Association,

as in that case, it will form a part of the Memorandum and Articles.
vi.
Any agreement which the company to be incorporated proposes to enter into with any
individual for appointment as its managing or whole-time director or manager.
vii. Original true copy of the Registrar of Companies letter intimating about the
availability of name.
MEMORANDUM OF ASSOCIATION
The Memorandum of Association is a document of great importance in relation to a
company. As per Section 2(28) of the Act, Memorandum means Memorandum of
Association of a company as originally framed or altered from time to time in pursuance of
any provisions of Company Law or of this Act. It is often described as the charter of the
company defining as well as confining the powers of the company. Any act done beyond
the scope of the memorandum is ultra vires the company and hence null and void.
The Memorandum of Association should follow the conditions given below:
Every memorandum should be printed.
Divided into paragraphs and numbered consequently.
Signed by each subscriber in the presence of at least one witness who shall attest the
signature and shall likewise add his address, description and occupation.
Section 13 of the Act prescribes that the memorandum of association of a limited company
should essentially have the following six clauses:
Name Clause
The memorandum of association should contain the name of a company, whether it is a
private or public company. Companies covered by Section 25 are exempted from the use of
word(s) Ltd./Private Ltd.
No company shall be registered by a name, which in the opinion of the Central Government
is undesirable.
17
Registered Office Clause

This clause should state the name of the State in which the registered office of the company
will be situated. Under Section 146, a company shall, as from the date of which it begins its
business, or as from the 30th day after the date of its incorporation, whichever is earlier,
have a registered office; and a notice of the exact place of the registered office must be
given to Registrar within 30 days after the date of incorporation.
A company can shift its registered office from one place to another within the same city,
town or village by a board resolution. Notice of such change should be intimated to the
Registrar in Form 18 within 30 days of such change. If it is proposed to shift the registered
office from one city to another city within the same state, a special resolution to that effect
has to be passed and the Registrar informed about the change within 30 days of passing the
special resolution. A copy of the special resolution along with Form 23 and Form 18
(change in location of registered office) should be filed with the Registrar within 30 days of
the change.
Change of Registered Office within a State (Section 17A): No company shall change the
place of its registered office from one place to another within a state unless it is confirmed
by the Regional Director.
However, the above section shall apply only to the companies which change the registered
office from the jurisdiction of one Registrar of Companies to the jurisdiction of another
Registrar of Companies within the same State.
Objects and Powers Clause
The objects clause defines the objects of the company and indicates the sphere of activities.
The objects must be divided into three sub-clauses, namely:
Main Objects:
This clause has to state the main objects to be pursued by the company on its
incorporation.
Objects incidental or ancilliary to the attainment of main objects.
Other Objects: This sub-clause must state other objects which are not included in the
above clauses.
The construction of the objects should be such that a concentrated line of activity exists and
it confines the corporate action within fixed limits.
It is to be noted that the function of the memorandum is to delimit and identify the objects
in an unambiguous manner so as to enable a layman identify the field of industry within
which the corporate activities are to be confined. A company intending to change its objects
clause can do so by passing a special resolution.
ARTICLES OF ASSOCIATION
Section 2(2) of the Act defines Articles of Association of a company as originally framed
or as altered from time to time in pursuance of any previous companies law or of this Act.
The articles of association of a company are its bylaws or rules that govern the management
of its internal affairs and the conduct of its business. It defines the powers of its officers and
also establishes a contract between the company and the members and between the
members inter se.
The articles play a subsidiary part to the memorandum of association. The memorandum
and articles are contemporaneous documents which must be read together. Any ambiguity
and uncertainty in one of them may be removed by reference to the other.
18

of Company
Contents: The articles usually contain the provisions relating to the following matters:
Share capital including sub-division thereof, rights of various shareholders, the

relationship of these rights, payment of commission, share certificates
Lien on shares
Calls on shares
Transfer of shares
Transmission of shares
Forfeiture of shares
Surrender of shares
Conversion of shares into stock
Share warrants
Alteration of share capital
General meetings and proceedings
Voting rights of members
Directors, including first directors or directors for life, their appointment,

remuneration, qualification, powers and proceedings of board of directors meetings
Dividends and reserves
Accounts and Audit
Borrowing Powers
Winding Up
Adoption of Preliminary Contracts.
As per Section 28, a public company limited by shares may either frame its own set of articles
or may adopt all or any of the regulations contained in Table A of Schedule I to the
Companies Act. If such company does not register the articles, Table A automatically applies.
The following companies should, however, have their own articles: (a) Unlimited Companies,
(b) Companies limited by guarantee, and (c) Private companies limited by shares.
14.7 DOCTRINE OF ULTRA VIRES

A purported activity beyond the powers of the company will be ineffective even if ratified
by all the members. This rule is commonly known as doctrine of ultra vires.
The powers exercisable by a company are to be confined to the objects specified in the
memorandum. While the objects are to be specified, the powers exercisable in respect of
them may be express or implied and need not be specified. However, it is prudent to include
the following powers expressly in the objects clause:
to acquire any business similar to companys own business;
to enter into agreements with other persons or companies for carrying on business in
partnership or for sharing profits, joint venture or other arrangements;
to take shares in other companies having similar objects;

19
to promote other companies and help them financially;
to use funds for political purpose; and
to give gifts and make donations or contributions for charities not relating to the
objects stated in the memorandum.
In a leading case of A. Lakshmanaswami Mudaliar vs. Life Insurance Corporation of India,

the directors of a company were authorized to make payments towards any charitable or
any benevolent object, or for any general or any other useful object. Following the
shareholders resolution, the directors paid two lakh rupees to a trust formed for the purpose
of promoting technical and business knowledge. However, the payment was held to be ultra
vires. The court held that the directors could not spend the companys money on any
charitable or general object of their choice. They could spend for the promotion of only
such charitable objects as would be useful for the attainment of the companys own objects.
The companys business having been taken over by Life Insurance Corporation, it had no
business left to promote. It can be interpreted that a companys funds cannot be directed to
every kind of activity just because such activity has been approved to that effect in the
companys memorandum.
Consequences of Ultra Vires Transactions
Injunction may be obtained by any shareholder to restrain the company from carrying
out an ultra vires act.
Directors are personally liable for any diversion of the funds for purposes other than
what is specified in the companys memorandum. A shareholder can bring about an
action against the directors for restoration of company funds used for ultra vires
objects. They can also be held personally liable for breach of warranty of authority.
In case the companys money has been spent ultra vires in purchasing some property,
the companys right over that property must be held secure as it represents the
companys funds. Hence, any property legally and by formal transfer or conveyance
transferred to a corporation, is in law, duly vested in such corporation, even though
the corporation was not empowered to acquire such property.
The rule of ultra vires was devised for the protection of the companys interest and it is
not capable of being used against the companys interest. Therefore, others cannot sue
on the ground of ultra vires the claim of a company which has matured.
14.8 DOCTRINE OF INDOOR MANAGEMENT

This doctrine lays down that the persons dealing with the company having satisfied
themselves that the proposed transaction is not in its nature inconsistent with the
memorandum and articles, are not bound to inquire into the regularity of the internal
proceedings. That is, while the persons contracting with a company are presumed to know
the provisions or contents of the memorandum and articles, they are entitled to assume that
the provisions have been observed by the officers of the company. An outsider is not bound
to see that the company carries out its own internal regulations. This rule has been found to
be of less rigor as compared to Doctrine of Constructive Notice.
The Doctrine of Constructive Notice says that every person who contemplates to enter into
a contract with a company has the means of ascertaining the propriety of the contract being
entered into, as the Memorandum and Articles of Association are public documents.
20

of Company
The doctrine of indoor management has its genesis in the case of Royal British Bank vs.
Turquand. The directors of a company borrowed a sum of money from the plaintiff. The
companys articles provided that the directors might borrow on bonds from time to time to
be authorized by a resolution passed at a general meeting of the company. The directors
gave a bond to Turquand without the authority of any such resolution. It was held that
Turquand could sue the company on the strength of the bond, as he was entitled to assume
that the necessary resolution had been passed.
14.8.1 Exceptions to the Doctrine of Indoor Management

The following are the exceptions where an outsider cannot claim relief on the grounds of
indoor management:
KNOWLEDGE OF IRREGULARITY
If the outsider already had the knowledge of lack of authority of the person on behalf of the
company, but still enters into a contract with the same person, he cannot seek protection
under this doctrine.
NO KNOWLEDGE OF ARTICLES
The rule assumes that the outsider has the knowledge of the memorandum and articles as
these are public documents which have to be read by persons dealing with the company.
NEGLIGENCE
The doctrine of indoor management does not encourage negligence. An outsider cannot
enter into a contract with an officer of a company who ordinarily is not permitted to enter
into a contract on behalf of the company.
FORGERY
This is an obvious exception. The directors cannot be held responsible for the signatures
they never made nor can the company do anything about it. Consequently, it is not the title
of the person that is defective but there is no title at all.
NON-EXISTENT AUTHORITY OF THE COMPANY
If a contract has been entered into by an outsider which is ultra vires to the activities of the
company itself, then there is no question of the contract being ultra vires the director.
a.
ABC Ltd., altered its Memorandum of Association for change of its registered office
from Hyderabad to Vijayawada in AndhraPradesh. The registrar had been informed
of the change within 30 days of altering of the MOA. Can the change be registered
by the Registrar?
b.
AlfaTech Ltd., put up cable wires in a certain area. There was no power in the
Memorandum of Association of the company to put up wires there. BetaTech Ltd., a
business rival of AlfaTech Ltd., cut the cable wires down. AlfaTech Ltd., wants to
sue BetaTech Ltd., for damages. Can AlfaTech Ltd. sue BetaTech Ltd., for damages.
21
c.
The secretary of Alfa Leo Technologies Ltd., forged signatures of two director
required under the articles on a share certificate and issued the certificate without the
authority of the company to Rajiv. Sanjay purchased these shares from Rajiv
without knowing the facts. The Alfa Leo Technologies Ltd., rejected to enter the
name of Sanjay in its Register of Members. Sanjay sues the company. Is the
company liable to Sanjay or Rajiv?
14.9 RAISING OF CAPITAL FROM PUBLIC

As companies grow, they may move from being privately owned to publicly owned. To
fund expansion and development, private companies can raise money by offering securities
for sale to the public. When the companies invite the public to participate in their affairs by
means of shares, it is known as public issues.
14.9.1 Prospectus
Section 2(36) defines a prospectus as any document described or issued as a prospectus and
includes any notice, circular, advertisement or other document inviting deposits from the
public or inviting offers from the public for the subscription or purchase of any shares in, or
debentures of a body corporate.
A prospectus is an invitation issued to the public to purchase/subscribe shares or debentures
of the company. The provisions of the Act relating to prospectus apply only if it is issued to
the general public. A single private communication will not be taken as an issue of
prospectus. In Pramatha Nath Sanyal vs. Kali Kumar Dutt, a newspaper advertisement
stating that some shares were still available for sale according to the terms of the prospectus
of the company which could be obtained on application was held to be a prospectus.
Where a company sends a circular to its agents and dealers inviting subscription to its share
capital, such a circular amounts to an invitation to the public and will require a registration
of the prospectus.
PROSPECTUS TO BE DATED
Section 55 specifies that every prospectus has to be dated. The date of publication of
prospectus should be differentiated from the date of its issue. While the date which appears
on the prospectus is the date of publication, the date of issue is the date on which the
prospectus first appears as an advertisement.
MATTERS TO BE STATED IN THE PROSPECTUS
Section 56 of the Act lays down that every prospectus issued by the company shall conform
to the requirements of Schedule II of the Companies Act. As per the schedule, Part I shall
disclose matters specified therein and Part II shall set out certain reports. Explanatory
statement shall be given in Part III. The matters that have to be stated in the prospectus are
summarized below:
General information
Capital structure
Terms of present issue
Management and project
Management perception of risk factors.
No prospectus can be issued unless it is registered with the Registrar.

22

of Company
DEEMED PROSPECTUS
As per Section 64, the document issued by the Issue House will be treated as a prospectus
issued by the company. Section 64(1) provides that where a company allots or agrees to
allot any shares or debentures with a view to these being offered for sale to the public, any
document by which the offer of sale to the public is made shall, for all purposes, be deemed
to be prospectus issued by the company. This Section applies if the offer of the shares or
debentures for sale to the public was made within six months after the allotment or
agreement to allot such shares to the Issuing House. This Section applies also if the whole
consideration to be received by the company in respect of shares or debentures had not been
received by it from the Issue House.
GOLDEN RULE FOR FRAMING OF PROSPECTUS
The Golden Rule of prospectus was laid down in the case of New Brunswick and Canada
Rly. Land & Co. vs. Muggeridge. It states that those who issue prospectus will be
bestowing great advantages to the public who take shares in the proposed undertaking as
per the prospectus. Every fact must be stated with strict and scrupulous accuracy. The
promoter should also disclose all other information within knowledge which might in any
way affect the decision of the prospective investors to invest in the company. That is, it is
the primary assumption of the public that the material facts that are stated in the prospectus
are true. Nothing should be stated as fact which is not so, and no fact should be omitted the
existence of which might in any degree affect the nature or quality of the principles and
advantages which the prospectus holds out as inducement to take shares.
CIVIL LIABILITY FOR MISSTATEMENTS IN PROSPECTUS
Civil Liability under Section 62 will arise in case of an untrue statement in the prospectus.
The following persons will be held liable under Section 62 in case a subscriber has
sustained loss because of an untrue statement in the prospectus.
Every person who is a director of the company at the time of issue of prospectus.
Every person who has authorized himself to be named and is named in the prospectus
as a director, or as one having agreed to become a director, either immediately or after
an interval of time.
Every promoter of the company.
Every person (including an expert) who has authorized the issue of the prospectus.
The misrepresentation should relate to a material fact. Where it is represented that

something will happen or be done in future, this does not amount to a representation of fact.
It is only an estimate or a forecast. Hence, there should be a misstatement relating to an
existing fact. In Bentley vs. Black it was held that a calculation of future profits is not a
representation of fact.
Remedies for misstatement in a prospectus against the company: Any person who takes
shares from the company relying on a prospectus containing misstatements or omission of
material facts may (a) rescind the contract to take the shares, (b) claim damages. Rescission
of the contract can be resorted to only when an investor subscribes to shares based on a
material misrepresentation of fact in the prospectus. The aggrieved investor should also
ensure that he rescinds the contract within a reasonable time.
It must be noted that the allottee cannot both retain the shares and get damages from the
company. Damages are normally claimed from the directors, promoters and other persons
who had authorized the issue of the prospectus personally, or from experts who had signed
reports referred to in the prospectus.
23
14.10 SHARE CAPITAL

According to Section 2(46) of the Companies Act, a share means share in the share capital
of a company, and includes stock except where distinction between stock and shares is
expressed or implied. By a share in a company it also means a right to participate in the
profits made by a company, while it is a growing, and in the assets of the company when it
is wound up.
Section 82 states that the share or other interest of any member in a company shall be
movable property, transferable in the manner provided by the articles of the company. A
share is not a negotiable instrument. The purchaser of shares cannot be denied registration
of the shares purchased by him/her on any ground other than those stated in the articles.
Also, a share certificate is not a share in itself it is only a prima facie evidence of the title
of the share.
14.10.1 Share Certificate

Share certificate is a document issued by the company and is an evidence that the person
named therein is the holder of specified number of shares (as indicated in the document) of
the company. It can be issued only in pursuance of a Board Resolution and on surrender of
the letter of allotment if issued.
It is issued under the common seal of the company and should be signed by two directors or
persons authorized to sign on their behalf and the Secretary or any other person appointed
by the Board for the said purpose. The certificate is also subject to stamp duty as per the
relevant Stamp Act of the state in which the registered office of the company is situated.
14.10.2 Share Capital

Under the Companies Act shares may be issued by the company to shareholders in return
for cash or other value equal to or greater than its nominal value. Shares in the authorized
share capital are available to be issued. The issued share capital refers to shares which have
been allotted, issued and held by shareholders. Not all of the authorized share capital needs
to be issued. When shares are issued the person subscribing must pay cash or equivalent
value of at least the nominal amount. Where the share is worth more than its nominal
amount, a premium may also be paid.
A company may have many different types of shares that come with different conditions
and rights. There are four main types of shares:
Ordinary shares are standard shares with no special rights or restrictions. They have
the potential to give the highest financial gains, but also have the highest risk.
Ordinary shareholders are the last to be paid if the company is wound up.
Preference shares typically carry a right that gives the holder preferential treatment
when annual dividends are distributed to shareholders.
Cumulative preference shares give holders the right that, if a dividend cannot be paid
in one year, it will be carried forward to successive years.
Redeemable shares come with an agreement that the company can buy them back at a
future date. A company cannot issue only redeemable shares.
24

of Company
PREFERENCE SHARES
Section 85(1) of the Act describes a preference share as one which satisfies the following
criteria:
With respect to dividend, it carries or will carry, a preferential right to be paid a fixed
amount or an amount calculated at fixed rate, which may be either free of or subject to
income tax.
With respect to capital it carries, on a winding up or repayment of capital, a

preferential right to be repaid the amount of the capital paid-up or deemed to have
been paid.
Types of Preference Shares

There are three main types of preference shares, namely:
Participating Preference Shares: Participating preference shares are those shares

which are entitled to fixed preferential dividend and which carry a right to participate
in the surplus profits along with equity shareholders after dividend at a certain rate has
been paid to them. In the event of winding up, surplus left after paying back to both
the preference and equity shareholders will be distributed to the participating
preference shareholders.
Cumulative and Non-cumulative Shares: With regard to the payment of dividends,

preference shares may be cumulative or non-cumulative. A cumulative preference
share confers a right on its holder to claim fixed dividend of the past and the current
year(s) out of future profits and the dividend is accumulated till the time it is paid.
Whereas non-cumulative preference share gives right to its holder to a fixed amount
or a fixed percentage of dividend out of the profits of each year only and the dividend
will not be accumulated.
Preference shares are cumulative unless expressly stated to be non-cumulative.
Redeemable and Irredeemable Preference Shares: Redeemable preference shares

are those which are redeemed either at a fixed date or after a certain period of time
during the life time of the company. Section 80 lays down the following conditions for
the issue of redeemable preference shares.
The articles must provide for the issue of such shares;
They may be redeemed only out of profits available for dividend or out of the
proceeds of a fresh issue of shares made for the purpose of redemption;
In case of payment of premium on redemption, the same has to be provided for

out of profits or out of companys security premium account, before the shares
are redeemed;
No such shares can be redeemed unless they are paid fully;
Where the shares are redeemed otherwise than out of the proceeds of the fresh
issue, a sum equal to the nominal amount of the shares redeemed shall be
transferred out of profits which would otherwise have been available for
dividend, to the Capital Redemption Reserve Account. This fund may also be
used to issue fully paid bonus shares;
No company limited by shares shall, after the commencement of the Companies

(Amendment) Act, 1996, issue any preference share which is irredeemable or is
redeemable after the expiry of a period of twenty years from the date of its issue.
25
EQUITY OR ORDINARY SHARES

Equity share capital means all the share capital which is not preference share capital. That
is, equity shares are those shares which do not enjoy any preferential right in the matter of
payment of dividend or repayment of capital. The equity shareholders are entitled to
dividend after the payment of dividend to the preferential shareholders (if any).
The equity shareholders are entitled to vote in proportion to the paid-up equity capital
subject to the provisions of Section 87.
SHARES AT A PREMIUM
Although the Company Law does not place any restriction on the issue of shares at a
premium, it has laid down guidelines for utilization of such share premium [Section 78(2)].
Share premium is in the nature of capital reserve and can be used for:
Issue of fully paid-up bonus shares;
Writing off preliminary expenses and any commission or discount allowed on issue of
shares; and
Providing for premium payable on redemption of preference shares or debentures of

the company.
The share premium raised is not available for payment of dividend as it is not profit. If a
company distributes the amount lying in the account for purposes other than those stated
above, it shall amount to reduction in capital and provisions of Section 100 shall apply. The
law also requires that a company should transfer the amount of share premium (whether
received in cash or in kind) to a separate account called the Security Premium Account.
SHARES AT A DISCOUNT
Issue of shares at a discount is governed by the provisions laid down by Section 79. Issue of
shares at a discount can be made only after one year from the date on which the company is
entitled to commence business. A company can issue shares at a discount only if the issue
is authorized by a resolution passed by the Company in a general meeting and the approval
of the NCLT is obtained. The maximum rate of discount as specified in the resolution
cannot exceed 10%. Where the company proposes to issue shares at a discount exceeding
10%, the NCLT may, on an application made by the company grant approval, if it is of the
opinion that circumstances warrant a higher percentage of discount.
When a company has issued shares at a discount, it must disclose information of such an
issue and the extent to which the discount has been written off up to the date of the
prospectus. Conversion of debentures issued at a discount resulting in issue of shares at a
discount or reissue of forfeited shares as fully paid shares will be considered illegal if the
provisions of Section 79 have not been complied with. Violation of this section entails
penal consequences not only on the directors authorizing such an issue but the allottees as
well.
BONUS SHARES
A company is allowed to capitalize profits by issuing fully paid-up shares to the members
thereby transferring the sums capitalized from the profit and loss account or reserve
account to the Share Capital. Such shares are known as bonus shares and are issued to the
existing members of the company free of charge. Bonus shares are also called as
capitalization shares.
26

of Company
RIGHT SHARES
The capital may also be raised by issue of additional shares to the existing shareholders.
These rights shares are required to be allotted as per Section 81. The shares are allotted in
proportion to the shares held by the existing shareholders. The provisions for issue of this
type of instrument is discussed below.
Section 81 provides that where at any time after the expiration of two years from the date of
incorporation of the company or after one year from the date of the first allotment of shares,
whichever is earlier, a public company limited by shares, issues further shares within the
limits of the authorized capital, its directors must first offer the shares to the existing
holders of equity shares in proportion to their holding.
For this purpose, a notice has to be given to the shareholder offering him more shares
against payment of specified money per share. The shareholder is presumed to have
declined the offer if he does not respond within the stipulated time. Minimum time of 15
days has been prescribed by the Act.
The notice should mention the number of shares that may be taken by the holder. If the
shareholder declines the offer, the Board of Directors may dispose off the shares in a way
that is most beneficial to the company. Unless provided otherwise by the Articles of
Association, the shareholder shall have a right to renounce the offer, in whole or in part, in
favor of some other person where it is specifically provided for in the notice. The equity
shareholders will not be eligible to exercise the option of renunciation for a second time in
case the person in whose favor the renunciation is first made declines to accept the offer.
The right of a company to make an issue of shares under this section is not dependent upon
the capacity of any shareholder to take up the shares offered. Also, the existing shareholder
cannot object to increase on the ground that the shareholding of the holding company
would be reduced thereby.
In Free Wheel (India) Limited vs. Dr. Veda Mitra, the Court refused to grant an injunction
restraining a subsidiary company to proceed with further issue of shares. In this case, a
petition was made by the holding company wherein it pleaded that because of its weak
financial position it would not be able to subscribe to the shares issued by the subsidiary,
resulting in a reduction in its shareholding in the subsidiary.
This Section is not applicable in the following circumstances:
In case of an issue or allotment of shares within two years of the formation of the
company or within one year after the first allotment, whichever event occurs earlier.
Where a special resolution u/s 81(1A) is passed in the general meeting providing that
the shares may be offered to the persons other than existing equity shareholders.
Where no such special resolution is passed but the votes cast in favor of the proposal
exceed the votes cast against the proposal and the Central Government is satisfied that
the proposal is most beneficial to the company [Section 81(1A)]. Opinion of the
Central Government is given only after an application is made by the Board of
directors in this behalf.
If the company that is raising capital through this method happens to be a private
company.
In case of issue of shares against conversion of loans or debentures, if relevant

conditions are satisfied.
If the allotment is made to the creditors in lieu of payment, then such allotment of
shares will not come under the scope of Section 81. The company is allowed to tide
over the financial difficulties by allotting shares to the creditors. That is, where the
shares were treated as paid-up by adjusting the amounts due by the company to the
various creditors, Section 81 would have no application.
27
14.10.3 Buy-Back of Securities

Purchase of its own securities by a company is popularly referred to as buy-back of
securities. A company may purchase its own securities subject to the restrictions and
safeguards contained in Sections 77A, 77AA and 77B of the Companies Act, 1956. The
basic provisions of buy-back of securities are that the articles of the company shall contain
a provision authorizing the company to purchase its own securities and it must be
authorized by a special resolution passed at the general meeting of the company. Buy-back
can be made only from the sources and in the modes prescribed by Section 77A. A
company is also prohibited from purchasing its securities through its subsidiary company or
an Investment Company.
A public company whose securities are listed on a recognized stock exchange shall, in
addition to the provisions of the Companies Act, also comply with the SEBI (Buy-Back
of Securities) Regulations, 1998. A listed company may buy-back its securities through
tender offer or from the open market which may be through the stock exchange or
through the book-building process or from odd-lots, subject to compliance with the
conditions specified therein.
A company whose securities are not listed on a recognized stock exchange i.e., a private
company and a public unlisted company shall, in addition to compliance with the
provisions of the Companies Act, also comply with the Private Limited Company and
Unlisted Public Company (Buy-Back of Securities) Rules, 1999 framed by the Central
Government. An unlisted company may buy-back its shares either from the existing
shareholders or purchase the securities issued to the employees by an Employee Stock
Option Scheme.
14.11 DIVIDEND PAYMENT

The term dividend can be defined in two ways. In the case where a company is a going
concern, it represents that portion of the profits which are distributed among the
shareholders of the company. In case of a company which is to be wound up, it represents a
distribution of the companys realized assets among the creditors and contributories
according to their rights.
The power to pay dividend is inherent in a company and is not derived from the Companies
Act or the Memorandum or Articles of Association, though the articles generally regulate
the manner in which the dividends may be declared.
Section 205 specifies the sources out of which the dividend should be paid. The dividend
shall be declared out of:
Current Profits;
Reserves;
Monies provided by the Government; and
Depreciation as provided by the Companies Act.
A final dividend for any financial year can, as a rule, be declared and paid only when the
balance sheet and profit and loss account are presented to the shareholders at the annual
general meeting, and the shareholders after a consideration of the amount recommended by
the directors, approve the same or such lesser amount as it may appear to them to be
reasonable and proper. The shareholders can approve the recommended rate of dividend or
lower the same, but cannot increase the amount of dividend. If the shareholders of a
company desire to increase the rate of dividend, the proper course of action would be to
adjourn the annual general meeting, hold a board meeting for increasing the rate of
dividend and adoption of revised accounts and then hold the adjourned annual general
meeting for declaration of dividend.
28

of Company
Preference shareholders are entitled to receive dividend at a fixed rate before any dividend
is declared on equity shares. In case there are two or more types of preference shares, the
shareholders of the class which has priority are similarly entitled to their preferential
dividend before any dividend is paid to other shareholders. However, dividends to
preference shareholders will be paid only if the company has earned sufficient profits.
According to subsection (3) of Section 205 dividend should be made payable only in cash.
However, if the articles provide, dividend may be paid in the form of assets such as the
paid-up shares or debentures in that or any other company. Dividend should be paid only to
the registered holder of such shares or to his order or to his bankers or in a case where a
share warrant is issued to the bearer of the warrant or to his bankers.
Capital profits may be considered as available for distribution of dividends if the articles of
association permit such distribution, or the surplus is realized or such surplus remains after
a valuation of the whole of the assets and liabilities has been fairly taken.
Dividend can be paid only out of profits and not out of capital. However, in certain cases,
the Central Government may permit payment of interest to shareholders even when there is
no profit. Where a companys project is likely to have a long gestation period, payment of
interest out of capital can be justified.
14.12 TRANSFER AND TRANSMISSION

14.12.1 Transfer of Shares
A transfer of shares will be registered by the company only when a proper instrument of
transfer accompanied by the share certificates or the letter of allotment is lodged with the
company. The instrument of transfer should be properly stamped. It is not enough if only
the transferor executes the transfer deed. In order to pass the title in the shares, it is essential
that the deed should be executed by the transferor as well as the transferee.
In case the share certificate or the letter of allotment and the instrument of transfer is lost, a
registration of transfer cannot be effected unless a duplicate certificate is obtained from the
company.
Subsection 1-A of Section 108 lays down that the instrument of transfer of shares duly
signed by or on behalf of the transferor and before any entry is made therein, should first be
presented to a person already in government service who will endorse the date on which it
is presented. Then the instrument, after it is executed by both the transferor and the
transferee should be delivered to the company:
At any time before the date on which the register of members is closed in case of
shares dealt on the stock exchange or within 12 months from the date of presentation
to the person in government service for endorsement whichever is later;
Within two months from the date of presentation for endorsement, in any other case.
Where documents have been lodged as per the provisions of Subsection 1-A, it amounts to
a good delivery.
A transfer is complete as between the transferor and the transferee when the transfer deed is
executed and share certificates are handed over to the transferee. However, as between the
company and the transferee it is complete, only when the transfer is registered in the
Companys Register. Until the transfer is actually registered in the companys register, the
title of the transferee to the shares is incomplete and the legal title vests with the transferor.
29
Even a legal representative of a deceased member is empowered to transfer the shares of

the deceased member provided he follows the procedure for transfer of shares.
14.12.2 Transmission of Shares

Where the right to any shares has passed to a person by operation of law such as the death,
insolvency, lunacy of the shareholder or by acquiring shares by purchase in a court sale, a
transmission of shares takes place. The process of transmission is not the same as a transfer,
and does not require any instrument of transfer to be lodged with the company. Similarly,
there is no payment of stamp duty in case of transmission of shares. However, the company
may insist upon evidence such as a succession certificate, production of probate or letter of
administration.
Where the persons acquire interest in shares by virtue of transmission, they will not be
eligible to exercise voting rights or receive dividends in case they do not get the shares
registered in their names. However, any calls due on such shares will be enforced against
them in their capacity as legal representatives of the deceased shareholder.
Where a company refuses a transmission without sufficient cause, the transmittee of shares
will be entitled to the same remedies available to a transferee under Section 111.
a.
According to section 79 of the Companies Act, 1956, a company can issue shares at
a discount only if the issue is authorized by a resolution passed by the company in
general meeting and the approval of the National Company Law Tribunal is
obtained. What is the maximum rate of discount that can be authorized?
b.
Can a newspaper advertisement stating that some shares were still available for sale
according to the terms of the prospectus of the company which could be obtained on
application be held as a Prospectus?
c.
Zaheerudin held shares in a Public Ltd. Co. After his death, his son has applied for
transfer of shares. What does this amount to?
14.13 SUMMARY
Once the company is incorporated and registered under the Companies Act, it exists as an
independent legal person and has its own entity distinct from the persons who constitute it.
The company enjoys rights and liabilities, which are not the same as that of its members.
Being a distinct legal entity, the company has the capacity to sue and be sued.
30

of Company
As companies grow, they may move from being privately owned to publicly owned.
To fund expansion and development, private companies can raise money by offering
securities for sale to the public. When the companies invite the public to participate in their
affairs by means of shares, it is known as public issues. A prospectus is an invitation issued
to the public to purchase/subscribe shares or debentures of the company. The provisions of
the Act relating to prospectus apply only if it is issued to the general public. A single
private communication will not be taken as an issue of prospectus.
A share means share in the share capital of a company, and includes stock except where
distinction between stock and shares is expressed or implied.
14.14 GLOSSARY
Abridged Prospectus is one where the salient points of prospectus accompany the
application forms.
Allotment is the distribution of shares to applicants in a new issue.
Articles of Association means the byelaws of the company, that is rules and regulations
relating to the internal management of the company which is incorporated.
Artificial Person is a legal entity usually an organization such as a corporation or a
government ultimately composed of natural persons.
Association not for Profit is generally a business organization that exists to serve some
public need without the intent of making a profit.
Blank Transfer is where the seller gives a blank deed to the buyer by only filling his name
and affixing his signature and he is said to have executed a blank transfer deed.
Bonus Shares are those which are issued to the existing shareholders without payment of
any consideration, either in cash or kind.
Certification of Incorporation means a certificate issued by a state that shows acceptance
of a corporations articles of incorporation.
Corporate Veil is a judicial doctrine that allows enjoyment of advantages of corporate
nature and which are otherwise not available.
Defunct Company means a company, which never commenced business or which is
not carrying on business and has either no assets or has such assets as shall not be
sufficient to meet the costs of liquidation.
Equity Shares are those shares which do not enjoy any preferential right in the matter of
payment of dividend or repayment of capital.
Foreign Company its means a foreign company means a company incorporated outside
India but having its place of business in India.
Government Company means any company that has at least 51% of the paid-up share
capital held either by the central government, or by any state government or governments or
partly by the central government and partly by one or more state governments.
Investment Company means a company whose principal business is the acquisition of
shares, stock, debentures or other securities.
Memorandum of Association is an important document of a company that is essential for
the incorporation. It contains companys name registered office, objectives etc.
31
Official Liquidator is an officer appointed by the court/central government under Section

448 of the Companies Act, 1956, to take control of the company that has been ordered to be
wound up by the court.
Perpetual Succession the continuation of a corporations existence despite the death of any
owner (shareholder) or any transfer of stock.
Preference Shares are those shares in a company which give their holders an entitlement
to a fixed dividend, but the holders do not usually carry voting rights.
Premium is the difference between the face value or par value of a security and its market
price when the latter is greater.
Promoter is one who alone or in the company of others actively participates in the
formation of a business or venture.
Red herring Prospectus means a prospectus that does not contain/limited complete
particulars about the price of the securities offered and the quantum of securities offered.
Share Certificate is a printed certificate issued by a company when a person is entered into
the register of members as the holder of shares in the company and is the prima facie
evidence of the registered persons title to the shares.
Share Warrants are securities which are issued by a company. These securities give their
owners the right to purchase shares in the company at a specific price at a future date.
Surrender means to relinquish possession or control to another voluntarily; In other words,
to give up completely or agree to forgo.
Transmission of Shares is called so when the right to any shares has passed to a person by
operation of law, such as the death, insolvency, lunacy of the shareholder or by acquiring
shares by purchase in a court sale.
Transposition of Shares is called so where the order of the joint holders is changed.
A simple application duly signed by all the shareholders along with the share certificate is
to be delivered to the company for transposition.
Majumdar, A K and Kapoor, Dr. G K Taxmanns Company Law and Practice.

10th Edition (2004).
Suryanarayanan, R Company Law Ready Reckoner. 6th Edition, 2003, Commercial

Law Publishers (India) Pvt. Ltd.
Kapoor, N D Elements of Mercantile Law. 2004, Sultan Chand & Sons.
Avtar Singh. Company Law. 14th Edition, 2005, Eastern Book Company.

a.
32
The Companies Act, 1956 expressly provides for the following provisions pertaining
to the lifting of the corporate veil.
i.
In case of reduction of membership.
ii.
Failure to Refund Application Money.
iii.
Mis-description of Company Name.
iv.
Misrepresentation in the Prospectus.
v.
Fraudulent Conduct.
vi.
Holding and Subsidiary Companies.

of Company
b.
Protection of Revenue can be ground on which courts have pierced the veil of
corporate entity. A noteworthy case in this point is that of Dinshaw Maneckjee Petit,
Re (1927). Here the assessee who was receiving huge dividend and interest income,
diverted his investments to four private companies formed for the purpose of reducing
the tax liability. The companies did not do any business but were created as legal
entities to ostensibly receive the dividends and interest and to hand them over to the
assessee as pretended loans. It was held that as the company was formed by the
assessee purely and simply as a means of avoiding super-tax, the company was
nothing more than the assesee himself.
c.
Section 617 defines a government company as any company which has at least 51% of
the paid up share capital held either by the Central Government, or by any State
Government or partly by both. In the given case too since 25% was held by State
Government and 30% by Central Government, the company is a Government
Company. Since the concept of Government Company has been introduced into the
Companies Act, 1956, it would mean a Government Company will mean a company
registered and incorporated under the Companies Act, 1956.
a.
If a company proposes to shift the registered office from one city to another within the
same state, a special resolution to that effect has to be passed and the Registrar
informed about the change within 30 days of passing the special resolution. A copy of
the resolution along with Form 23 and Form 18 should be filed with the registrar
within 30 days of the change. In the above case ABC Ltd., did not pass special
resolution and hence did not fulfill the precondition. Hence, the change in registered
office of the company cannot be accepted by the Registrar.
b.
The AlfaTech Ltd., can recover the damages from BetaTech Ltd., as the Doctrine of
Ultravires cannot prevent the company from protecting its property. More specifically,
the rule of ultra Virus was devised for the protection of the companys interest and it
is not capable of being used against the company s interest or to cause loss to
companys property.
c.
According to the Doctrine of indoor management, the persons dealing with the
company having satisfied themselves that the proposed transaction is not in its nature
inconsistant with the Memorandum and Articles of the company, are not bound to
enquire into the regularity of the internal proceeding. An outsider is not bound to see
that the company carries out its own internal regulations.
But there are certain exceptions to the Doctrine of indoor management.
i.
If the outsider had the knowledge of irregularity of the transactions.
ii.
If the outsider had no knowledge of articles.
iii.
If an outsider enters the contract negligently.
iv.
If an outsider entered the contract with a person having no authority.
v.
Incase of forgery: The Director of a company cannot be held responsible for the
signatures they never made nor the company can do any thing about it.
In the given case also the company is not liable to either Sanjay or Rajiv as the
signatures of the directory were forged by the secretary of the company.
33
a.
Issue of shares at a discount is governed by the provisions laid down by Section 79.
Issue of shares at a discount can be made only after one year from the date on which
the company is entitled to commence business. A company can issue shares at a
discount only if the issue is authorized by a resolution passed by the Company in a
general meeting and the approval of the NCLT is obtained. The maximum rate of
discount as specified in the resolution cannot exceed 10%. Where the company
proposes to issue shares at a discount exceeding 10%, the NCLT may, on an
application made by the company grant approval, if it is of the opinion that
circumstances warrant a higher percentage of discount.
b.
A prospectus is an invitation issued to the public to purchase/subscribe shares or

debentures of the company. The provisions of the Act relating to prospectus apply
only if it is issued to the general public. In Pramatha Nath Sanyal vs. Kali Kumar
Dutt, a newspaper advertisement stating that some shares were still available for sale
according to the terms of the prospectus of the company which could be obtained on
application was held to be a prospectus.
c.
The transfer of shares to deceased Zaheerudinss son is known as Transmission of

shares by operation of law.
Where the right to any shares has passed to a person by operation of law such as the
death, insolvency, lunacy of the shareholder or by acquiring shares by purchase in a
court sale, a transmission of shares takes place. The process of transmission is not the
same as a transfer, and does not require any instrument of transfer to be lodged with
the company. Similarly, there is no payment of stamp duty in case of transmission of
shares. However, the company may insist upon evidence such as a succession
certificate, production of probate or letter of administration.
Where the persons acquire interest in shares by virtue of transmission, they will not be
eligible to exercise voting rights or receive dividends in case they do not get the shares
registered in their names. However, any calls due on such shares will be enforced
against them in their capacity as legal representatives of the deceased shareholder.

A. Multiple Choice
1.
2.
34
A company is regarded as an entity separate from its members, hence:

a.
The shareholders have insurable interest in the property of the company
b.
The assets and liabilities of the company are also the assets and liabilities of its
members
c.
The shareholders can enter into contracts with the company
d.
The shareholders are the agents and trustees of the company
e.
The members of the company can be sued for the debts of the company.
A public company can commence business if:

a.
It has more than 100 members
b.
Obtains certificate of commencement of business
c.
Need not hold the statutory meeting
d.
Can allot shares before the minimum subscription is subscribed
e.
Must have at least three directors.

of Company
3.
4.
5.
An act is said to be Ultra Vires

a.
When the transaction is effected beyond the powers conferred by the articles
b.
On winding up
c.
On merger
d.
On acquisition
e.
On change of managing director.
A certified copy of the order of the Central Government confirming the alteration of
Memorandum of Association is to be registered with the Registrar of Companies
within _______ of its alteration:
a.
One month
b.
Two months
c.
Three months
d.
Six months
e.
Twelve months.
A person dealing with a company having satisfied himself that the proposed
transaction is not in its nature inconsistent with the memorandum and articles, is not
bound to enquire into the regularity of the internal proceedings. This is known as:
a.
Doctrine of Ultra Vires
b.
Doctrine of Constructive Notice
c.
Doctrine of Indoor Management
d.
Doctrine of Fraudulent Transfer
e.
Doctrine of Lispendens.
B. Descriptive
1.
What do you mean by Lifting the Corporate Veil? Explain the statutory provisions
pertaining to the lifting of the corporate veil.
2.
How can a Private Company be formed? Discuss the features of a Private Company.
3.
Prospectus is a tool for raising the capital from the Public. Discuss.
only.
35
UNIT 15 COMPANY MANAGEMENT AND

WINDING UP
Structure
15.1
Introduction
15.2
Objectives
15.3
Company Management
15.3.1 Legal Status of a Director
15.3.2 Disqualifications for Appointment as Director
15.3.3 Appointment of Director
15.3.4 Duties and Liabilities of Director
15.4
Company Meetings
15.4.1 Kinds of Meetings
15.4.2 Conducting Meetings
15.5
Reconstruction and Amalgamation

15.5.1 Provisions Concerning Reconstructs and Amalgamation
15.6
Changing Legal Entity on Mergers and Acquisitions

15.6.1 Types of Mergers
15.6.2 Amalgamation and Reconstruction of Non-Banking Companies
15.6.3 Amalgamation and Reconstruction of Banking Companies
15.7
Winding Up
15.7.1 Winding up by Courts
15.7.2 Voluntary Winding Up
15.7.3 Winding up Subject to the Supervision of the Court
15.8
Dissolution of a Company
15.9
Summary
15.10 Glossary
15.1 INTRODUCTION
In our earlier unit we have studied the features of a company, types of companies, different
kinds of shares and doctrines of ultra vires and indoor management. On incorporation,
a company becomes a legal entity an artificial person. Being a legal entity, it conducts its
business with the help of representatives chosen by the shareholders. These representatives
are termed as Directors.
In this unit we shall discuss the rights, duties and liabilities of directors. In addition, we
shall also discuss the different types of meetings, provisions governing the change in form
as a result of amalgamations and reconstruction and other aspects as winding up, and
dissolution of a corporate entity.
Company Management and

Winding Up
15.2 OBJECTIVES
Summarize the qualifications, disqualifications, rights and duties of directors;
State the different kinds of company meetings;
Discuss the procedures to be followed in conducting meetings;
State the provisions concerning Amalgamation and Reconstruction;
Identify the different types of mergers; and
Summarize the provisions pertaining to different types of winding up.
15.3 COMPANY MANAGEMENT

On incorporation, a company becomes a legal entity. Being a legal entity, it conducts its
business with the help of representatives chosen by the shareholders. These representatives
are termed as directors. Section 2(13) defines a director as including any person occupying
the position of a director by whatever name called.
In order to determine whether a person is the director, it is important to see if that person is
appointed and authorized by the articles to act on behalf of the company or not. It should be
noted that a person who performs all the functions of a director, but who is not duly
appointed as one cannot be considered as a director. Only an individual should be the
director of a company.
15.3.1 Legal Status of a Director

AS A TRUSTEE
A director of the company occupies a position of a trustee in relation to the company. As a
trustee, he should exercise his powers for the benefit of the company and its shareholders.
AS AN AGENT
The relationship between the company and its directors can also be construed as one of
principal and agent. When the directors act on behalf of the company, the company is liable
for all the acts performed within the authority of the directors.
They will also be held personally liable when they
a.
Enter into contracts in their own names.
b.
When they use the name of the company incorrectly.
c.
When it is not clear as to who is signing the contract (that is, whether the principal or
the agent).
AS A MANAGING PARTNER
As they are entrusted with the responsibility of managing the affairs of the company, their
position can be likened to that of managing partners.
HOLDER OF QUALIFICATION SHARES
A director will have to take up qualification shares only if required by the articles of
association. According to Section 270, if the articles require a director to take up
qualification shares, then such a person to be eligible to act as a director must acquire such
qualification shares within two months of his appointment as director. On the expiry of two
months, he automatically vacates his office if he has failed to acquire these shares.
37
The qualification shares to be taken up by the directors can be purchased from the open
market or from a friend and not necessarily from the company.
Where the director has made an application to the company for qualification shares, but the
company has neither made allotment nor commenced its business within two months of his
appointment, it was held that he cannot be held liable as a contributory. Re, Youdes
Billposting Limited Claytons case.
If the articles of the company are altered to increase the share qualification, then a director
who has purchased shares as per the old provision will not be liable to vacate his office.
However, existing directors who have not yet taken up qualification shares or directors who
are to be appointed in future will have to abide by the new provision.
15.3.2 Disqualifications for Appointment as Director

Section 274 of the Companies Act, 1956 provides that the following persons shall not be
capable of being appointed as directors of any company:
A person found by a competent court to be of unsound mind and such finding

remaining in force;
An undischarged insolvent;
A person who has been convicted by court of an offense involving moral turpitude and
sentenced in respect thereof to imprisonment for not less than six months, and a period
of five years has not elapsed from the date of the expiry of the sentence;
A person who has applied to be adjudged an insolvent;
A person who has not paid any call in respect of shares of the company held by him,
whether alone or jointly with others and six months have elapsed from the last date
fixed for the payment of the call; and
A person who has been disqualified by a court in pursuance of Section 203, which
empowers the court to restrain fraudulent persons from managing companies, unless
the leave of court has been obtained for his appointment.
Such person is already a director of a public company which,
has not filed the annual accounts and annual returns for any continuous three financial
years commencing on and after the 1st day of April, 1999; or
has failed to repay its deposit or interest thereon on due date or redeem its debentures
on due date or pay dividend and such failure continuous for one year or more.
A private company, which is not a subsidiary of a public company may, by its articles,
provide that a person shall be disqualified for an appointment as a director on any grounds
in addition to those of specified in Subsection(1).
A private company which is not a subsidiary of a public company may add to the above list
of disqualifications.
15.3.3 Appointment of Directors

NUMBER
Section 252 of the Companies Act lays down that a public limited company shall have at
least three directors.
Companies other than a public limited company should have at least two directors.
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Winding Up
For ascertaining the maximum number of directors for the purpose of determining whether
the number has crossed the limit as stated in the Articles or not, the following are not taken
into account:
Directors appointed by the Central Government under Section 408 of the Act or by the
NCLT under Section 397 or 398 of the Act,
Nominee directors appointed by the financial institutions,
Special directors appointed by the Board for Industrial and Financial Reconstruction
under SICA, and
Audit Committee: As per Section 292A, every public company having paid-up
capital of not less than five crore rupees shall constitute a committee of the Board
known as Audit Committee, which shall consist of not less than three directors and
such number of other directors as the Board may determine of which 2/3rds of the
total number of members shall be directors, other than managing or whole time
directors.
The members of the Audit Committee shall elect a chairman from amongst themselves.
Directors may be appointed by,
Subscribing to the memorandum of association; Section 254, Regulation 64 of Table A.
Shareholders in general meeting; Sections 255, 256, 257, 265.
Board of Directors; Sections 260, 262, 313.
Central Government; Sections 408, 409.
Third parties.
CONSENT TO ACT AS DIRECTOR TO BE FILED WITH THE COMPANY AND

THE REGISTRAR
Section 264(1) lays down that a person (other than a director retiring by rotation and a
director appointed under Section 257) proposed as a candidate for the office of a director
shall file with the company, his consent in writing to act as director if appointed.
Section 264(2) requires that a person appointed as a director can act as a director only if he
files his consent in writing with the Registrar of Companies. This consent should be given
within 30 days of his appointment.
APPOINTMENT OF MANAGING DIRECTOR
A Managing Director may be appointed in any of the four ways:
by virtue of an agreement with the company,
by virtue of a resolution passed by the company in general meeting,
by virtue of a resolution passed by the Board of Directors, and
by virtue of the Memorandum/Articles of Association.
It is compulsory for every public company and a private company which is a subsidiary of a
public company, having a paid-up capital of Rs.5 crore or more to appoint a managing
director or a wholetime director or a manager. A wholetime director is one who devotes his
whole time services to the company and in effect he can be construed as a managing
director even though he is not so designated.
The Central Government may suo moto or on information received, is of prima facie
opinion that the appointment is in contravention to the schedule or without approval, it may
refer the matter to the NCLT for its decision.
39
NUMBER OF COMPANIES TO ACT AS A MANAGING DIRECTOR

A person can be appointed as a managing director of any number of private companies not
being subsidiaries of a public company. However, if he is the managing director of a public
company or a private company which is a subsidiary of a public company, then he can be
appointed as a managing director in only one more company whether a public company, or
a private company which is a subsidiary of a public company or a private company.
TENURE OF APPOINTMENT OF A MANAGING DIRECTOR
Section 317 lays down that the managing director of a public company or a private
company which is a subsidiary of a public company can be appointed for a period of not
more than 5 years (Section 317). However, he may be re-appointed or re-employed or his
term of office may be extended but again the period shall not exceed five years on each
occasion. Such re-appointment or extension shall not be sanctioned earlier than two years
from the date on which it is to come into force.
APPOINTMENT OF FIRST DIRECTORS
According to Section 254, subject to the provisions of the Articles, the subscribers to the
Memorandum of Association will be deemed to be the first directors of the company, until
the directors are appointed in accordance with Section 255.
APPOINTMENT OF DIRECTORS BY THE MEMBERS AT THE GENERAL
MEETING
Section 255 provides for appointment and retirement by rotation of the directors of a
company.
This subsection provides that not less than 2/3rds of the total number of Directors shall
Be persons liable to retire by rotation at an annual general meeting of the company; and
Be appointed in a general meeting.
It is to be noted that directors liable to retire by rotation, are to retire at an annual general
meeting, whereas, they can be appointed either at the Annual General Meeting or at an
Extraordinary General Meeting of the company.
The connotation not less than 2/3rds of the total number of Directors means that in case
of a fraction, it should be counted as one. Also the term total number means the total
number of Directors who are for the time being on the Board. It excludes directors
appointed by the Central Government, nominee directors and vacancies if any.
POSITION IN A PRIVATE COMPANY
Subsection 1 of Section 255 is not applicable to a private company, and hence the directors
of a private company need not retire by rotation as laid down by Section 255(1). Their
retirement may be determined by a separate provision in the Articles of the company.
However, Section 255(2) requires that the appointment of directors of a private company
can be made only at a general meeting.
The first directors will hold office till the first annual general meeting [Section 256(1)].
POSITION IN A PUBLIC COMPANY
According to Section 256, 1/3 of the directors of a public company or a private company
which is a subsidiary of a public company who are liable to retire, should do so at the first
annual general meeting which is held after the general meeting at which the directors were
appointed.
40

Winding Up
If the number of directors to retire is not three or a multiple of three then the number
nearest to 1/3 shall retire from office.
Section 256(3) provides that the vacancy created by the retiring director should be filled in
the same annual general meeting by appointing the said director or any other person.
If no appointment is made or if no resolution is passed expressly stating that the vacancy
shall not be filled up, then the retiring director will be deemed to be automatically
reappointed unless:
Where the annual general meeting has not been held in accordance with Section 166(1), the
directors cannot extend their continuance in office by not holding a meeting. In such a case,
they will be deemed to have vacated their office on the last day on which the meeting ought
to have been held.
APPOINTMENT OF PERSONS OTHER THAN A RETIRING DIRECTOR
Even a person other than the retiring director can be appointed to the post of a director.
However, such a person, is required to give a written notice signifying his candidature for
the office of director, to the company at least 14 days before the meeting.
As per Section 264(2), a director shall not act as one unless he has within 30 days of his
appointment, signed and filed with Registrar his consent in writing to act as such director.
Section 264 does not apply to:
a director re-appointed after retirement by rotation or immediately after retirement,
an additional or an alternate director or a person filling a casual vacancy, appointed as

a director or re-appointed as an additional or alternate director immediately on expiry
of his term of office,
a person named as a director of the company under its articles as first registered, and
a director of a private company which is not a subsidiary of a public company.
APPOINTMENT OF DIRECTORS BY THE BOARD

The Board may appoint the following directors in certain exigencies:
Appointment of an Additional Director
The Board may, if authorized by the articles, appoint an additional director who hold office
only up to the date of the next annual general meeting. The appointment of an additional
director may be made either at a meeting of the Board or by passing a resolution by
circulation as provided in Section 289.
The number of directors and additional directors shall however not exceed the maximum
number fixed by the Articles.
Appointment of a Casual Director
According to Section 262, if the office of a director appointed in a general meeting is
vacated before the expiry of his term either by reason of death, resignation, disqualification,
failure of a director to accept the office or for any other reason except that of retirement by
rotation, then subject to the articles, the Board of Directors may fill the vacancy at a
meeting of the Board. This provision is applicable to a public company and a private
company which is a subsidiary of the public company.
Appointment of an Alternate Director
Section 313 lays down that the Board of Directors of a company can appoint an alternate
director in place of the original director during his absence for a period of not less than
three months from the state in which board meetings are held. This power can be exercised,
only if authorized by the articles or by a resolution passed by the company in a general
meeting.
41
The power to appoint the alternate director is not given to the original director but to the
board.
He will have to vacate his office in case the original director returns to the state in which
board meetings are held.
APPOINTMENT OF DIRECTORS BY THE CENTRAL GOVERNMENT
The Central Government has the power under Section 408 to appoint directors for the
purpose of prevention of oppression and mismanagement.
APPOINTMENT OF DIRECTOR(S) BY NCLT
Section 402 empowers the NCLT to appoint persons as Directors of the company to prevent
oppression and mismanagement.
APPOINTMENT OF DIRECTORS BY PROPORTIONAL REPRESENTATION
Section 265 provides an opportunity to the minority shareholders to have their
representative on the board of directors. It states that notwithstanding anything contained
in this Act, the articles of a company may provide for the appointment of not less than twothirds of the total number of the Directors of a public company or of a private company
which is a subsidiary of public company, according to the principle of proportional
representation, whether by single transferable vote or by a system of cumulative voting or
otherwise, the appointment being made once in every three years and interim casual
vacancies being filled in accordance with the provisions, mutatis mutandis, of Section 262.
Under the cumulative voting system, each shareholder has votes equal to the number of
voting shares he owns multiplied by the number of directors to be elected. This system is
helpful in giving representation to the minority groups in a situation where all the directors
are elected at the same time.
APPOINTMENT OF DIRECTORS BY THIRD PARTIES
The Articles may give a right to financial institutions and debentureholders, to nominate
Directors on the Board with a view to ensure that the funds lent by them are used for the
purpose for which they were borrowed. Normally, the nominee-directors are non-retiring.
15.3.4 Duties and Liabilities of a Director

DUTIES
The duties of a director may be classified into four categories, viz., (a) fiduciary duties,
(b) duties of care, (c) statutory duties, and (d) other duties. These duties are in addition to
the specific duties as specified by the Companies Act, 1956.
Fiduciary Duties
The first duty or obligation of directors is not to exceed their authority and powers and to
act with honesty and in good faith. They should not engage in any activity which is ultra
vires the company or illegal.
The obligation of Directors is to act honestly and with utmost good faith.
Directors should not use unpublished and confidential information belonging to the
company for their own purpose. Any knowledge or information that is generated by the
company is its own property and cannot be put to unauthorized use. Any gain by use of
such inside information has to be accounted for to the company.
Duties of Care
A director of a company, like any other agent, is duty bound to exercise reasonable care in
the management of its affairs as is expected from the person occupying such position.
42

Winding Up
Statutory Duties
According to Section 297, a director of a company or his relative, a firm in which the
director or his relative is a partner, or any other partner of a firm in which such director is a
member or director should not enter into contracts with the company for sale, purchase or
supply of any goods, materials or services unless with the consent of the Board of Directors
[(Subsection (1)].
Section 297(1) further provides that in case of a company having a paid-up share capital of
rupees one crore or more, no such contract shall be entered without the prior approval of the
Central Government.
According to Section 299, every director who is interested directly or indirectly in any
contract, whether present or future should reveal his interest at a meeting of the Board of
Directors.
Disclosure of his interest may be made by giving a general notice to the Board which shall
be treated as adequate disclosure of interest in relation to any contract so made.
Duty not to Delegate
Shareholders appoint a director because of their faith in his skill, integrity and competence.
Hence, the same faith cannot be delegated by the director to another person on his own
judgment. Delegation by director is permitted to an extent under section 292 by the
Companies Act.
Duty to Attend Board Meetings
Directors are appointed by the shareholders to manage the company. It is their duty to
attend board meetings and review periodically the progress of the company. Section 283(g)
states that the office of a director will be vacated if the director absents himself from three
consecutive meetings of the board or from all meetings of the board for a period of three
consecutive months whichever is longer, without obtaining the leave or absence of the
board. Though it is not mandatory for a director to attend all board meetings yet it is
expected of the director to attend whenever it is possible. Provisions of Section 283(g)
attempt to negate habitual absence by a director by stipulating stringent action viz., vacation
of office.
Duty to Convene General Meetings
Calling of Annual General Body Meeting (AGM), statutory and extraordinary meeting is
the duty and responsibility of the directors (Sections 165, 166 and 169).
LIABILITIES
The directors who do not act diligently and honestly are subjected to the following
liabilities:
Unlimited Liability (Sections 322 & 323): In a limited company, the liability of all
or any of the directors or managers may be made unlimited if so provided by the
memorandum of association. If the memorandum does not contain such provision, it
may be altered by passing a special resolution.
Liability for Breach of Fiduciary Duty: A director, being in the fiduciary position of
a trustee for the company, may incur liability for breach of his fiduciary duty to the
company.
Directors are personally liable for the following Acts:
For ultra vires acts: The act on part of the directors ultra vires the company may
render the directors liable to indemnify the company in respect of any
consequent loss or damages sustained. If the directors apply the companys
money for purposes which the company cannot sanction, they become personally
liable to replace it, however honestly they may have acted.
43
44
For mala fide acts: If the directors act dishonestly and in breach of trust or
misfeasance in that capacity, the directors would be liable to account for and
surrender profits to their company. Also, they should make good the loss
sustained by the company by reason of the mala fide exercise of any of the
powers vested in them, such as the power to allot shares or accept surrender of
shares, or remit any due by a director to the company.
For negligence: As long as the directors act within their powers with reasonable
skill and care as expected of them as prudent businessmen, they discharge their
duty to the company.
Liability to the third parties: In certain circumstances, directors may incur

personal liability to third parties either under the Act or apart from it. For
example, if a prospectus of the company does not contain all the items that have
to be specified as laid down in the Act or contains material misrepresentations in
it, then the Directors incur a liability to the third parties (investors). They are also
liable to third parties in case of irregular allotment of shares.
Directors are criminally liable in pursuance of the following sections of the

Companies Act, 1956:
Section 44(4) Filing of prospectus containing untrue statements two years

imprisonment and/or fine up to Rs.50,000.
Section 58A(6)(b) Inviting deposits in contravention of the Rules, or manner or

conditions imprisonment for a term which may extend up to five years and fine.
Section 58B Issuing false advertisement inviting deposits imprisonment

which may extend to two years and Rs.50,000 fine.
Section 63 Criminal liability for mis-statement in prospectus imprisonment up

to two years or fine up to Rs.50,000 or both.
Section 68 Fraudulently inducing persons to invest money imprisonment up

to five years, or fine up to Rs.1,00,000 or both.
Section 73 Failure to repay excess application money imprisonment up to

one year and fine up to Rs.50,000.
Section 105 Concealing name of creditor imprisonment up to one year or

fine or both.
Section 202(1) Undischarged insolvent acting as Director imprisonment up

to two years or fine up to Rs.50,000 or both.
Section 207 Default in distributing dividends simple imprisonment which

may extend to 3 years and shall also be liable to pay a fine of 1,000 rupees for
every day during which default continues and fine.
Section 209A Failure to assist the Registrar or any officer so authorized by the
Central Government in inspection of books of account, etc. imprisonment up to
one year and fine not less than Rs.50,000.
Section 210(5) Failure to lay balance sheet, etc., at annual general meeting
imprisonment up to six months or fine up to Rs.10,000 or both.
Section 211(8) Failure to comply with Section 211 regarding form of balance
sheet and matters to be stated imprisonment up to six months or fine up to
Rs.10,000 or both.
Section 217(5) Failure to attach to balance sheet a report of the Board

imprisonment up to six months for each offense or fine up to Rs.20,000 or both.

Winding Up
Section 221(4) Failure to supply information to auditor and the company

imprisonment up to six months, or fine up to Rs.50,000 or both.
Section 250(9) Improper issue of shares imprisonment up to six months or

fine up to Rs.50,000 or both.
Section 293(A) Contribution to political parties in contravention of the said

section three years imprisonment and fine.
Section 295(4) Grant of loan to directors without obtaining the approval of the
Central Government simple imprisonment up to six months or fine up to
Rs.50,000.
Section 308(3) Failure to disclose shareholdings in the company

imprisonment up to two years or fine up to Rs.50,000 or both.
Section 371 Giving loans to other corporate bodies in excess of the limits
prescribed under Section 370 simple imprisonment up to six months or fine up
to Rs.50,000.
Section 407(2) Acting as director after removal by court imprisonment up to

one year, or fine up to Rs.50,000 or both.
Section 488(3) False declaration of companys solvency imprisonment up to

six months or fine up to Rs.50,000 or both.
Sections 538 to 542 and 550 Offenses antecedent to or in course of winding

up imprisonment ranges between two years and five years and fine from
Rs.10,000 to Rs.1,00,000.
a.
The director of Aditya Pvt. Ltd. borrowed money from an outsider exceeding his
authority and misused the money without the knowledge of the other directors and
shareholders. Discuss the liability of the director of Aditya Pvt. Ltd. for having
misused the money.
..
..
..
b.
Sanjay has been appointed the director of ABC Ltd. On the date of appointment he
held no shares in ABC Ltd. Is he required to take up qualification shares to be
eligible to act as director of ABC Ltd?
..
..
..
c.
Mr. Khan has been appointed by the Board of ZlL Ltd. as alternate director in place
of Mr. Praveen for a period of four months. Mr. Khan refuses to vacate the office on
Mr. Praveens return from Europe tour. Does Mr. Khan contention to continue in
office till the next Annual General Meeting hold good?
..
..
..
45
15.4 COMPANY MEETINGS

Every company meeting has to be called by the directors except in the case when the
meeting has, in the event of default by the directors, been called by the requisitionists or by
the NCLT. The directors have to fix the date, time and place of the meeting. Notice of a
meeting given by the Secretary without the sanction of the Board of Directors is invalid, but
such a notice may be ratified by the directors before the meeting.
Shareholders are also empowered under Section 169 to requisition holding an extraordinary
general meeting subject to compliance of the provisions of the said section.
Section 167 empowers the NCLT to call for an annual general meeting in case of
default in holding the meeting in accordance with Section 166.
15.4.1 Kinds of Meetings

Meetings under Companies Act, 1956 may be classified as follows:
Shareholders meetings:
Statutory meeting as per Section 165 of the Act;
Annual General Meeting (AGM) as per Section 166 of the Act;
Extraordinary General Meeting (EGM); and
Class Meetings of Shareholders.
Board Meetings.
Meetings of the Committees of Board.
Meetings with the Debenture-holders.
Meetings of Creditors.
STATUTORY MEETING
Section 165 of the Companies Act, 1956 lays down the following:
Every company limited by shares, and every company limited by guarantee and having a
share capital, shall, within a period of not less than one month nor more than six months
from the date at which the company is entitled to commence business hold a general
meeting of the members of the company, which shall be called statutory meeting. This is
the first meeting of the shareholders of a public company and there would be only one such
meeting in the lifetime of the company.
ANNUAL GENERAL MEETING (AGM)
According to Section 166(2)(a), a public or a private company which is a subsidiary of a
public company may fix the time for its annual general meeting either through its articles,
or it may also by passing a resolution in one annual general meeting fix the time for the
subsequent annual general meeting.
A private company which is not a subsidiary of a public company, may in like manner and
also by a resolution agreed to by all the members thereof, fix the time as well as the place
for its annual general meeting.
Where an annual general meeting is adjourned, the board has the power to hold the
adjourned meeting at any place other than the place where the annual general meeting was
held. However, so far as possible, it should be ensured that the meeting is held at the same
place as the original meeting and if that is not possible, the meeting should be held either at
the registered office of the company or at a place within the city in which the registered
office is located.
46

Winding Up
A public company or a private company may fix the time for holding its AGMs. The
private company can also with the consent of all its members thereof fix the place of its
annual general meetings.
EXTRAORDINARY GENERAL MEETINGS (EGM)
All the general meetings of the company with the exception of the Statutory Meeting and
Annual General Meeting are Extraordinary General Meetings (EGM).
Object: The purpose of EGM is to transact special business defined in the previous
meeting which arises in between two annual general meetings. The special business
transacted at the EGM has to be urgent, which cannot be deferred to the next annual general
meeting. For instance, a change in the objects or shift of registered office or alteration of
capital or removal of a director/auditors require immediate attention which cannot be
deferred till the next annual general meeting.
An extraordinary general meeting may be called by,
The board of directors on its own or on the requisition of a specified number of

members entitled to vote.
By the requisitionists themselves in case of failure by the board to call for a meeting.
By the NCLT.
CLASS MEETINGS OF SHAREHOLDERS

Class meetings are those meetings which are held by holders of a particular class of shares,
for example, preference shares. Need for such meetings arises when it is proposed to vary
the rights of a particular class of shares. Thus, for effecting such changes, it is necessary
that a separate meeting of the holders of that particular class is held. The meeting is
necessary only if the variation involves the curtailments of the rights of any classes of
shareholders.
It was held in House of Fraser vs. ACGEE Investments Ltd.(1987) that a cancellation of
preference shares by repayment of the capital paid upon those shares and in accordance
with rights attached to those shares does not involve any modification or variation of class
rights so as to require a meeting of the preference shareholders.
Section 107 gives a right to a minority group of shareholders belonging to a class, not
being holders of less than ten percent of the issued shares of that class, to challenge the
variation of the rights attached to the shares of that class. That is, a class meeting should
be called if variation of the class of shares in question would unfairly prejudice the
shareholders of that class.
BOARD MEETINGS
The meetings of the Board of the Directors for the purpose of collectively taking decisions
for smooth functioning of the company are referred as Board Meetings.
Object: To formulate management policies, take decisions of importance pertaining to
running of the company, review of progress made by the company among other matters
related to the company.
The power delegated to the Board of Directors will have to be exercised at the properly
convened board meeting unless the articles provide otherwise.
Powers: Section 292 lays down that the following decisions have to be taken only at the
meeting of the board of directors:
make calls on shareholders in respect of unpaid money on their shares;
to issue debentures;
47
to borrow moneys otherwise than on debentures;
to invest the funds of the company; and
to make loans.
It has to be noted that the meeting does not require any agenda for the meeting of the
directors. Any business whatsoever, thus can be transacted at a board meeting.
MEETINGS OF COMMITTEE OF DIRECTORS
Any meeting by the committee consisting of individuals who have been delegated the
powers as permitted by Section 292 is referred to as Meeting of Committee of Directors.
Section 292 allows the power to borrow money otherwise than on securities, power to
invest funds of the company and power to make loans to be delegated subject to the limits
and terms and conditions as resolved by the Board of Directors. The committee so formed
cannot delegate its powers further.
The provisions relating to the meetings of a committee of directors and provisions relating
to directors meetings are by and large same as those of board meetings.
The minutes of the proceedings of a committee of directors is not open for inspection to
general public.
MEETING OF DEBENTURE HOLDERS
As in the case of Class Meetings, if any variation is proposed to be made in terms of
security or to alter the rights of debentureholders in certain circumstances, then a Meeting
of Debenture holders is called. All the matters connected with the holding, conduct and
proceedings of the meetings of the debenture holders are given in the Debenture Trust
Deed. The decisions arrived at such meetings with the requisite majority, are valid and
binding upon the minority.
MEETING OF CREDITORS
Meeting of creditors for certain arrangements with the company either in case of a running
concern or in the event of winding-up is referred to as Meeting of Creditors. These kind of
meetings are not company meetings in the real sense.
Section 391 to Section 393 authorize the company to enter into arrangements with the
creditors with the sanction of the NCLT. The NCLT, on application, may order the holding
of a creditors meeting. If the scheme of arrangement is agreeable to, by majority of
creditors in number holding debts to the value of three-fourths majority, the NCLT may
sanction the scheme.
When a company goes into liquidation, a meeting of creditors and of contributors is held to
ascertain the total amount due by the company to its creditors and also to appoint a
liquidator to wind-up the affairs of the company.
15.4.2 Conducting Meetings

NOTICE OF MEETING
A written notice of the board meeting should be sent to every director for the time being in
India and to his usual address in case of every other director. The notice should be issued
under the authority of the company.
An officer who fails to give such a notice will be punishable with fine which may extend to
rupees one thousand.
Any such failure to give notice will render the proceedings of the meeting invalid.
48

Winding Up
RESOLUTION
A motion when passed is called resolution. Motions may relate to closure of discussion or
postponement of the discussion.
With respect to general body meetings, there are two kinds of resolutions ordinary
resolutions and special resolutions. As per Section 189(1), a motion passed by a simple
majority of the members voting at a general meeting is said to have been passed by an
ordinary resolution. An ordinary resolution is a simple majority resolution which requires
that votes cast in favor of the resolution should be more than votes cast against the
resolution. In respect of special resolutions, the notice as per the provisions of the
Companies Act must have been duly given specifying the intention to propose the
resolution as a special resolution.
According to Section 189(2), a resolution is a special resolution when
The intention to propose the resolution as a special resolution has been duly specified
in the notice calling the general meeting or other intimation given to the members;
The notice required under the Act has been duly given of the general meeting; and
The votes cast in favor of the resolution by members present (in person or in proxy
either by poll or by show of hand, as applicable) are not less than three times the
number of votes, if any, cast against the resolution. Abstentions, if any, are not to be
taken into account.
QUORUM
Quorum is the minimum number of members who must be present at a meeting required
by law/rules. The idea is to avoid situations where decisions taken by a minority of people
are imposed on the vast majority of members. A minimum of five members should be
personally present at the meeting of a public company and a minimum of two members in
case of a private company. The members present as quorum should be the members who
are eligible to vote in respect of business on the agenda of the meeting. If the quorum is not
present within half an hour from the appointed time, (i) the meeting if called upon the
requisition of members shall stand dissolved; (ii) in any other case, the meeting shall be
adjourned to the same day in the next week at the same time and place or to such other day,
time and place as the board of directors may determine.
PROXY (SECTION 176)
A member who is entitled to attend and vote at a meeting can appoint another person
(whether a member or not) to vote on his/her behalf. A person so appointed is a proxy. A
proxy has no right to participate in the discussions in the meeting. However, he may
demand or join in a demand for a poll.
15.5 RECONSTRUCTION AND AMALGAMATION

Reconstruction includes reorganization, arrangement and amalgamation. The terms
reorganization and arrangement are used when only one company is involved whereas
the term amalgamation is used when more than one company is involved (i.e., when two
or more companies are amalgamated or where one company is merged with another or
where one company is taken over by another).
Any amalgamation or reconstruction may take the form of takeover or a merger. Takeover
is the passing over of the direct or indirect control of the assets of the target company to the
acquiring company. In a merger, the shareholding in the combined enterprise will be spread
between the shareholders of the two companies.
Reconstruction can be effected by a scheme of compromise or arrangement under Section 391.
49
Where a compromise or an arrangement is proposed:
between the company and the creditors or any class of them; or
between the company and the members or any class of them.
An application can be made to the court under Section 391(1), by a creditor or a

member or in the case of winding up of the company by a liquidator. Where the company is
being wound up, even a member or a creditor is entitled to make an application to the court
under Section 391(1), and their right is not taken away merely by the fact that the company
is being wound up.
Where the scheme of compromise or arrangement is likely to operate differently on
different classes of creditors, the calling of a separate meeting for each class becomes
necessary.
At the meeting, the scheme should be approved by a majority in number representing three
fourths in value of the creditors, or class of creditors, or members, or class of members as
the case may be, present and voting either in person or, where proxies are allowed
under the rules made under Section 643, by proxies. [Section 391(2)]
A scheme may be rejected if it is not approved by the requisite majority as specified by this
Section.
The three fourths majority construed under Section 391(2) means three fourths majority of
those present at the meeting and voting. Any member who attends the meeting but abstains
from voting will not be reckoned in order to determine the required majority.
Where the scheme is approved by the requisite majority, the court may in its discretion
sanction the scheme. Before sanctioning the scheme, the court should be satisfied that each
class is fairly represented at the meetings. It is the responsibility of the court to properly
classify creditors or members and to see that their interests are taken care of, before
sanctioning a scheme.
The court is not empowered to sanction a scheme which has not been approved by the
creditors, even though they have withheld their consent arbitrarily or even when the court is
of the opinion that scheme is beneficial and in the interest of the company.
15.5.1 Provisions Concerning Reconstruction and Amalgamation

As described above any reconstruction and/or amalgamation should follow the rules
prescribed in Section 392 if it involves reaching of compromises and/or arrangements. The
legal provisions vary according to the forms adopted for reconstruction and amalgamation.
Reconstruction or amalgamation may be done in the following ways:
RECONSTRUCTION/AMALGAMATION BY SALE OF UNDERTAKING
If a petition is made to the court under the scheme that the whole or any part of the
undertaking, property or liabilities of any company is to be transferred to another company,
the court may make the following provisions for all or any of the following matters as per
Section 394:
50
the transfer to the transferee company of the whole or any part of the undertaking,
property or liabilities of any transferor company;
the allotment or appropriation by the transferee company of any shares, debentures,

policies, or other like interests in that company which, under the compromise or
arrangement, are to be allotted or appropriated by that company;
the continuation by or against the transferee company of any legal proceedings

pending by or against the transferor company;

Winding Up
the dissolution, without winding up, of any transferor company;
the provision to be made for any persons who, within such time and in such manner as
the court directs, dissents from the compromise or arrangement; and
such incidental, consequential and supplemental matters as are necessary to secure

that the reconstruction or amalgamation shall be fully and effectively carried out.
A copy of the order made under Section 394 is required to be filed with the Registrar for
registration within thirty days of the making of the order.
RECONSTRUCTION/AMALGAMATION BY SALE OF SHARES (SECTION 395)
This is the most often heard amalgamation or takeover. Shares are sold and registered in the
name of the purchasing company or on its behalf. The shareholders who are selling shares
receive compensation in the form of cash or shares in the acquiring company.
Section 395 contains provisions for the compulsory acquisition by the transferee company
of shares of the dissenting minority. It lays down that:
Where the transferee company has offered to acquire the shares or any class of shares
of the transferor company, the scheme or contract embodying such offer has to be
approved by the shareholders concerned within four months. The approval must be
given by the holders of not less than 9/10ths in value of the shares whose transfer is
involved. In computing 9/10th value of shares, the shares already held by the
transferee company or its nominee or subsidiary are excluded.
If the offer is approved, the transferee company may, at any time within two months
of the expiry of the said four months, give a notice to the dissenting shareholders that
it desires to acquire their shares.
If the transferee company already holds in the transferor company, shares of the class
whose transfer is involved, to a value more than 1/10th of the total value of all shares
of that class in that company, then the above provisions will not apply and the
transferee company need not acquire the shares of the dissenting members.
The transferee company will be entitled and bound to acquire such shares on the same
terms as that of the approving shareholders or on such other terms as may be agreed or
as ordered by the court, on the application of the transferee company or the shareholder.
Where notice has been given by the transferee company to the dissenting shareholders
expressing its desire to acquire their shares and the court has not made an order on the
application of the dissenting shareholders modifying the scheme of transfer, then the
transferee company must send a copy of the notice to the transferor company on the
expiry of one month from the date of notice, together with an instrument of transfer
executed by the transferee company either by itself or through any of its persons. This
time period of one month shall also run in a case where a court reference was made by
the dissenting shareholder and the court disposed off the petition only after the notice
was given, then from the date the petition was disposed off. The transferee company
must also pay or transfer to the transferor company the amount or consideration
representing the price of the shares which it is entitled to acquire under the section.
Thereupon, the transferor company shall register the transferee company as the holder
to those shares and inform the dissenting shareholder of the fact within one month of
registration. The transferor company will also deposit the amount so received in a
separate bank account to be held in trust for the holders of shares in respect of which
such amount has been received.
AMALGAMATION OF COMPANIES IN PUBLIC INTEREST

Section 396(1) lays down that where the Central Government is satisfied that it is
essential in public interest to amalgamate two or more companies, then notwithstanding
anything contained in Sections 394 and 395, but subject to the provisions of Section 396
51
it may by an order be notified in the Official Gazette, provide for the amalgamation of
those companies into a single company with such constitution, property, powers, rights,
interests, authorities and privileges, and with such liabilities, duties and obligations as
may be specified in the order.
The compensation so assessed shall be paid to the members or creditor concerned by the
company resulting from the amalgamation.
a.
A meeting was called on the requisition of members on a specified date. On the day
of the meeting quorum was not present within half an hour of the appointed time.
Can the meeting be adjourned the same day in the next week?
..
..
..
b.
Mr. Prabhu a shareholder appoints Mr. Syam to attend the AGM meeting as Proxy.
Mr. Syam wants to participate in the discussion that has come up at the meeting. Can
he take part in such discussion?
..
..
..
c.
An arrangement has been proposed for the purpose of reconstruction of a company.

How many shareholders are required to approve the scheme?
..
..
..
15.6 CHANGING LEGAL ENTITY ON MERGERS AND

ACQUISITIONS
In the globalization era it has become imperative for the policy makers to retain
competitiveness within the sphere so as to ensure the acceleration of market driven
economy. Financial liberalization as an essential part of reforms has encouraged setting up
of privately owned companies on the platform of advanced technology and best practices of
prudential norms for governance. Regulating authoritys role has been limited to the macro
level supervision of ensuring the smooth flow of the system and manages the risks against
potential blocks.
Though the words merger and amalgamation are used as one for the other, many
analysts feel that in the game of merger one loses corporate existence and the survivor
acquires the assets as well as liabilities of the merged company.
Acquisition in legal sense amounts to acquiring the ownership in the property. It is the
purchase of a controlling interest in the share capital of another existing company. In
business terms, it is an act of acquiring assets and/or management of the other corporate.
Takeover is also considered as acquisition and both the terms are used interchangeably.
The process of takeover is unilateral and the offeror company decides the maximum price.
52

Winding Up
The words merger, amalgamation, acquisition and takeover are not bound by strict legal
definitions and are interpreted contextually by referring to the ownership of the changed
legal entities.1
15.6.1 Types of Mergers

The different kinds of mergers in practice are the following:
HORIZONTAL MERGERS
Horizontal merger is a merger of two or more companies that are competing each other in
producing the similar line of products and/or services. For example, a pharmaceutical
company of one place acquiring another pharmaceutical company at another place.
VERTICAL MERGERS
A merger can be called as vertical merger, when a company acquires or merges with
another company that supplies raw material or provides services. For example, a heavy
engineering company if acquires a supplier company that provides tools, it is ensured that
tools will be supplied economically and timely.
CONGLOMERATE MERGERS
It is a merger of two or more companies that are dealing in different products or areas. The
main aim behind this kind of merger is to diversify the products marketed. For example, a
software development company merging a company that doing well in hospitality line. It
can be called a pure conglomerate merger, as there are no common features exist in both the
companies for merger.
AMALGAMATION/MERGER OF COMPANIES
Any study on merger of companies would be incomplete without considering the special
provisions relating to scheme of compromise or arrangement, amalgamation and/or
reconstruction of companies. The merger/amalgamation of companies can be classified into
the following two categories:
15.6.2 Amalgamation and Reconstruction of Non-Banking

Companies
A company, which is not a banking company, that merges or amalgamates would follow
the procedures mentioned under Sections 391 to 396A of the Companies Act.
Amalgamation of companies is done through a scheme of an arrangement approved by
the shareholders and/or creditors of the companies concerned. The following is the
procedure in brief:
A company needs to approach the Court with a scheme of arrangement and a petition
for the fulfillment of the desired merger/amalgamation.
The company is to file an affidavit giving all material facts like the latest financial
position of the company, the latest auditors report on the accounts of the company, at
the time of filing petition. The directors too need to submit a disclosure regarding their
interest on the scheme if they deviate from others concerned.
The Court will hold a general meeting of the company by giving ex-parte orders,
gives directions on particulars like how and where to conduct the meeting and the
quorum of the meeting, by appointing a Chairman for the meeting. After the meeting,
the Chairman submits the minutes of the meeting and if number representing 3/4ths in
value of the creditors or class of creditors as the case may be. The Court will pass its
orders and confirms the arrangement as approved on the basis of voting of the
members and/or creditors as the case may be.
Gopala Krishna, V. Radhe Syam, Ch. Mergers and Acquisitions in Banking Sector Legal and
Regulatory Perspectives. ICFAI Books, Hyderabad, 2006.
53
The Companies Act permits companies to amalgamate irrespective of whether there is

a specific authorizing power in memorandum of association or not. It was held that
that the power to amalgamate is a statutory power given to a company expressly under
the provisions of the Companies Act.2
15.6.3 Amalgamation and Reconstruction of Banking Companies

Reserve Bank of India (RBI), the super coordinator and regulator of the banking system, is
authorized by the Banking Regulation Act, 1949 to manage the risk level of banking system
that is necessary to avoid the financial stress and strain on the economy. RBI normally steps
after the expiry of gestation period made available to an ailing bank to establish itself
amidst the turbulent market competition. The scenario is quite challenging to both the
policymaker and the regulator in arriving at a decision either to wind up the sick bank or
merge with another healthy bank. RBI is left with no option but to cancel the licenses of
many small cooperative banks not withstanding the distress caused to the small depositors
and investors. The move to cancel licenses for bigger banks can have negative
consequences on the other tiers of the system owing to linkages and adverse impact on the
credibility of the system.
Banking Regulation Act, 1949 (X of 1949) has provided procedures and schemes for
amalgamation and reconstruction of banking companies.
The provisions of the Banking Regulation Act will also cover a foreign registered company
carrying on in India a banking business. Since the organization which is operating banking
business and wants to amalgamate is generally incorporated as a company under the
Companies Act, the provisions of both the Companies Act as well as the Banking
Regulation Act would apply.
According to Section 5 of Banking Regulation Act, 1949, explains the nature of banking as
follows:
Banking Company is separate from a normal manufacturing or trading company.
Banking company means a company that carries banking business in India.
Banking business means accepting deposits, for the purpose of lending or investment,
from the public which is repayable on demand or otherwise.
Banking regulation act overrides memorandum and articles of a company:

It is provided that the provisions of the BR Act overrides provisions contained in the
memorandum and articles of a company.
A resolution, passed by the banking company in general meeting or by its Board of
Directors or executed any agreement, is not valid if it is inconsistent with the provisions of
the Banking Regulation Act.
SCHEME OF COMPROMISE/ARRANGEMENT BY A BANKING COMPANY
The banking company which compromises or amalgamates would require to follow the
procedures mentioned under Sections 391 to 393 of the Companies Act. To protect the
interests of the members or creditors and public, the Court, before sanctioning such a
scheme to the Banking company, should obtain the requisite certificate referred to in the
said section.
Section 44(B) of Banking Regulation Act empowers the High Courts to sanction any
compromise or arrangement under Section 391 of the Companies Act, if it is certified by
the Reserve Bank, in writing, that such scheme does not harm the interests of the depositors
of such banking company.
2
54
Sampath, K.R. Mergers Amalgamations, Takeovers & Corporate Restructure. Snow White
Publications, 2005.

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If a compromise or arrangement sanctioned by a court in respect of the banking company

not satisfactorily worked out with or without modifications, in the opinion of the Reserve
Bank, under Section 38(3)(b)(i) of the Banking Regulation Act, the Reserve Bank can
propose the winding up of a banking company.
Section 543 of the Companies Act empowers the Court to examine and take action, if it is in
past or present, the conduct of the person, director, manager, liquidator or officer who has
taken part in the promotion or formation of the company and who has misapplied or guilty of
any misfeasance or breach of trust in relation to the company. In such conditions, the High
Court may direct the Reserve Bank to enquire the conduct of its directors and affairs of the
banking company if the banking company applied for compromise or arrangement and the
Court can direct the Reserve Bank to make enquiries even in case of a compromise or
arrangement not involving amalgamation.
PROCEDURE FOR AMALGAMATION OF BANKING COMPANIES
The Banking Regulation Act provided provisions relating to the scheme of compromise or
arrangement that relates to amalgamation of two banking companies.
COMPROMISE
For compromise or arrangement of banking companies, the High Court along with the
Reserve Bank has powers to finalize a scheme. But in the case of amalgamation of
banking companies only the Reserve Bank has the powers.
The amalgamation shall be according to the Banking Regulation Act provisions, if

both the parties involved in are banking companies. If both the parties are not banking
companies then the provisions of Companies Act alone will apply but not the Banking
Regulation Act. In such a case, the jurisdiction will be of the Court but not the
Reserve Bank.
If the parties to the amalgamation i.e., both the transferee and transferor are banking
companies, then the amalgamation shall be according to the Banking Regulation Act
provisions, wherein the jurisdiction will be under the Reserve Bank. Otherwise, i.e.,
both the transferee and transferor are not banking companies, it will be under the
purview of the Companies Act or the Tribunal.
In Bank of Madura Shareholders Welfare Association vs. The Governor, Reserve

Bank of India, the Chennai High Court observed that:
The scheme of amalgamation of two banking companies should contain in it the

complete details regarding the proposed merger of the two companies. The High
Court is not given the power to grant its approval to the scheme of merger of
banking companies and the Reserve Bank of India is given such a power. The
Reserve Bank of India is also empowered to determine the market value of
shares of the shareholder who has voted against the scheme of amalgamation or
who has given such notice against the amalgamation in writing prior to the
meeting of the company to the Presiding Officer concerned.
Section 44-A of the Banking Regulation Act says that no banking company shall
be amalgamated with another banking company unless a draft, regarding the
terms of the scheme of amalgamation, is placed before shareholders of each of
the banking companies separately.
55
The full details of the meeting called for this purpose shall be intimated to each
of the shareholder of both the banking companies, and shall also be published at
lease once a week for three consecutive weeks in not less than two newspapers where
circulated in the areas of registered offices of that Banking companies are situated.
A resolution shall be passed by a two-thirds majority value of the shareholders of

each of the banking company.
After the scheme of amalgamation is approved by requisite majority of shareholders,

it should be submitted to the Reserve Bank for sanction.
RECONSTRUCTION OR AMALGAMATION OF A SICK BANKING COMPANY

Under Section 45 of the Banking Regulation Act, the Reserve Bank, may approach the
Central Government for issue of an order for moratorium in respect of a banking company.
The Central Government may put moratorium on all the activities of a banking company on
the basis of the Reserve Banks application for a fixed period of time or may extend from
time to time. However, the total period of moratorium shall not exceed six months. During
the period of moratorium, keeping in view of the interests of the depositors, shareholders or
public or to put a proper new management the banking company or in the interest of the
banking system of the country, the Reserve Bank may prepare a scheme for the
reconstruction of the banking company or to amalgamate the banking company with any
other banking institution with in the definition of the SBI or a subsidiary or corresponding
new bank.3
EMERGING DEVELOPMENTS
The latest amendments pertaining to Mergers and Acquisitions are mentioned in The
Companies (Amendment) Bill, 2003. In 2005, the Central Government has appointed an
expert committee under the Chairmanship of Mr. J.J. Irani, to study and submit a report on
Company Law.
Accounting aspects are considered as one of the important issues in the case of
merger/amalgamations. There shall be a clear approach towards the amalgamations.
Accounting Standard 14 (AS-14) (Accounting for Amalgamation) is designed to serve this
purpose by the Institute of Chartered Accountants of India.
This Accounting Standard deals with accounting for amalgamations and the treatment of
any resultant goodwill or reserves. This Accounting Standard is directed principally to
companies although some of its requirements also apply to financial statements of other
enterprises. This Accounting Standard deals, inter alia, with the types of amalgamations,
methods of accounting for amalgamations, treatment of reserves and goodwill arising on
amalgamation etc.4
15.7 WINDING UP
15.7.1 Winding up by Courts
Section 433 of the Act empowers the court to order winding up of a company under
specified circumstances. These circumstances are the following:
SPECIAL RESOLUTION [SECTION 433 (A)]
The court may order winding up of a company, if the company has, by special
resolution resolved that it be wound up. The court can exercise this power discretionarily
and may not order the companys winding up if in its opinion such winding up is opposed
to the interests of the company or the public.
3
4
56
Ibid.
Ibid.

Winding Up
DEFAULT IN HOLDING STATUTORY MEETING [SECTION 433 (B)]

If a public company defaults in delivering the statutory report to the Registrar or in
holding the statutory meeting, the court may order winding up of the company. The petition
for winding up may be presented either by the Registrar or a contributory.
FAILURE TO COMMENCE BUSINESS [SECTION 433 (C)]
If the company does not commence its business within a year from its incorporation, or
suspends its business for a whole year, the court may order winding up of the company.
Before deciding on the issue of winding up of a company, the court examines the
circumstances due to which the company has been unable to commence business or has
suspended it and the possibilities or intention of starting or continuing the business.
The court may make an order for winding up of companies for the following reasons:
REDUCTION IN MEMBERSHIP [SECTION 433 (D)]
If the number of members is reduced, in case of a public company, below seven, and in
case of a private company, below two, the court may order winding up of the company.
INABILITY TO PAY DEBTS [SECTION 433 (E)]
The court may order winding up of a company if it is unable to pay its debts.
Section 434 lays down the circumstances where a company will be deemed to be
unable to pay its debts.
A company will be construed as being unable to pay its debts, if a creditor of the
company, to whom the company by assignment or otherwise owes a sum exceeding
five hundred rupees has demanded the said amount in writing and the company has for
three weeks thereafter neglected to pay the sum or to secure or compound for it to the
reasonable satisfaction of the creditor. [Section 434(1)(a)]
The presumption of inability to pay debts will be legitimate only where the company
has failed to pay without any reasonable excuse, inspite of the statutory notice being
served on it.
Other grounds for winding up by courts:
Just and equitable grounds
Deadlock
Loss of substratum
Oppression of minority
Incorporation for fraudulent purpose
Extension of a partnership
Public interest.
Who can file a petition for winding up:
Shareholders
Creditors
Contributories
Registrar
Central Government
Official Liquidator.
57
15.7.2 Voluntary Winding Up

Sections 484 to 520 deal with voluntary winding up of a company. A company may be
voluntarily wound up either by passing an ordinary resolution or a special resolution:
A company may pass an ordinary resolution in a general meeting requiring the

company to be wound up voluntarily when the period, if any, fixed for the duration of
the company by its Articles, has expired, or the event if any, has occurred, on the
occurrence of which the articles provide that the company should be dissolved
[Section 484(1)(a)].
Under Section 484(1)(b), the company may also be wound up voluntarily by passing a
special resolution. This is when the members want to wind up the company
voluntarily, inspite of the company being solvent.
It was held in British Water Gas Syndicate vs. Notts Derby Water Gas Co. Limited., that
even an injunction by the court cannot take away this statutory right of the company.
A voluntary winding up does not mean that the existence of the company comes to an end.
The company continues to exist until it is dissolved. The directors will continue to exercise
those powers to the extent allowed by the liquidator. Further, a voluntary winding up will
neither result in a stay of existing proceedings nor will it prevent the institution of new
proceedings.
Notice of the resolution passed by the company should be given by advertisement in the
Official Gazette and also in some newspaper circulating in the district where the registered
office of the company is situated. This notice should be given within fourteen days of
passing the resolution. The company and every officer who commits a default in complying
with this requirement will be punishable with fine which may extend to five hundred rupees
for every day during which the default continues.
A voluntary winding up will be deemed to have commenced from the date of the passing of
the resolution. From the commencement of the voluntary winding up, the company will
cease to carry on business except so far as may be required for the beneficial winding up of
such business. However, it retains its corporate status and powers until it is dissolved.
15.7.3 Winding Up subject to the Supervision of the Court

According to Section 522, at any time after a company has passed a resolution for
voluntary winding up, the court may make an order that the voluntary winding up should
continue subject to the supervision of the court and with such liberty for creditors,
contributories or others to apply to the court and generally on such terms and conditions
as the court thinks just.
The winding up will commence from the date of the resolution passed by the company for
the said purpose.
Where an order is made for a winding up subject to supervision, the court may, by that or
any subsequent order, appoint an additional liquidator or liquidators [Section 524(1)].
The court is empowered to remove any liquidator so appointed or any liquidators continued
under the supervision order, and fill any vacancy occasioned by the removal or by death or
resignation [Section 524(2)].
A liquidator appointed by the court under Section 524 shall have the same powers, subject
to the same obligation, and in all respects stand in the same position, as if he had been duly
appointed in accordance with the provisions of this Act with respect to the appointment of
liquidators in a voluntary winding up [Section 525].
58

Winding Up
15.8 DISSOLUTION OF A COMPANY

Where the affairs of the company are would up or where the NCLT is of the opinion that
the liquidator cannot proceed with the winding up due to lack of funds and assets or for any
other reason whatsoever and further where the NCLT feels it is just and equitable to do so,
it may make an order that the company be dissolved from the date of the order and the
company shall be dissolved accordingly.
The power of the NCLT will continue till the date of dissolution. It was held in Official
Liquidator, Gannon Dunkerley & Co. (Madras) Limited vs. Assistant Commissioner.,
Urban Land Tax that a company in liquidation will continue to exist as a legal person and it
will be liable to pay taxes in respect of the land in its name till the order of dissolution is
made by the NCLT.
Once the dissolution order is made, the existence of the company comes to an end. Also the
liquidators duty towards creditors and contributories comes to an end on the dissolution of
the company. Where a liquidator has committed a breach of his duty to any creditor in
contravention of any of the provisions of the Companies Act, he will be held liable to pay
damages.
According to Section 481(2), the order of dissolution should not only be communicated but
also forwarded to the Registrar for registration within thirty days from the date of the order.
The Registrar shall then make a minute of the dissolution of the company in his books.
If the liquidator makes a default in forwarding a copy as aforesaid, he shall be punishable
with fine which may extend to fifty rupees for every day during which the default
continues.
a.
Amit & Co. had been facing the problem of mismanagement for past one year.
Hence, Amit & Co. passed a special resolution for winding up the business of the
Company. Is this a voluntary winding up?
..
..
..
b.
ABC (P) Ltd., has only two shareholders who are also the directors with equal rights
of management and voting power. The company was continuously making profits
but there is a dead lock in the management of the company. Can the company be
wound up?
..
..
..
c.
It was found by NCLT that the liquidator of Co. A was unable to proceed with the
winding up of the company due to lack of funds and assets. What steps can be taken
in such a case?
..
..
..
59
15.9 SUMMARY
The duties of a director may be classified into four categories, viz., (a) fiduciary duties,
(b) duties of care, (c) statutory duties, and (d) other duties. These duties are in addition to
the specific duties as specified by the Companies Act, 1956. Directors should not use
unpublished and confidential information belonging to the company for their own purpose.
Any knowledge or information that is generated by the company is its own property and
cannot be put to unauthorized use. Any gain by the use of such inside information has to be
accounted for to the company. A director of a company, like any other agent, is duty bound
to exercise reasonable care in the management of its affairs as is expected from the person
occupying such position.
Reconstruction includes reorganization, arrangement and amalgamation. The terms
reorganization and arrangement are used when only one company is involved whereas
the term amalgamation is used when more than one company is involved (i.e., when two
or more companies are amalgamated or where one company is merged with another or
where one company is taken over by another). Any amalgamation or reconstruction may
take the form of takeover or a merger. Takeover is the passing over of the direct or indirect
control of the assets of the target company to the acquiring company. In a merger, the
shareholding in the combined enterprise will be spread between the shareholders of the two
companies.
The High Court of a State is empowered to order winding up of a company under specified
circumstances. A company may be voluntarily wound up either by passing an ordinary
resolution or a special resolution.
15.10 GLOSSARY
Acquisition means when one company purchases a majority interest in the acquired.
Adjourn means to suspend until a later stated time.
Compromise means a settlement of differences in which each side makes concessions.
Fiduciary Duty means the duty of a fiduciary (as an agent or trustee) to act in the best
interests of the beneficiary of the fiduciary relationship (as a principal or trust beneficiary).
Insolvent is a person who is unable to meet debts or discharge liabilities.
Liquidation refers to a business whose assets are converted in to money in order to pay
off debt.
Proxy is a written authorization given by a shareholder for someone else, usually the
companys management, to cast his/her vote at the shareholders meeting or at another
time.
Quorum means gathering the minimum number of members of an organization to conduct
business.
Resolution means an action taken by a deliberative body, like legislature.
Scheme is a combination of elements (statutes or regulations) that are connected, adjusted,
and integrated by design; A systematic plan or program (an administrative inspection
scheme).
Ultra Vire means beyond the scope or in excess of legal power or authority (as of a
corporation) (the agency acted ultra vires) (the agreement was ultra vires).
60

Winding Up
Avtar Singh. Company Law. Eastern Book Company.
Majumdar A. Kand Dr. G. K. Kapoor. Taxmanns Company Law and Practice.
Eilis Ferran. Company Law and Corporate Finance.
www.companylawinfo.com

a.
The director of Aditya Pvt. Ltd. will be liable for breach of his fiduciary duties for
borrowing money beyond his authority and misusing it without the knowledge of the
other directors of the company.
Fiduciary Duties: The first duty or obligation of directors is not to exceed their
authority and powers and to act with honesty and in good faith. They should not
engage in any activity which is ultra vires the company or illegal.
The obligation of Directors is to act honestly and with utmost good faith.
Directors should not use unpublished and confidential information belonging to the
company for their own purpose. Any knowledge or information that is generated by
the company is its own property and cannot be put to unauthorized use. Any gain by
use of such inside information has to be accounted for to the company.
b.
A director will have to take up qualification shares only if required by the articles of
association. According to Section 270, if the articles require a director to take up
qualification shares, then such a person to be eligible to act as a director must acquire
such qualification shares within two months of his appointment as director. On the
expiry of two months, he automatically vacates his office if he has failed to acquire
these shares. In the above case, Sanjay will have to take up qualification shares if the
articles of the company requires. Otherwise he becomes the director even if he does
not hold any qualification shares.
c.
Section 313 lays down that the Board of Directors of a company can appoint an
alternate director in place of the original director during his absence for a period of not
less than three months from the state in which board meetings are held. This power
can be exercised, only if authorized by the articles or by a resolution passed by the
company in a general meeting.
He will have to vacate his office in case the original director returns to the state in
which board meetings are held. In the above case Mr. Khan has to vacate office on
return of Mr. Praveen and so his contention to continue in office till the next annual
general meeting does not hold good.
a.
If the quorum is not present within half an hour from the appointed time,
(i) the meeting if called upon the requisition of members shall stand dissolved; and
(ii) in any other case, the meeting shall be adjourned to the same day in the next week
at the same time and place or to such other day, time and place as the board of
directors may determine. Hence in the above case, it is clear that the meeting stands
dissolved and cannot be adjourned.
61
b.
A member who is entitled to attend and vote at a meeting can appoint another person
(whether a member or not) to vote on his/her behalf. A person so appointed is a proxy.
A proxy has no right to participate in the discussions in the meeting. However, he may
demand or join in a demand for a poll. Hence Mr. Syam cannot take part in the
discussion as he is a proxy.
c.
Where an arrangement has been proposed for the purpose of reconstruction of a

company, the scheme shall be approved by the holders of three fourths in value of the
shares concerned. At the meeting, the scheme should be approved by a majority in
number representing three fourths in value of the creditors, or class of creditors, or
members, or class of members as the case may be, present and voting either in
person or, where proxies are allowed under the rules made under Section 643, by
proxies. [Section 391(2)]
a.
Yes, Amit & Co. can voluntarily wind up the company due to the problem of
mismanagement happening in the company for the past one year.
Voluntary Winding Up
Sections 484 to 520 deal with voluntary winding up of a company. A company may be
voluntarily wound up either by passing an ordinary resolution or a special resolution.
A company may pass an ordinary resolution in a general meeting requiring the

company to be wound up voluntarily when the period, if any, fixed for the
duration of the company by its Articles, has expired, or the event if any, has
occurred, on the occurrence of which the articles provide that the company
should be dissolved [Section 484(1)(a)].
Under Section 484(1)(b), the company may also be wound up voluntarily by

passing a special resolution. This is when the members want to wind up the
company voluntarily, inspite of the company being solvent.
b.
ABC (P) Ltd., has only two shareholders who are also the directors with equal rights
of management and voting power. The company was continuously making profits but
there is a dead lock in the management of the company. Dead lock in management is a
ground for winding up of a company and hence the company can be wound up by the
court.
c.
Where the affairs of the company are would up or where the NCLT is of the opinion
that the liquidator cannot proceed with the winding up due to lack of funds and assets
or for any other reason whatsoever and further where the NCLT feels it is just and
equitable to do so, it may make an order that the company be dissolved from the date
of the order and the company shall be dissolved accordingly. In the above NCLT can
make an order to dissolve Co. A.

A. Multiple Choice
1.
62
The office of the director becomes vacant if he fails to obtain the required share
qualifications as per articles:
a.
Within two months of his appointment
b.
Immediately on his appointment
c.
Before he is appointed
d.
Within one year from the date of appointment
e.
Within six months from the date of appointment.

Winding Up
2.
3.
4.
5.
The Additional Director of a company can be appointed upto next AGM by:
a.
Annual General Meeting and Extraordinary General Meeting
b.
Annual General Meeting and Board Meeting only
c.
Board Meeting and by Passing a Resolution by Circulation
d.
Board meeting and Committee Meeting only
e.
Board Meeting only.
The quorum for a board meeting shall be:

a.
Two directors
b.
One-half the total strength of the Board or 2 directors whichever is less
c.
One-third the total strength of the Board or 3 directors whichever is higher
d.
One-half the total strength of the Board
e.
One-third the total strength of the Board or 2 directors whichever is higher.
Voluntary winding up of a company through the court commences:

a.
At the time of presentation of petition
b.
On acknowledgement by the court
c.
From the date of resolution of the company
d.
14 days after passing the resolution
e.
By an order for winding-up by the court.
A private company must have atleast ___________________.

a.
Seven directors
b.
Two Directors
c.
One director
d.
Six directors
e.
Three directors.
B. Descriptive
1.
Write a note on the criminal liability of a director under the Companies Act, 1956.
2.
Explain the different kinds of meetings that a company can conduct under the
Companies Act, 1956.
3.
When can a company be wound up as per the provisions of the Companies Act, 1956?
practice only.
63
NOTES
64

Block Unit
Nos.
I
Unit Title
1.
2.
3.
4.
II

5.
6.
7.
Trade Environment
8.
BUSINESS
III
9.
10.
Tax Environment
11.
Ethical Environment
IV
BUSINESS CONTRACTS
12.
Law of Contracts
13.
Special Contracts

14.
15.
VI
TAX LAWS
16.
Direct Taxes
17.
Indirect Taxes
Block
6
TAX LAWS
UNIT 16
Direct Taxes
UNIT 17
Indirect Taxes
49
Expert Committee
Dr. O. P. Gupta
Vice Chancellor
IU, Nagaland
Prof. Hilda Amalraj

IBS Hyderabad
Prof. Bratati Ray

IBS Kolkata
Prof.Marzun E Jokhi
IBS Ahmedabad
Dr. B.Padma
IBS Bangalore

IBS Hyderabad

IBS Hyderabad

Prof. Vivek Gupta

Ms. C.Padmavathi
Ms. Sunitha Suresh


IU, Dehradun
Ms. Anita
Ms.Padmaja
IU, Meghalaya
Ms. Mrudula
Ms.Anurita Jois
IU, Sikkim

BLOCK 6
TAX LAWS
Ignorance of Law is no excuse. Taxes are vital inflows for social and economic
development of a nation. Taxes form an important component of State revenue in most
developing economies. Business organizations must keep themselves abreast with the
various tax laws of the State. Businesses need to take advantage of certain incentives,
exemptions provisions and embedded in the prevailing Tax laws to reduce their tax burden.
This calls for proper planning on the part of business. There are two types of taxes Direct
Taxes and Indirect Taxes. While the direct taxes is based on principle of ability to pay
indirect tax are not.
Unit 16 outlines the important provisions of direct taxes. Direct Taxes are the taxes that are
borne completely by the business entity on which the tax is levied and has been paid. The
Income Tax and Wealth Tax fall under this category. The income tax levied on the income
of an entity is governed by Income Tax Act, 1961 and the wealth tax levied on wealth
(property) of an entity is governed by Wealth Tax Act, 1957 in India.
Unit 17 deals with indirect taxes. Indirect Taxes are the taxes levied on expenditure,
consumption right or privilege. These are taxes that are passed on from one entity to
another till the ultimate consumer. The Customs duties levied on imports is governed by
Customs Act 1962, the excise duties levied on production is governed by Central Excise
Act, 1944, the Value Added Tax (VAT) levied on value added in production process is
governed by, the Central Sales tax levied on sale of goods is governed by Central Sales Tax
Act, 1956 and Service Tax levied on services rendered is governed by Service Tax, Finance
Act, 1994 in India.
UNIT 16 DIRECT TAXES

Structure
16.1 Introduction
16.2 Objectives
16.3 Classification of Taxes
16.4 Income Tax
16.4.1 Residential Status and Tax Incidence
16.4.2 Incomes that are Exempted
16.4.3 Income from Salaries
16.4.4 Income from House Property
16.4.5 Income from Profits and Gains of Business or Profession
16.4.6 Capital Gains
16.4.7 Income from Other Sources
16.4.8 Deductions from Gross Total Income
16.5 Wealth Tax
16.5.1 Debt Owed
16.5.2 Current Developments
16.6 Summary
16.7 Glossary
16.1 INTRODUCTION
The origin of the word tax is derived from the term taxation, which means an estimate.
The word tax refers to the required payments of money made to governments that provide
public goods and services for the benefit of the community as a whole. Taxes on income in
some form or other were levied existed even in primitive and ancient communities, and
were levied on the sale and purchase of merchandise and livestock and were collected in a
haphazard manner from time to time.
In India, the system of taxation existed even in ancient times, which find references in
Manu Smriti and Arthasastra. A detailed analysis given by Manu on the subject clearly
shows the existence of a well-planned taxation system in ancient India. Taxes were paid as
gold coins, cattle, grains, raw materials and also by rendering personal service. In this unit,
we shall identify the different types of taxes and the various taxes that fall under each
category. First, we shall deal with the first category of taxes Direct taxes in detail.
16.2 OBJECTIVES
Classify the various types of taxes;
List a few important incomes that are exempted from tax;
Summarize important provisions that fall under the head of Salaries;
Reproduce the various deductions that can be claimed under the head of House
Property;
Recognize the expenditure that is allowable as deduction, and the expenditure that is
disallowed for the purpose of computation of Profits and Gains of Business or
Profession;
List the items that will be considered Deemed Income for the purpose of taxation
under the head of Profits and gains of Business or Profession;
State the important deductions that are allowed from Gross Total Income; and
State the important provisions pertaining to Wealth Tax.
16.3 CLASSIFICATION OF TAXES

Today the system of taxation in India is divided into the direct tax system and the indirect
tax system (see Figure 1). Direct tax is a tax that cannot be shifted to others, such as the
income tax, wealth tax etc. Indirect tax, on the other hand, is a tax that can be shifted to
others, such as sales tax, excise duty, custom duty etc.
System of Tax
Direct Tax
Income Tax
Indirect Tax
Wealth Tax
Excise Duties
Custom Duties
Sales Tax
Figure 1
DIRECT TAXES
The Government directly collects these taxes from the pockets of the earners out of their
income. These taxes are collected from certain category of people only. Income tax,
professional tax, wealth tax and estate tax are such kind of taxes.
INDIRECT TAXES
Though these taxes are paid by the people of the country, these taxes need not be paid by
them directly. These taxes are collected through the manufacture and sale of products and
services i.e., the amount of tax is inclusive in the price of the product or service. The only
difference is that every person who becomes a consumer for a product or service needs to
pay this tax irrespective of his earnings. Sales tax/VAT, excise duty, customs duty and
service tax etc., comes under this category. These taxes are also known as commercial taxes
as these are imposed on traded items.
According to the Indian Constitution, the revenues that are generated in the form of levying
taxes are divided between Central and State Governments on ratio basis. Accordingly both
Center and States will share the revenue as per the subjects listed under Union List and
State List of the VIIth Schedule of the Indian Constitution. According to this,
Taxes collected by Center: The Central Government collects wholly indirect taxes like
customs duty, excise duty, Central Sales Tax (CST), and direct taxes like income tax,
wealth tax, estate duty and education cess, etc.
Taxes collected by State: Indirect taxes like Sales Tax/VAT, excise duty on liquor etc.,
and direct taxes like property tax, professional tax are collected by the concerned State
Government.
Taxes are applied to every citizen of India if he comes under the purview of the tax. Taxes
are calculated on the basis of revenues generated or expected to be generated on the
particular entities. Direct taxes are mainly collected from the individuals and companies or
organizations etc. Whereas indirect taxes are collected from the entrepreneurs or
manufacturers or traders on the basis of their turnover during the financial year.
6
Direct Taxes
16.4 INCOME TAX

Income Tax is a species of direct tax and is governed by the Income Tax Act, 1961. By
virtue of the power conferred on the Central Government by the Constitution of India, the
former enacted the Income Tax Act, 1961 (herein the chapter referred to as the Act).
The Act extends to whole of India and came into force on the first day of April 1962. Part
B of the Finance Act contains detailed tax proposals. Once it is approved by the
Parliament and acquires the assent of the President, the income shall be charged
according to the rates of tax prescribed in Schedule I of the Finance Act. The Act is
administered by Central Board of Direct Taxes (CBDT), which is empowered to frame
rules to achieve the purpose of the enactment and ensure proper governance of the Act.
The CBDT issues circulars from time to time:
to clarify any doubts regarding the scope and meaning of the Act;
to act as a guide for officers and assessees.
However, the circulars of CBDT, an executive authority, are binding on assessing

officers but not on assessees and courts. The Central Government is empowered to
constitute an independent authority, settlement commission, a quasi-judicial body to
subordinate the CBDT.
Income tax can be levied on both individuals (personal income taxes) and businesses (tax
on business and corporate income) with respect to the income, both earned (salaries, wages,
tips, commissions) and unearned (interest, dividends).
Before discussing about the other aspects of the Act, let us have a look at the important
terminology pertaining to the Income Tax Act.
Assessee (Section 2(7)): An assessee is a person by whom any tax or any other sum of
money is payable under the Act.
Assessment Year (Section 2(9)): Assessment year means the period of 12 months
starting from 1st April of every year and ending on 31st March of the next year.
Previous Year (Section 3): Income earned in a year is taxable in the next year. The
year in which income is earned is known as the previous year and the next year in
which income is taxable is known as the assessment year.
Receipt vs. Accrual of Income: Income is said to have been received by a person
when payment has been actually received whereas income is said to have accrued if
there arises in the person a fixed and unconditional right to receive it.
Belated Return: Section 139(4) provides that a return which has not been furnished
by the due date may still be furnished as a belated return before the expiry of one year
from the end of the assessment year or before the completion of assessment,
Revised Return: If a person having filed his return within the due date discovers any
omission or wrong statement therein, he may file a revised return before the expiry of
one year from the end of the assessment year or completion of assessment whichever
is earlier.
Income: The definition of income under Section 2(24) of the Income Tax Act, 1956,
is of an inclusive nature, i.e., apart from the items listed in the definition, any receipt
which satisfies the basic condition of being income is also to be treated as income and
charged to income tax accordingly. Income includes:
a.
Profits and gains of business or profession including any benefit, amenity,

perquisite obtained in the course of such business or profession.
b.
Salary income including any benefit, allowance, amenity or perquisite obtained

in addition to or in lieu of salary.
7
c.
Income from house property.
d.
Dividend Income.
e.
Winnings from lotteries, crossword puzzles, races, games, gambling or betting.
f.
Capital gains on sale of capital assets.
g.
Amounts received under a Keyman Insurance Policy, i.e., a life insurance policy
taken by a person on the life of another person who is or was the employee of the
first mentioned person or is or was connected in any manner whatsoever with the
business of the first mentioned person.
h.
Voluntary contributions received by a religious or charitable trust or scientific

research association or a sports promotion association.
i.
Any allowance granted to the assessee either to meet the personnel expenses at
the place where the duties of his office or employment of profit are ordinarily
performed by him or at a place where he ordinarily resides or to compensate him
for the increased cost of living.
j.
Any sum received from an individual or HUF on or after 1st September 2004 in
cash or by cheques or by any other mode or credit in excess of Rs.50,000, then
the whole of such sum,
Which excludes,
i.
Amounts received or credited to by an individual from a relative out of

natural love and affection.
ii.
Amounts received or credited to by an individual or HUF under a will or by

way of inheritance.
iii.
Any sum received in contemplation of death of an individual or

karta/member of a HUF.
iv.
Any sum received on occasion of marriage of the individual.
v.
Money received from a local authority.
vi.
Money received from any fund, foundation, university, other educational

institutions, hospital, medical institution, any trust or institution referred to
in Section 10(23C).
vii. Money received from a charitable institute registered under Section 12AA
Gross Total Income.
According to Section 14 income of a person is computed under the following five
heads: (a) Income from Salaries, (b) Income from House Property, (c) Profits and
Gains of Business or Profession, (d) Capital Gains and (e) Income from Other
Sources.
APPLICABILITY
The Income Tax Act, 1961 is applicable to all persons of India. According to Section 2(31)
of the Income Tax Act, a person means and includes:
i.
an individual;
ii.
a Hindu Undivided Family (HUF);
iii.
a company;
iv.
a firm;
Direct Taxes
v.
an Association of Persons (AOP) or a body of individuals, whether incorporated or

not;
vi
a local authority; and
vii. every artificial juridical person, not falling within any of the above clauses.
BASIS OF CHARGE
According to Section 4 of the Income Tax Act, 1961 the gross taxable income of every
person during the previous year is the basis of calculation of income tax. The rate of tax
depends upon the class of assessee he belongs to, and the tax rates prescribed by the
Finance Act.
TAX RATES
Tax rates are given by the Finance Act which is passed by the Parliament every year.
Income tax is computed according to the relevant Finance Act. The tax rates are contained
in the First Schedule (Parts i, ii and iii). For the Assessment Year 2009-2010, the rates are
i.
In the case of Individuals

a.
In case of an individual (man or woman) being resident in India who is of the

age of 65 years and above
Income
b.
Up to Rs.2,25,000
Nil
Rs.2,25,001 Rs.3,00,000
10%
Rs.3,00,001 Rs.5,00,000
20%
Above Rs.5,00,000
30%
In case of a woman, resident in India and below the age of 65 years

Income
ii.
Tax Rates
Tax Rates
Up to Rs.1,80,000
Nil
Rs.1,80,001 Rs.3,00,000
10%
Rs.3,00,001 Rs.5,00,000
20%
Above Rs.5,00,000
30%
In case of other individuals, HUF, AOP

Income
Tax Rates
Up to Rs.1,50,000
Nil
Rs.1,50,001 Rs.3,00,000
10%
Rs.3,00,001 Rs.5,00,000
20%
Above Rs.5,00,000
30%
In case of Individuals, HUF, AOP (other than co-operative societies):

Surcharge is not leviable, if the total income does not exceed Rs.10,00,000. Where the
total income exceeds Rs.10,00,000, surcharge will be levied @ 10% of the income
tax payable.
Education Cess
In addition to income tax and surcharge, an additional levy of 3% towards education
cess is to be made on the aggregate of income tax and surcharge payable for the
Assessment Year 2009-10.
9
iii. Companies
Domestic companies are levied a tax @30%; surcharge @10% and education cess of
3% levied on tax plus surcharge.
The tax rate in the case of foreign companies is @40%, surcharge of @ 2.5% and
education cess of 3%.
In addition to the tax rates prescribed by relevant Finance Act, special rates are prescribed
under Income Tax Act. For example, the long-term capital gains are taxable at the rate of
20% under Section 112, winnings from lotteries, crossword puzzles, races, card games is
taxable at 30% under Section 115 BB.
16.4.1 Residential Status and Tax Incidence

As per Section 5 of the Income Tax Act, the total income of any person in the previous
year is determined according to his residential status (Resident and Ordinary Resident,
Resident but not Ordinarily Resident and Non-Resident) of that person for the relevant
assessment year.
RESIDENTIAL STATUS OF AN INDIVIDUAL
The basis for determination of residential status of the same is presented an individual is
laid down in Section 6.
There are a few conditions to be taken into consideration for determining the residential
status of an individual.
In the case of an individual In the case of an Indian
[other than that mentioned in citizen who leaves India
columns (2) and (3)].
during the previous year for
the purpose of employment
or, in the case of an Indian
citizen who leaves India
during the previous year as a
member of the crew of an
Indian ship.
(1)
(2)
a. Presence for at least

182 days in India
during the previous
year.
b.
In the case of an Indian

citizen or a person of Indian
origin (who is abroad) who
comes to India on a visit
during the previous year.
a. Presence for at least

182 days in India
during the previous
year.
Presence of at least 60 b. Non-functional.

days in India during the
previous year and 365
days during 4 years
immediately preceding
the relevant previous
year.
(3)
a. Presence for at least 182
days in India during the
previous year.
b. Non-functional.
Table 1: Basic Conditions at a Glance

i.
Resident India in at least 2 out of 10 years preceding the previous year [or must
satisfy at least one of the basic conditions, in 2 out of 10 preceding previous years].
ii. Presence of at least 730 days in India during 7 years preceding the previous year.
Table 2: Additional Conditions at a Glance
10
Direct Taxes
RESIDENTIAL STATUS OF A HUF, FIRM, AND AOP

According to Section 6(2) a hindu undivided family, firm or other association of persons is
said to be resident in India, if control and management of its affairs is wholly or partly
situated in India.
They are treated as Non-Resident in India if control and management of its affairs is wholly
situated outside India.
Note: Only an individual and a HUF can be resident but not ordinarily resident.
Whereas Firm, AOP, BOI, Company and other persons can be either be residents or nonresidents only.
Therefore if the control and management of the affairs of the HUF is wholly or partly
situated in India and if the manager or Karta of the family satisfies any of the following
conditions, the HUF shall be considered as Resident and Ordinarily Resident:
a.
Resident in India in at least 2 out of 10 years preceding the previous year [or must
satisfy at least one of the basic conditions, in 2 out of 10 preceding previous years].
b.
Presence of at least 730 days in India during 7 years preceding the previous year.
If the control and management of the affairs of the HUF is wholly or partly situated in India
and if the manager or Karta of the family fails to satisfy any of the above conditions, the
HUF shall be considered as Resident and not Ordinarily Resident.
RESIDENTIAL STATUS OF A COMPANY
According to Section 6(3) an Indian company is always resident in India. A foreign
company is resident in India only, if during the relevant previous year, control and
management of its affairs is situated wholly in India. A foreign company is treated as nonresident if, during the previous year, control and management of its affairs is either wholly
or partly situated out of India.
RESIDENTIAL STATUS OF EVERY OTHER PERSON
According to Section 6(4) every other person is resident in India if during the relevant
previous year control and management of its affairs is wholly or partly situated within
India. On the other hand, every other person is non-resident in India if control and
management of its affairs is wholly situated outside India.
16.4.2 Incomes that are Exempted

Section 10 of the Act provides exemption for certain incomes from the calculation of Total
Income. That means those incomes need not to be considered as taxable income. Some of
those incomes are:
i.
Agricultural income.
ii.
Receipts by an individual HUF member out of the income of the family.
iii.
Share of profit of a partner in a partnership firm.
iv.
Salary received by a ships crew.
v.
Remuneration to foreign trainee.
vi.
Technical fees received by a notified foreign company.
vii.
Payment from public sector company at the time of voluntary retirement

[Section 10(10C)].
viii.
Tax on perquisite paid by employer [Section 10(10CC)].

11
ix.
Amount received on life insurance policies [Section 10(10D)].
x.
Payment from provident fund [Section 10(11), (12)].
xi.
Payment from an approved superannuation fund [Section 10(13)].
xii.
Scholarships granted to meet the cost of education.
xiii.
Any long-term capital gain arising out of transfer or a listed security being equity in
a listed company.
xiv.
Income and allowances of MLAs and MPs arisen from such position.
xv.
Income of former rulers.
xvi.
Income of local authorities.
xvii.
Incomes of political parties.
xviii. Incomes of trade unions.

xix.
Incomes of charitable and religious trusts.
xx.
Income of a mutual fund [Section 10(23D)].
xxi.
Income of provident funds [Section 10(25)].
xxii.
Income of employees state insurance fund [Section 10(25A)].
xxiii. Income of investor protection fund set up by recognized stock exchange

[Section 10(23EA)].
xxiv. Income of venture capital funds and venture capital undertakings
[Section 10(23FB)].
xxv.
Income of trade unions [Section 10(24)].
xxvi. Income of a member of scheduled tribe [Section 10(26)].

xxvii. Exemption of commodity boards and authorities from income tax [Section 10(29A)].
xxviii. Income of a minor [Section 10(32)].
xxix. Exemption of capital gain on transfer of a unit of unit scheme, 1964 (US 64)
[Section 10(33)].
xxx.
Dividend to be exempt in the hands of the shareholders [Section 10(34)].
xxxi. Interest to be exempt in the hands of the unit holders [Section 10(35)].
xxxii. Long-term capital gains on transfer of listed equity shares [Section 10(36)].
xxxiii. Capital gain on compulsory acquisition of urban agriculture land [Section 10(37)].
xxxiv. Income from transfer of long-term capital asset covered by Securities Transaction
Tax (STT) [Section 10(38)].
xxxv. Capital gains on transfer of business to an Indian Company [Section 10(41)].
xxxvi. Income of new undertakings in FTZ/EPZ/SEZs.
xxxvii. Income of new undertaking which are 100% export oriented units.
12
Direct Taxes
a.
What is scope/applicability of Indian Income Tax Act in terms of geographical area

and when did it come into force?
..
.
.
b.
Can January 1st to December 31st, the period of 12 months be considered as

assessment year under Income Tax Act, 1961?
..
.
.
c.
Mr. Xs (below 65 years) total income for the assessment year 2009-10 is
Rs.4,50,000. Compute his tax liability.
..
.
.
16.4.3 Income from Salaries

For the income to be taxable under this head, the relationship of employer and employee
must exist between the payer and payee. The person employed may be on a full-time or
part-time basis.
The remuneration received by an individual is taxable under the head Salaries
irrespective of whether the remuneration is termed as salary or wages as both are
compensation for work done or services rendered.
The salary payable must be real and not fictitious and there must be an intention to pay on
the part of employer and receive on the part of employee.
Under Section 17(1), salary includes:
wages,
any annuity or pension,
any gratuity,
any fees, commission, perquisite or profits in lieu of or in addition to any salary or

wages,
any advance of salary,
any payment received in respect of any period of leave not availed by the employee,
portion of the annual accretion in any previous year to the balance at the credit of an
employee participating in recognized provident fund to the extent it is taxable and
transferred balance in a recognized provident fund to the extent it is taxable.
ADVANCE SALARY
Any salary received in advance is taxable on receipt basis in the year in which it is
received, irrespective of incidence of tax in the hands of the employee. For this purpose,
any loan taken from the employer is not regarded as advance salary.
13
ARREARS OF SALARY
If there are any arrears of salary which have not been taxed in the past, such arrears will be
taxed in the year in which these arrears are paid or allowed to the employee.
SURRENDER OF SALARY
If any employee opts to surrender his salary to the Central Government under Section 2 of
the Voluntary Surrender of Salaries (exemption from taxation) Act, 1961, the salary so
surrendered is excluded while computing his taxable income.
TAX-FREE SALARY
When the employee receives tax-free salary from his employer, it means that the employer
himself pays the tax which is due on the salary of such employee. The amount of tax, so
paid by the employer, is also to be considered as the income of the employee and will be
added to his salary.
LEAVE SALARY
Any amount received as cash equivalent of leave salary in respect of period of earned leave
at his credit at the time of retirement whether on superannuation or otherwise is exempt
from tax in the case of government employees. Similar provisions with certain limits apply
to leave salary in the case of other employees.
GRATUITY
Gratuity is paid for the long and meritorious services rendered by an employee. Under
Payment of Gratuity Act, 1972, gratuity payment has become legally compulsory in most
of the cases and where it is not applicable the employee can claim gratuity under the terms
of contract of employment. In the case of government employees gratuity is wholly exempt
in the case of employees covered under Payment of Gratuity Act, 1972, the amount is
limited to 15 days salary, actual gratuity received or Rs.3,50,000 whichever is less.
When the gratuity is received from more than one employer the maximum amount that is
exempt.
PENSION
Pension is a periodical payment of money for past service and it is received by employee
after his retirement and is taxed as salary. Pension earned and received abroad but later
remitted to India is exempt from tax, in the case of a non-resident and a resident but not
ordinarily resident. It is chargeable to tax if the pensioner is resident and ordinarily resident.
Pension may be received by the assessee either in lump sum or periodically. The former is
known as commuted pension and the latter is known as uncommuted pension.
Uncommuted pension is treated as salary, taxable in the hands of the recipient irrespective
whether he is a government or non-government employee.
Any amount received by a Government employee as commutation of pension is fully
exempted from tax under Section 10(10A)(i).
But in case of non-government employee the amount exempt from tax is limited to
commuted value of 1/3 of pension or 1/2 of pension depending on whether he is receipt of
gratuity or not.
BONUS
It is taxable in the year of receipt. Contractual bonus is treated as salary while gratuitous
bonus is treated as perquisite. An assessee may claim relief under Section 89(1) where he
receives bonus in arrears.
14
Direct Taxes
FEES AND COMMISSION

They are taxable as salary irrespective of the fact that they are paid in addition to or in lieu
of salary. However, commission paid to a director (not being an employee) for his giving
guarantee for repayment of loan is taxable under the head Income from Other Sources.
DEARNESS ALLOWANCE (DA)
It is taxable under the head Income from Salaries.
CITY COMPENSATORY ALLOWANCE
It is taxable whether given for meeting personal and other expenses that an employee
may have to incur either due to the special circumstances he works in or posting at a
particular place.
HOUSE RENT ALLOWANCE
The least of the following will be allowed as deduction:
i.
50 percent of salary in case the residential house is situated at Mumbai, Delhi,

Kolkata, and Chennai;
40 percent of salary in case the residential house is situated at any other place;
ii.
Actual house rent allowance received by the employee in the previous year;
iii.
The excess of rent paid over 10 percent of the salary.
For the purpose of calculating HRA,

Salary includes DA if the terms of employment so provide and it also includes
commission based on a fixed percentage of turnover achieved by an employee as per
terms of contract of employment but it excludes all other allowances and perquisites.
Exemption in case of HRA is denied where rent paid does not exceed 10 percent of salary
or when employee lives in his own house or when he lives in a house for which he does not
pay any rent.
SPECIAL ALLOWANCES
Special allowance will be allowed as exemption which is not in nature of a perquisite
within the meaning of Section 17(2) and which is specifically granted to meet expenses
incurred wholly, necessarily and exclusively for the performance of the official duties or
employment for profit, as notified by the Central Government in the Official Gazette.
PERQUISITES
Perquisite is defined as any casual emolument or benefit attached to an office or position in
addition to salary or wages. They may be provided either in cash or in kind. Perquisites are
included in salary only if they are:
a.
received by an employee from his employer,
b.
allowed during the continuance of employment,
c.
directly dependent upon service,
d.
resulting in the nature of personal advantage to the employee, and
e.
derived by virtue of employers authority.

15
According to Section 17(2), perquisite includes:

a.
The value of rent-free accommodation provided to the assessee by his employer:

[Section 17(2)(i)].
b.
The value of any concession in the matter of rent in respect of any accommodation
provided to the assessee by his employer [Section 17(2)(ii)].
c.
The value of any benefit or amenity granted or provided free of cost or at concessional
rate in any of the following cases:
i.
By a company to an employee who is a director thereof;
ii.
By a company to an employee, being a person who has substantial interest in the

company;
iii.
By any employer (including a company) to an employee to whom provisions of

(i), (ii) above do not apply and whose income under the head Salaries
exclusive of the value of all benefits or amenities not provided for by way of
monetary benefits, exceeds Rs.50,000 [Section 17(2)(iii)].
d.
Any sum paid by the employer in respect of any obligation which but for such
payment would have been payable by the assessee [Section 17(2)(iv)].
e.
Any sum payable by the employer, whether directly or through a fund other than a
recognized provident fund or approved superannuation fund or a deposit-linked
insurance fund, to effect an assurance on the life of the assessee or to effect a contract
for an annuity [Section 17(2)(v)].
f.
The value of any other fringe benefit or amenity as may be prescribed [Section
17(2)(vi)] excluding the fringe benefits chargeable to tax under Chapter XII-H
[Section 17(2)(vi)].
DEDUCTIONS UNDER THE HEAD SALARY

The income chargeable under the head Salaries shall be computed after making the
following deductions from gross salary:
i.
Deduction for entertainment allowance.
ii.
Deduction for profession tax.
16.4.4 Income from House Property

The annual value of property consisting of any buildings or lands appurtenant thereto, of
which the assessee is owner, is chargeable to tax under the head, Income from House
Property. Any house property occupied by the assessee for the purpose of business or
profession carried on by him, the profits of which are chargeable to tax, annual value of
such property is not chargeable to tax under this head.
According to Sec.22 of the Income Tax Act, 1961, tax is charged only if (a) the property
consists of any building or land appurtenant thereto; (b) the assessee is the owner of house
property; and (c) the property should not be used by the owner for purpose of his business
or profession, the profits of which are chargeable to tax. If the house property is sublet, it is
not taxable under this head but it is taxed under the head Income from Other Sources.
Tax on house property is levied only if the assessee is the owner of the property. Owner
includes legal as well as deemed owners. Under this section owner may be an individual,
firm, company, co-operative society, or association of persons.
16
Direct Taxes
Under Section 27 of the Act the following persons will be treated as deemed owners an
individual, who transfers house property otherwise than for adequate consideration to his or
her spouse or to minor child, the holder of impartible estate, a member of co-operative
society, company or association of persons to whom a building or a part thereof is allotted
or leased under a house building scheme of the society, company or association, a person
who is allowed to take or retain possession of any building in part performance of a
contract entered into under Section 53A of the Transfer of Property Act.
Tax is levied on the annual value of the property and not on rent.
ANNUAL VALUE
The annual value is calculated by taking the following factors into consideration
(i) the rent payable by the tenant, (location of property), (ii) municipal valuation of the
property, (iii) fair rent of the property, and (iv) the standard rent under the Rent
Control Act.
Income from house property is referred to as annual value. For the purpose of taxation, the
annual value of house property is determined as follows:
1.
The annual value is taken as nil if the house property is occupied by the owner.
2.
If the house cannot be occupied by the owner because of his employment, business or
profession being at some other place forcing him to reside there, the annual value is
again taken as nil.
However, these two clauses are applicable only for one house, and that too only if the
owner does not let-out the house during any part of the year, nor does he derive any
other benefit from such house.
3.
In other cases, the annual value of any property is taken as:

a.
The sum for which the house may reasonably be expected to let from year to
year; or
b.
Where the house is let-out for a sum higher than one mentioned in (a) above, the
actual rent; or
c.
Where the house is let-out for a part of the year, and the rent received is lower
than the sum mentioned in (a) above due to the house being vacant for a part of
the year, the actual rent received.
For the above purpose Reasonably expected rent means municipal valuation or fair rent,
whichever is higher subject to a maximum of standard rent under Rent Control Act.
COMPUTATION OF INCOME FROM HOUSE PROPERTY
Gross Annual Value
xxx
Less: Municipal Taxes
xxx
Net Annual Value
xxx
Less: Deductions under section 24
xxx
Standard deduction
Interest on borrowed Capital
Income from House Property
xxx
17
PROPERTY EXEMPT FROM TAX

There are certain properties which are completely exempt from tax under this head. They
are:
i.
Income from farm house.
ii.
Annual value of any one palace of an ex-ruler.
iii.
Property income of local authority.
iv.
Property income of an authority constituted for the purpose of planning, development

or improvement of cities, towns and villages.
v.
Property income of an approved scientific research association.
vi.
Property income of a university or other educational institutions, hospital or other

medical institution, games association, trade union.
vii
Property income of a trade union.
viii. House property held for charitable purposes.

ix.
Property income of a political party.
x.
Property used for own business or profession and one self-occupied property.
DEDUCTIONS UNDER THE HEAD OF HOUSE PROPERTY

i.
Municipal rates and taxes.
ii.
30% of Net Annual Value: 30% of the Net Annual Value is allowed as deduction
under this head. This deduction is automatic and does not depend on the quantum of
actual expenditure incurred in respect of repairs, collection charges etc. This deduction
is allowed even if no expenditure is incurred by the assessee. The assessee can avail
this deduction even if the tenant undertakes to do the repairs.
iii.
Interest on Loans: Interest payable on the loans borrowed for the purpose of
acquisition, construction, renovation, repairing or reconstruction can be claimed as
deduction. Interest relating to the year of completion of construction can be fully
claimed in that year irrespective of the date of completion. Interest accrued during the
construction period preceding the year of completion of construction can be
accumulated and claimed as deduction over a period of five years in equal
installments commencing from the year of completion of construction.
In the case of self-occupied property interest on loan borrowed on or after April 1,
1999 is limited to Rs.1,50,000. In the case of others there is no such ceiling.
iv.
Unrealized rent from the tenant.
TAX TREATMENT OF LOSS FROM HOUSE PROPERTY

If the assessee incurs a loss under the head Income from House Property, the loss can be
set-off against any other head of income. Any unadjusted loss can be carried forward for a
period of 8 years for being set-off against any future income under the same head.
18
Direct Taxes
a.
The maximum exemption of gratuity in case of non-government employees covered

under Payment of Gratuity Act, 1972 for the assessment year 2009-2010 is?
..
.
.
b.
If the rent is paid for a house situated in Delhi, the HRA shall be exempt to the
maximum extent of ?
..
.
.
c.
The municipal value of a let-out property of Mr.Naidu was Rs.90,000; its fair value
was Rs.1,05,000; and the standard rent fixed under Rent Control Act is Rs.95,000.
What can be taken as reasonable rent for this property?
..
.
.
16.4.5 Income from Profits and Gains of Business or Profession

Meaning of Business
In view of Section 2(13) business includes any (a) trade (b) commerce (c) manufacture or
(d) any adventure or concern in the nature of trade, commerce or manufacture. Though the
definition is not exhaustive, it covers every facet of an occupation carried on by a person
with a view to earning profit. Production of goods from raw material, buying and selling of
goods to make profits and providing services to others are different forms of business.
Profits arising therefrom are, therefore, chargeable to tax under the head Profits and Gains
of Business or Profession. The term business is a word of wide import and in fiscal
statutes it must be construed in a broad rather than a restricted sense.
EXPENSES EXPRESSLY ALLOWED AS DEDUCTIONS
i.
Rent, rates, taxes, repairs and insurance for buildings.
ii.
Repairs and insurance of machinery, plant and furniture.
iii.
Depreciation.
iv.
Expenditure on scientific research.
v.
Expenditure on acquisition of patent rights and copyrights.
vi.
Expenditure on know-how.
vii.
Amortization of telecom licence fees.
19
viii.
Expenditure on eligible projects or scheme used for promoting social and economic
welfare or upliftment of the public as may be specified by the Central Government.
ix.
Amortization of preliminary expenses.
x.
Amortization of expenditure on prospecting, etc., for development of certain

minerals.
xi.
Insurance against risk of damage or destruction of stocks or stores, used for the
purposes of business.
xii.
Insurance premium paid by a federal milk co-operative on the lives of cattle.
xiii.
Premia for insurance on health of employees.
xiv.
Bonus or commission to employees.
xv.
Interest on borrowed capital.
xvi.
Employers contribution to recognized provident fund and approved superannuation

fund.
xvii.
Employers contribution towards an approved gratuity fund.
xviii. Employees contribution towards staff welfare schemes amount of any debt or part.
xix.
Provisions for bad and doubtful debts in case of certain banks and financial institution.
xx.
20 percent of the profits derived from business of providing long-term finance

carried on to a special reserve account.
xxi.
Revenue expenditure incurred for the purpose of promoting family planning among
its employees.
xxii.
Any sum paid by a public financial institution by a way to contribution towards any
exchange risk administration fund.
xxiii. Banking cash transaction tax paid by an assessee during the previous year on taxable
banking transactions.
xxiv. Expenses not in the nature of a capital expenditure, not represent any item of
personal nature, wholly and exclusively for the purpose of business or profession.
EXPRESSLY DISALLOWED EXPENSES
a.
Any interest, royalty, fees for technical services or other sum chargeable under
Income Tax Act which is payable:
i.
Out of India; or
ii.
In India to a non-resident, not being a company or to a foreign company on

which tax has not been paid or after deduction, has not been paid during the
previous year, or in the subsequent year before the expiry of the time prescribed
under law.
In case the tax is deducted in any subsequent year or has been deducted in the
previous year but paid in any subsequent year after the expiry of time prescribed
under law, such sum shall be allowed as a deduction in computing the income of
the previous year in which such tax has been paid [Section 40(a)(i)]:
a.
Any interest, commission or brokerage, fee for professional services or fees

for technical services payable to a resident contractor or sub-contractor on
which tax is deductible at source shall be disallowed if on which tax has not
been paid or after deduction, has not been paid during the previous year, or
in the subsequent year before the expiry of the time prescribed under law;
20
Direct Taxes
b.
In case the tax is deducted in any subsequent year or has been deducted in
the previous year but paid in any subsequent year after the expiry of time
prescribed under law, such sum shall be allowed as a deduction in
computing the income of the previous year in which such tax has been paid
[Section 40(a)(ai)];
c.
Any sum paid on account of Income Tax, Wealth Tax, Fringe Benefit Tax
and Securities transaction tax are not deductible;
d.
Salary payable out of India if tax has not been paid or deducted at source;
and
e.
Any payment to a provident or any other fund established for the benefit of
employees of the assessee in respect of which the assessee has not made
effective arrangement to secure that tax shall be deducted at source from
any payment, made from the fund;
f.
Tax paid by employer at his option on non-monetary perquisites of the

employee on behalf of the latter;
g.
Expenditure incurred by an assessee in respect of which payment has been

made to relative;
h.
Any expenditure in excess of Rs.20,000 spent in a mode otherwise than by

a crossed cheque or crossed bank draft;
i.
Any provision made by the assessee for payment of gratuity to his

employees in respect of Provision for Unapproved Gratuity;
j.
Contribution to Non-statutory Funds;
DEEMED PROFITS
Deemed profits are those receipts which have to be treated as income for the sake of
inclusion under the head profits and gains of business or profession even though these
incomes are not considered as one as per the accounting norms of the company.
i.
Any recovery or salvage obtained from items allowed as deduction in any of the
previous years, is chargeable to tax as business income.
ii.
Balancing charge on asset of an undertaking engaged in generation or generation and

distribution of power.
iii.
Sale of assets used for scientific research.
iv.
Recovered bad debts earlier allowed as deduction.
v.
Amount withdrawn from special reserve created and maintained by certain financial
institutions.
vi.
Any amounts in the form of unexplained investments; Unexplained money.

investments not fully disclosed; Unexplained and amount borrowed or repaid on hundi
are considered as deemed incomes.
ACCOUNTING METHOD
The accounting method regularly employed by the assessee has to be used to calculate the
income under the head Profits and Gains of Business or Profession. That is, it shall be
computed only in accordance with either the cash or the mercantile system of accounting
regularly employed by an assessee.
21
COMPULSORY MAINTENANCE OF BOOKS OF ACCOUNT

This section provides for compulsory maintenance of books of account by certain specified
persons.
a.
Persons carrying on
specified profession
Gross receipts does not

exceed Rs.1,50,000 in any
of the three preceding
previous years.
b.
Persons carrying on
specified profession
c.
Persons carrying on nonspecified profession or

carrying on business
d.
Persons carrying on nonspecified profession
The persons falling under

this category should
maintain books of account
and other documents to the
satisfaction of Assessing
Officer.
Gross receipts from the
The persons falling in this
profession exceeds
category should maintain
Rs.1,50,000 in any of the such books of account as
three preceding previous
are prescribed under Rule
years.
6F.
Income from profession or Not required to maintain
business or business does any books of account.
not exceed Rs.1,20,000 or
the total sales turnover or
gross receipts thereof are
not in excess of
Rs.10,00,000 in any of the
three years immediately
preceding the previous
year.
Income from such
Should maintain books
profession or business
and other documents to the
exceeds Rs.1,20,000 or the satisfaction of Assessing
total sales, turnover or
Officer.
gross receipts thereof are
in excess of Rs.10,00,000
in any of the three years
immediately preceding the
previous year.
Table 3: Compulsory Maintenance of Books by Specified Persons

For (a) and (b), the income limit is Rs.80,000 in the case of a person who, in the course of
medical profession, dispenses drugs and medicines.
AUDIT OF CERTAIN PERSONS
This section provides for audit of accounts of certain persons.
Different taxpayers
When then are covered by the provisions of compulsory audit

under Section 44AB.
A person carrying on
If the total sales, turnover or gross receipts in business for the
business
accounting year or years relevant to the assessment year

exceeds Rs.40 lakh.
A person carrying on
If the gross receipts in profession for an accounting year
profession
relevant to any of the assessment year, exceeds Rs.10 lakh.
A person covered under
If such person claims that the profits and gains from the
Section 44AD, 44AE,

44AF, 44BB, 44BBB
business are lower than the profits and gains computed under
these sections (irrespective of his turnover).
Table 4: Audit of Certain Persons
22
Direct Taxes
MINIMUM ALTERNATE TAX

Section 115JB provides that, where in the case of an assessee, being a company, the income
tax, payable on the total income as computed under this Act in respect of any previous year
relevant to the assessment year commencing on or after the 1st day of April, 2001, is less
than seven and one-half percent of its book profit, the tax payable for the relevant previous
year shall be deemed to be seven and one-half percent of such book profit and such book
profit shall be deemed to be the total income.
16.4.6 Capital Gains

Section 2(14) defines a Capital Asset as property of any kind whether fixed or
circulating, movable or immovable, tangible or intangible.
The term Capital Asset does not include the following:
Any stock-in-trade, consumable stores or raw materials held for the purpose of
business or profession;
Personal effects of the assessee, that is movable property including wearing apparel,
furniture and jewelry held for personal use or for the use of any member of his family
dependent upon him;
Agricultural land in India provided it is not situated in any area within the jurisdiction
of a municipality or a cantonment board, having a population of 10,000 or more or in
any such notified area;
6 percent Gold Bonds, 1977 or 7 percent Gold Bond, 1980 or National Defence Gold
Bonds, 1980 issued by the Central Government; and with effect from assessment year
2000-01, Gold Deposit Bonds issued under the Gold Deposit Scheme, 1999 shall not
be included;
Special Bearer Bonds 1991;
Gold Deposit Bonds issued under the Gold Deposit Scheme, 1999.
The goodwill of a business is capital asset and any excess realized over its book value
would be a capital gain chargeable to tax, right to subscribe to shares, partners share in a
firm, leasehold in mines and license to manufacture an item, dealership rights, right of
tenancy under Tenancy Act, a right to obtain conveyance of an immovable property, a
business undertaking, and route permits are included as capital assets.
COMPUTATION OF CAPITAL GAINS
Steps Computation of short-term capital gain.
Computation of long-term capital gain.
Full value of consideration received.
Full value of consideration received.
II
Deduct
Deduct
a.
Expenditure incurred wholly and a.

exclusively in connection with such
transfer
Expenditure incurred wholly and

exclusively in connection with
such transfer
b.
Cost of acquisition
b.
Indexed cost of acquisition
c.
Cost of improvement
c.
Indexed cost of improvement
III From the above resultant deduct

exemptions.
From the above resultant deduct

exemptions.
IV Balance is short-term capital gains.
Balance is long-term capital gains.
23
TRANSACTIONS NOT REGARDED AS TRANSFER

For the purpose of capital gain tax, certain transactions are not regarded as transfer. Hence,
for these transactions, there is no liability towards capital gains;
Any distribution of capital assets on the total or partial partition of a Hindu Undivided
Family (HUF).
Any transfer of a capital asset under a gift, or will or an irrevocable trust.
Any transfer by way of conversion of bonds or debentures, debenture-stock or deposit

certificates in any form, of a company into shares or debentures of that company.
Transfer of shares in certain schemes of amalgamations, etc.
Transfer of a capital asset being any work of art, archaeological, scientific or art
collection, book, drawing, painting etc. to the government or any university or
museum notified by the Central Government.
Any transfer involved in a scheme entered into by the assessee with borrower of
securities for lending of any securities under an agreement or arrangement subject to
guidelines issued by SEBI.
Any transfer of capital asset in a transaction of reverse mortgage under a scheme made
and notified by the Central Government shall not be regarded as transfer. The revenue
received from reverse mortgage scheme by senior citizens would not be taxable
income.
TAX TREATMENT IS DIFFERENT FOR SHORT-TERM CAPITAL GAINS AND

LONG-TERM CAPITAL GAINS
Short-term Capital Gains
A short-term capital asset is one which is held for 36 months or less 12 months or less in
the case of equity shares, units of mutual funds/UTI and listed securities immediately
preceding the date of transfer. Short-term capital gains, i.e. gains arising from the transfer
of short-term capital assets, are treated as a part of total income in the year in which the
transfer is effected, and taxed at the normal rates of tax.
Prior to amendment made in Finance Act 2004 the short-term capital gains are taxed at
applicable tax rates (i.e., slab rates). This treatment continues to apply to all short-term
capital assets except short-term capital gains from sale of securities. A new section 111A
has been introduced, to tax the short-term capital gains arising from the sale of securities to
investors @ fifteen per cent.
Cost of Acquisition
To determine capital gains arising out of the transfer of a long-term capital asset, the cost of
acquisition and the cost of improvement are allowed as a deduction from the sales proceeds.
The cost of acquisition and the cost of improvement of asset are linked to the Cost Inflation
Index.
Long-term capital gains are therefore computed by deducting from the full value of the
consideration the expenditure incurred in connection with the transfer, the indexed cost of
acquisition, and the indexed cost of improvement.
24
Direct Taxes
Cost Inflation Index

Financial Year
Cost of Inflation Index
Financial Year
Cost of Inflation Index
1981-82
100
1995-96
281
1982-83
109
1996-97
305
1983-84
116
1997-98
331
1984-85
125
1998-99
351
1985-86
133
1999-00
389
1986-87
140
2000-01
406
1987-88
150
2001-02
426
1988-89
161
2002-03
447
1989-90
172
2003-04
463
1990-91
182
2004-05
480
1991-92
199
2005-06
497
1992-93
223
2006-07
519
1993-94
244
2007-08
551
1994-95
259
2008-09
582
Taking 1981-82 as the base year, the Central Government notified cost inflation index in
August 1992 and further as amended in 1993 (table 1), based on 75% of the increase in
consumer price index for urban and non-manual employees.
Indexed cost of acquisition means an amount which bears to the cost of acquisition the
same proportion, as the Cost Inflation Index (CII) for the year in which the asset is
transferred bears to the Cost Inflation Index for the first year in which the asset was held by
the assessee or for the year beginning on 1 April, 1981, whichever is later. In other words,
indexed cost of acquisition for financial year 2008-09 = [(CII for 2008-09) (CII for
1981-82 or later)] x Cost of Acquisition.
The indexed cost of improvement will also be similarly computed.
LONG-TERM CAPITAL GAINS
Assets other than short-term capital assets are regarded as long-term capital assets. Under
Section 112, individual assesses and HUFs will pay a flat rate of tax @ 20% on long-term
capital gains (except on securities). The long-term capital gains on sale of securities are
fully exempt. Instead a tax of 0.125 % on the value of all the transactions of purchase of
securities that take place in recognized stock exchange in India has been introduced.
The threshold exemption of Rs.1,50,000 is fully available in cases where there is no income
other than long-term capital gains and partially to the extent of unabsorbed threshold
exemption after set-off of any other income if it falls below Rs.1,50,000. A cess of 3% is
applicable in the case of all assesses and (cess of 3% + 10% surcharge) is applicable in the
case of assessees with total income exceeding Rs.10,00,000.
25
EXEMPTIONS FROM CAPITAL GAINS

Certain exemptions are provided from taxation of capital gains.
Exemption on Transfer of Residential House Property (Section 54)
Under Section 54, exemption from long-term capital gains tax on transfer of residential
house property is available if the whole or part of the capital gains are used to purchase
another residential house within a period of one year before the date of such transfer or
within two years of the date of transfer. In case of construction of residential property, the
construction must be completed before three years of the date of transfer.
The condition is that the new residential house should be held for a minimum period of 3
years from date of its acquisition.
In case the individual is unable to utilize the amount for the aforesaid purpose before the
date for furnishing the return of income, it shall be deposited in a Deposit Account notified
in accordance with Capital Gains Account Scheme, 1988.
Exemption from Long-term Capital Gains Invested in Bonds (Section 54EC & 54F)
Under Section 54EC, exemption from long-term capital gains tax is available if the
whole or part of the capital gains are invested within six months of the date of transfer
of the asset in bonds which are redeemable after three years. Such exemption is
available only in respect of investment in bonds issued by National Highways
Authority of India (NHAI) or by Rural Electrification Corporation Limited. The
investment is proposed to be restricted upto Rs.50,00,000 per assessee per financial
year for investments made on or after 1 April 2007.
The condition is that such investments should not be used as security for taking loans
during this lock-in period.
In the case of individuals and HUFs, long-term capital gains arising out of transfer of
capital assets other than a residential house are protected from tax under Section 54F
provided the sales proceeds are invested to either purchase a residential house within two
years or construct one within three years, subject to other conditions.
Exemption on Transfer of Assets in case of shifting of Industrial Undertaking from
Urban Area (Section 54G)
Capital gains arising on transfer of plant, machinery, land, building or any rights in land /
building effected in course of or in consequence of the shifting of an industrial undertaking
situated in an urban area to any area (other than an urban area), shall be exempt to the
extent of the amount of capital gains utilized within a period of 1 year before or 3 years
after the date of transfer of the above assets, for purchase of new plant and machinery, land
and building and for shifting expenses.
Exemption on Transfer of Assets in case of shifting of Industrial Undertaking from
Urban Area to Special Economic Zone (Section 54GA)
Capital gains arising on transfer of plant, machinery, land, building or any rights in land/
building effected in course of or in consequence of the shifting of an industrial undertaking
situated in an urban area to any SEZ, shall be exempt to the extent of the amount of capital
gains utilized within a period of 1 year before or 3 years after the date of transfer of the
above assets, for purchase of new plant and machinery, land and building and for shifting
expenses, subject to specified conditions.
26
Direct Taxes
ADJUSTMENT OF CAPITAL LOSSES

Losses due to transfer of short-term or long-term capital assets cannot be set-off against any
other income. Long-term capital losses can be set-off only against long-term capital gains.
However, Short-term capital losses can be set-off against both short-term capital gains and
long-term capital gains. Any unadjusted capital loss may be carried forward and set off
against income under the head, capital gains of the subsequent years. However such loss
cannot be carried forward for more than 8 assessment years.
a.
X purchases a house property on March 10, 2006 and transfers it on June 6, 2008.
Is this a short-term asset or long-term asset? Justify.
..
..
..
b.
Mr.Ramesh claims Rs.42,500 as deduction in respect of Income tax paid on May

15th, 2008 in respect of earlier year. Is the amount allowable as deduction under the
head of Profits and Gains of Business or Profession?
..
..
..
c.
Ms.Jasmine purchased a house on June 30th, 1981 for Rs.6,50,000. She sold the
property on June 15, 2008 for Rs.75,00,000. The expenses incurred on transfer were
Rs.50,000. Compute the capital gains.
..
..
..
16.4.7 Income from Other Sources

Incomes like
dividends;
any winnings from lotteries, crossword puzzles, races including horse races, card
games and other games of any sort or from gambling or betting of any form or nature;
any sum received by the assessee from his employees as contributions to any staff
welfare scheme (if not taxable under Section 28);
interest on securities, if not charged to tax under the head Profits and gains of
business or profession;
income from machinery, plant or furniture let on hire [if it is not taxable in profits and
gains of business or profession];
income from letting of plant, machinery or furniture along with the building and
letting of building is inseparable from the letting of plant, machinery or furniture (if it
is not taxable under Section 28); and
any sum received under a keyman insurance policy, including bonus, if not taxable as
salary or business income.
27
The treatment of each of the incomes that may be included in the head income from other
sources is detailed in the following paragraphs:
EXEMPTED ASSESSES
Interest on securities is not taxable in the hands of the following assessees:
i.
Local authority.
ii.
An authority constituted in India for town planning, etc.
iii.
Approved scientific research association.
iv.
A regiment fund or non-public fund.
v.
An approved hospital.
vi.
An approved athletic association.
vii. A registered trade union.

viii. A statutory, recognized provident fund and approved superannuation fund and an
approved gratuity fund.
ix.
A charitable trust.
DEDUCTIONS [SECTION 57]

The income that is taxable under the head income from other sources will be arrived at
after making the following deductions under Section 57:
a.
Any reasonable sum paid by way of commission or remuneration to a banker or any

other person for the purpose of realizing such dividend or interest on behalf of the
assessee is allowed as deduction.
b.
The amount credited by the employer on or before the due date in the employees
accounts towards provident fund/superannuation/other funds with the amounts of
contribution received is allowed as deduction.
c.
Repairs in respect of building, insurance premium paid in respect of insurance against

risk of damage or destruction of the premises, repairs and insurance of machinery,
plant and furniture and depreciation are deductible in case of income chargeable under
Section 56 (ii)/(iii).
d.
Rs.15,000 or 33 1/3% of income in the nature of family pension under Section 57(iia)
whichever is less.
e.
Any other expense not being personal/capital in nature, expended in the previous year
wholly and exclusively for the purpose of making or earning income.
INADMISSIBLE EXPENSES [SECTION 58]

The following expenses are not deductible by virtue of Section 58:
i.
Personal Expenses.
ii.
Wealth Tax.
iii.
Expenses of the nature described in Section 40A.
iv.
Interest and salary payable outside India, if tax has not been paid or deducted at
source.
v.
No deduction shall be allowed in respect of winnings from lotteries, card games, races
including horse races, gambling, betting, etc. (These incomes are charged to tax under
Section 115BB at a flat rate of 40% subject to availability of exemption under Section
10(3) of the Income Tax Act.)
In respect of the activity of owning and maintaining race horses, expenses incurred shall be
allowed even in the absence of any stake money earned. Such loss shall be allowed to be
carried forward in accordance with the provisions of Section 74A.
28
Direct Taxes
16.4.8 Deductions from Gross Total Income

DEDUCTIONS MADE IN RESPECT OF CERTAIN PAYMENTS AND EXPENDITURE
The deductions that are allowed for payment or expenditure for computation of gross total
income are as follows:
DEDUCTIONS IN RESPECT OF CERTAIN PAYMENTS
Deduction in Respect of Life Insurance Premia, Contribution to PF etc. (Sec. 80C)
a.
b.
Premia paid on life insurance policies.

Sum paid for a deferred annuity as is not in excess of 20% of the actual capital sum
assured.
c.
Provident fund contributions.
d.
Subscriptions to any savings certificates as the Central Government may specify on

this behalf in the Official Gazette.
e.
Contribution by an individual towards an approved superannuation fund.
f.
Premium to keep in force a contract for annuity plan of the LIC or any other insurer as
the Central Government may notify.
g.
Subscription to National Savings Certificates (VIII issue), issued under the

Government Saving Certificates Act, 1959.
h.
Subscription of any security of the Central Government.
i.
Any unit-linked insurance plan of LIC mutual fund.
j.
Subscription to any units of the mutual fund notified under section 10 (23D).
k.
Contribution to any pension fund set-up by any mutual fund notified under section 10
(23D).
l.
Subscriptions to home loan account scheme or a notified pension fund of the National
Housing Bank.
m.
Any sum paid on account of repayment of the sum borrowed for the purchase or
construction of house property from approved agencies.
n.
Education expenses for the purpose of full time education (restricted to two children).
o.
Amount invested in equity shares, debentures of a public company engaged in

infrastructure including power sector.
p.
From the AY 2007-08, investment in term deposit for a fixed period of not less than
five years with any scheduled bank.
q.
Five year time deposit in an account under post office time deposit rules, 1981.
r.
Deposit in an account under the senior citizens savings scheme rules, 2004.
Deduction in Respect of Contribution to Pension Fund (Section 80CCC)

This section provides a deduction to an individual for any amount paid by him in any
annuity plan of LIC for receiving pension. This contribution under this section is limited to,
the overall ceiling of Rs.1,00,000 laid down under Section 80CCE.
29
Deduction in Respect of Contribution to New Pension Scheme (Section 80CCD)

A new pension scheme has been introduced and is applicable to new entrants to
Government service. This section provides a deduction of the amounts paid or deposited by
an individual employed by the Central Government on or after 1st January 2004, in the
pension account subject to a maximum of ten per cent of his salary as per the scheme
notified by the Central Government. From the AY 2008-09, an individual employed by any
other employer on or after the 1 January 2004 and who has paid or deposited the specified
amount in his account under the pension scheme referred to in section 80CCD(1) of the
said section is also eligible for deduction.
An assessee claiming deduction under this section cannot claim deduction under 80C for
the same amount.
However, the total of the deductions under 80C, 80CCC and 80CCD shall not exceed
Rs.1,00,000 (inserted by Section 80CCE).
Deduction in Respect of Medical Insurance Premium (Section 80D)
A deduction of Rs.15,000 is allowed under Section 80D in respect of any sum paid by an
assessee to effect or keep in force mediclaim insurance policy. Additionally, with effect
from AY 2009-2010, a deduction of Rs.15,000 is allowed on any payment made to effect or
keep in force an insurance on the health of parent or parents. If however, either of the
parents is a senior citizen, the additional deduction would be Rs.20,000.
Medical Treatment of Handicapped Dependents (Section 80DD)
Section 80DD provides that if a person makes some expenditure on the maintenance or
medical treatment of a handicapped dependent, or deposits money in an approved scheme
for the maintenance of such dependent, a deduction of Rs.50,000 from taxable income will
be allowed in respect of a person with disability and Rs.75,000 in case of a person with
severe disability irrespective of the expenditure actually incurred, or the amount actually
deposited. The deduction under this section has been extended to persons suffering from
autism, cerebral palsy and multiple disability.
Deduction in Respect of Medical Treatment (Section 80DDB)
An individual can claim a deduction of Rs.40,000 limited to the actual expenditure
incurred towards expenditure for the medical treatment for individual himself or for his
relative or for any member of hindu undivided family in respect of selected serious
diseases. The amount of deduction is irrespective of the amount actually incurred. If the
amount is spend on a senior citizen, a deduction of Rs.60,000 limited to the actual
expenditure incurred is allowed.
Interest on Loan taken for Higher Education (Section 80E)
A deduction is allowed in respect of interest on loan taken for pursuing higher studies. The
loan should be from an approved institution. The loan can be taken for higher education of
himself or his relative being spouse and children. The deduction is allowed from the year
the assessee starts paying interest on the loan and subsequent seven years.
Deduction in Respect of Donations (Section 80G)
Under this section, certain specified donations are eligible for deductions from income. For
some kind of donations, the amount deductible is 50% of the donation, while for some
others, it is 100% of the donation. The total deduction under this section, is however,
limited to 10% of gross total income after being adjusted for certain items.
Deduction in Respect of Rent Paid (Section 80GG)
Any amount paid in respect of an expenditure towards payment of rent by a self-employed
person and/or salaried employee who is not in receipt of any house rent allowance is
allowed as deduction under this section. Only individuals are eligible for deduction under
this section.
30
Direct Taxes
The amount deductible under this section is the least of the following amount:
i.
Rs.2,000 per month; or
ii.
25 percent of total income; or
iii.
The excess of actual rent paid over 10 percent of total income.
Donations for Scientific Research or Rural Development (Section 80GGA)

Under this section, certain donations to specific kinds of institutions are eligible for 100%
deduction.
Deduction in Respect of Contributions given to Political Parties Sec. 80GGB and
80GGC
Deduction shall be allowed in respect of contribution given to political parties during the
previous year, while computing the total income of an assessee (including an Indian
Company).
Deductions in Respect of Certain Incomes
Deduction in respect of profits and gains from industrial undertakings or enterprises
engaged in infrastructure development etc. (Section 80-IA)
Deduction under Section 80-IA is available to the industrial undertakings engaged in the
following activities:
i.
Provision of infrastructure facility.
ii.
Telecommunication facility.
iii.
Industrial park or special economic zone.
iv.
Power generation, transmission and distribution.
v.
Undertaking set up for reconstruction of a power unit.
vi.
A cross-country natural gas distribution network (from the assessment year 2008-09).
Deduction under Section 80-IB in Respect of profits and Gains from certain Industrial
Undertakings other than Infrastructure Development Undertakings
Section 80-IB of the Income Tax Act, 1961 provides exemption from tax in respect of
profits and gains from certain industrial undertakings engaged in the following activities
(other than infrastructure development):
i.
Business of industrial undertaking.
ii.
Operation of ship.
iii.
Hotels.
iv.
Industrial research.
v.
Production of mineral oil.
vi.
Developing and building housing projects.
vii. Integrated handling, storage and transmission of foodgrains units.

viii. Multiplex theatres.
ix.
Convention center.
Deduction under Section 80-IC in respect of profits and gains of certain undertakings in
certain special category of states.
Deduction under Section 80-IC is available to any undertaking or enterprise which has
begun or begins to manufacture or produce any article or thing, not being any article or
thing specified in the thirteenth schedule, or which manufactures or produces any article or
thing specified in the thirteenth schedule and undertakes substantial expansion.
31
Tax Holiday under Section 80-ID Introduced for Hotels and Convention Centers in
National Capital Territory and Specified Areas
100% deduction of the profits and gains derived from such business shall be allowed for 5
consecutive assessment years beginning from the initial assessment year.
Deduction in Respect of Certain Undertaking in North Eastern States Section-80IE
from Assessment Year 2008-09
100% of the profits from the aforesaid business shall be deductible for 10 consecutive years
beginning with the assessment year relevant to the previous year in which the undertaken
begins to manufacture/ produce articles or things or complete substantial expansion.
Deduction in Respect of Profits and Gains from Business of Collecting and Processing
of Bio-degradable Wastes: Section 80JJA
The whole of the profits and gains of these units shall be deductible for a period of five
consecutive assessment years beginning with the assessment year relevant to the previous
year in which such business commences.
Deduction in Respect of Employment of New Workmen: Section 80JJAA
Where the gross total income of an assessee, being an Indian company, includes any profits
and gains derived from any industrial undertaking engaged in the manufacture or
production of article or thing, there shall, subject to the conditions, allowed a deduction of
an amount equal to 30%, of additional wages paid to the new regular workmen employed
by the assessee during the previous year will be allowed a deduction.
Deduction in Respect of Certain Income of Offshore Banking Units and International
Financial Services Center: Section 80LA
The assessee being a scheduled bank and having an offshore banking unit in a special
economic zone or a foreign bank having an offshore banking unit in a special economic
zone or a unit of international financial services center is eligible for a deduction of 100
percent of the gross total income for five consecutive assessment years beginning with
the assessment year relevant to the previous year in which the permission from SEBI or
under other law is obtained, and 50 percent of such income for the next five years is
allowed as deduction.
Deduction under Section 80P in Respect of Income of a Co-operative Society
In the case of a co-operative society, the following amounts are allowed as deductions:
The whole of the amount of the profits attributable to any one or more of the following
activities in the case of a co-operative society engaged in:
a.
Carrying on the business of banking or providing credit facilities to its members; or
b.
A cottage industry; or
c.
Marketing of the agricultural produce of its members; or
d.
Purchase of agricultural implements, seeds, livestock or other articles intended for

agriculture for the purposes of supplying them to its members; or
e.
Processing, without the aid of power of the agricultural produce of its members; or
f.
Collective disposal of the labor of its members; or
g.
Fishing or allied activities, that is to say, catching, curing, processing, preserving,

storing or marketing of fish or the purchase of materials and equipment in connection
therewith for the purpose of supplying them to its members.
32
Direct Taxes
Deduction in Respect of Royalty Income, etc. of Authors of Certain Books other than
Text Books: Section 80QQB
Section 80QQB provides deduction up to Rs.3,00,000 to an individual resident, being an
author, in respect of any income derived from the exercise of his profession, on account of
any lump sum consideration for the assignment or grant of any of his interests in the
copyright of any book, or of royalties or copyright fees (whether receivable in lump sum or
otherwise) in respect of such book.
Deduction for Royalty on Patents: Section 80RRB
Section 80RRB provides for tax breaks on royalty income earned from patents to a resident
in India.
A deduction equivalent to the royalty income received or Rs.3 lakh, whichever is less, is
allowed as deduction to an individual who is registered under the Patents Act as the true
and first inventor in respect of an invention. Even a co-owner of a patent can opt for the
deduction.
Deduction in the Case of a Permanent Physical Disability (Including Blindness) or
Mental Retardation: Section 80U
The amount of deduction permitted under this section is Rs.50,000 and Rs.75,000 in the
case of a person with severe disability. The deduction under this section has been extended
to persons suffering from autism, cerebral palsy and multiple disability.
a.
Mr.Sagar does not own any house and stays in a rented house and pays a rent of
Rs.3,500 per month. Compute the amount of deduction that can be claimed by
Mr.Sagar for the Assessment Year 2009-10 if his total income is Rs.2,30,000.
..
..
..
b.
Ms.Latha has taken a loan of Rs.7,00,000 to pursue her post graduation. She repays
an amount of Rs.30,000 towards principle and an amount of Rs.42,000 towards
interest on loan for the previous year 2008-09. How is the amount she can claim as
deduction under section 80E.
..
..
..
c.
Sheela (widow of Arvind) was in receipt of Rs.1,00,000 family pension for

AY 2009-2010. Is she eligible for any deduction under this income? If so how
much?
..
..
..
33
16.5 WEALTH TAX

Wealth Tax is another species of direct tax. It is governed by Wealth Tax Act, 1957 that
came into force on the 1st day of April, 1957. This Act is applicable to the whole India.
CHARGEABILITY
The wealth tax is chargeable in respect of net wealth of every individual, hindu undivided
family and company in respect of every assessment year at the rate of 1 percent of the
amount where the net wealth exceeds Rs.15 lakh (For AY 2009-10). The net wealth on
valuation date is chargeable to wealth tax in the immediately following assessment year.
Valuation date is March 31 immediately preceeding the assessment year.
However, according to Section 45 of the Act, no wealth tax is chargeable in respect of the
wealth of:
Any company registered under Section 25 of the Companies Act, 1956.
Any co-operative society.
Any social club.
Any political party.
A mutual fund specified under Section 10(23D) of the Income Tax Act.
COMPUTATION
Net wealth for the purpose of Wealth Tax is computed as follows:
Assets (Sec. 2(ea))
xxx
Add: Deemed Assets (Sec. 4)
xxx
Total
xxx
Less: Exempted Assets (Sec. 5)
xxx
Assets Chargeable to Wealth Tax
xxx
Less: Debt Owed (Sec. 2(m))
xxx
Net Wealth
xxx
NET WEALTH [SECTION 2(M)]

The term net wealth means taxable wealth. It represents the excess of assets over debts.
Assets include deemed assets but do not include assets exempted under Section 5. The net
wealth is calculated on the consideration of certain assets. For the purpose of calculation of
net wealth, the term Assets Sec. 2(ea) includes:
i.
34
Any building or land appurtenant thereto hereinafter referred to as house, whether

used for residential or commercial purposes or for the purpose of maintaining a guest
house or otherwise including a farm house situated within twenty five kilometers from
local limits of any municipality whether known as municipality, municipal
corporation or by any other name or a cantonment board, but does not include.
a.
A house meant exclusively for residential purposes and which is allotted by a

company to an employee or an officer or a director who is in whole-time
employment, having a gross annual salary of less than five lakh rupees;
b.
Any house for residential or commercial purposes which forms part of stock-intrade;
c.
Any house which the assessee may occupy for the purposes of any business or
profession carried on by him;
Direct Taxes
d.
Any residential property that has been let-out for a minimum period of three
hundred days in the previous year; and
e.
Any property in the nature of commercial establishments or complexes.
ii.
Motor cars (other than those used by the assessee in the business of running them on
hire or as stock-in-trade);
iii.
Jewelry, bullion, furniture, utensils or any other article made wholly or partly of gold,
silver, platinum or any other precious metal or any alloy containing one or more of
such precious metals, provided if the above said are forming part of any stock-in-trade
they are not considered as assets. If above jewelry or ornaments made of gold, silver,
platinum or any other precious metal and contain any precious stones are also
included for this purpose;
iv.
Yachts, boats and aircrafts (other than those used by the assessee for commercial
purposes);
v.
Urban land (which is comprised within the jurisdiction of a municipality or a

cantonment board and which has a population of not less than ten thousand. If the
same land is held as stock-in-trade by the assessee is not considered as asset); and
vi.
Cash-in-hand, in excess of fifty thousand rupees, of individuals and hindu undivided

families and in the case of other persons any amount not recorded in the books of
account.
DEEMED ASSETS [SECTION 4]
Assets Transferred by One Spouse to Another Section 4(1)(a)(i): The assets which
have been transferred after March 31, 1956 by an individual, directly or indirectly, to his
or her spouse otherwise than for adequate consideration or in connection with an
agreement to live apart are included in the net wealth of the transferor.
Assets held by Minor Child Section 4(1)(a)(ii): All the assets held by a minor
child are included in the net wealth of the individual. However, if such a minor is (i)
suffering from any disability of the nature specified in Section 80U of the Income Tax
Act or (ii) a married daughter of such individual, there will be no such clubbing of
wealth. The clubbing provision will not apply in respect of assets acquired by the
minor child out of his income earned from any manual work done by him or activity
involving application of his skill, talent or specialized knowledge and experience. The
net wealth of a minor will be included in the net wealth of that parent whose net
wealth excluding the assets of minor child so includible under Section 4(1) is greater.
Asset Transferred to a Person or Association of Persons [Section 4(1)(a)(iii)]:

Any asset transferred directly or indirectly by an individual to a person or association
of persons for the immediate or deferred benefit of the transferor, his or her spouse
without adequate consideration is included in the net wealth of the transferor.
Assets Transferred under Revocable Transfers [Section 4(1)(a)(iv)]: Assets

transferred by an individual after March 31st, 1956, to a person or association of
persons under a revocable transfer are included in the net wealth of the transferor.
Assets Transferred to Sons Wife [Section 4(1)(a)(v)].
Assets transferred after May 31, 1973 by an individual, directly or indirectly to his or
her sons wife without adequate consideration are included in the net wealth of the
transferor.
35
Interest of Partner [Section 4(1)(b)]: Where the assessee is a partner in a firm or a

member of an association of persons, the value of his interest in the assets of the firm
or association determined in the manner laid down in Schedule III to the Wealth Tax
Act will be includible in his net wealth.
Conversion of Self-acquired Property by an Individual into Joint Family

Property [Section 4(1A)]: Where an individual converts his self-acquired property
after December 31, 1969 into a joint family property of the HUF by impressing such
property with the character of joint family property or by throwing it into the common
stock of the family or makes a gift of separate property or transfers property otherwise
than for adequate consideration to the family, such property is deemed to be the asset
of the transferor and is includible in his net wealth. In case of partition of the HUF,
only so much of the converted property which is received by the spouse of the
transferor is deemed to be the asset of the transferor and is includible in his net wealth.
Gifts by Book Entries [Section 4(5A)]: Where a gift of money is made by means of
book entries in the books of account maintained by the person making the gift, or by
an individual, or HUF, or a firm or an association of persons or a body of individuals
with whom he has business connection, the value of such gift will be included in the
net wealth of the person making the gift unless Wealth Tax Officer is satisfied that the
money had actually been delivered to the other person at the time of entry of gift.
Property held by a Member of Housing Society [Section 4(7)]: The building or part
thereof allotted or leased to an assessee who is a member of co-operative housing
society, company or an association of persons will be deemed to be the asset of the
assessee and the value of that building or part thereof will be included in the net
wealth of the assessee. While determining the value of the building any outstanding
installments payable by the assessee towards the cost of such house are deductible as
debt owed by the assessee.
Property held by a person in part performance of a contract [Section 4(8)] will be
included in the net wealth of the assessee.
ASSETS THAT ARE EXEMPTED

The following assets are exempt from tax:
Property held under a Trust [Section 5(i)]: Any property held by an assessee under
a trust or other legal obligation for any public purpose of charitable or religious nature
in India, is totally exempt from tax.
Coparcenary Interest in a Hindu Undivided Family [Section 5(ii)]: The interest

of the assessee in the coparcenary property of the hindu undivided family is exempt
from tax.
Residential Building of a Former Ruler [Section 5(iii)]: The value of any one
building used for residential purpose by a former ruler is exempt from tax.
Jewelry of Former Ruler [Section 5(iv)]: Jewelry in possession of a former ruler not
being his personal property, which is recognized as his heirloom by the Central
Government before April 1, 1957 or by the board is exempt from tax.
Assets belonging to Indian Repatriates [Section 5(v)]: Wealth Tax exemption is

provided to assessee who is Indian repatriate in respect of:
36
i.
Money bought by him into India;
ii.
Value of assets brought into India;
iii.
Value of assets acquired out of such money brought into India;
Direct Taxes
iv.
Monies standing to the credit of such assessee in a Non-resident (External)

Account in any bank in India on the date of his return to India; and
v.
Value of assets acquired by him out of money referred to in (i) and (iv) within
one year prior to the date of his return to India.
The exemption is provided (for 7 years from the date on which such person returned
to India) to an assessee who is a person of Indian origin or a citizen of India who is
ordinarily resident abroad and returns to India with an intention of permanently
residing in India.
One House or a Part of House [Section 5(vi)]: A house or part of house or a plot of
land not exceeding 500 square metres in area belonging to individual or a hindu
undivided family is exempt from tax. If the house is owned by more than one person,
the exemption is available to each of the co-owner of the house.
16.5.1 Debt Owed

From the aggregate of all assets (including deemed assets but excluding exempted assets)
the debts owed by the assessee on the valuation date in relation to the assets included in the
net wealth of the assessee shall be deducted. The term debt owed within the meaning of
Section 2(m) may be defined to pay in present or in future unascertainable money. Owe
means to be under an obligation to pay. The value of any asset other than cash is
determined in the manner laid down in the Schedule III to the Wealth Tax Act, on the
valuation date.
a.
A commercial multi-storeyed building given on rent by X (not being held as

stock-in-trade). Is it an asset for the purpose of Wealth Tax?
..
..
..
b.
Geet gifts a house property to his wife Geeta. The property is valued at
Rs.45,00,000. In whose net wealth does the value of property be included?
..
..
..
c.
X, an Indian citizen, was ordinarily residing in Canada. He purchased a house in

Bangalore for Rs.5 crore out of the money remitted from Canada on August 3rd,
2007. He comes to India permanently on July 8th, 2008. Will the value of house be
included in the net wealth for Wealth Tax purpose?
..
..
..
37

With an aim to establish an economically efficient, effective and equitable direct tax
system, 2009 New Direct Tax Code was introduced by the Finance Minister. This new code
is to replace the Income Tax Act, 1961 and other Direct tax laws. Hence, it is to become a
single code for direct taxes. Some of the features are:
i.
Simplifying the Language: With a view to facilitate voluntary compliance and keep
the compliance costs low, the language of the New Code has been kept simple with
clear intent and scope.
ii.
Reduction in Scope of Litigation: Attempt has been made to avoid ambiguity in the
provisions with an intent to reduce rival interpretations and hence reduce the scope for
litigations. Power to avoid protracted litigation on procedural issues has been
delegated to Central Government.
iii.
Flexibility: The flexibility embedded in the New Code allows for any future changes
to suit the growing economy without resorting to frequent amendments.
While the general and essential principles are contained in the Statute, the matters of
detail are contained in the rules and schedules.
The structure of the tax laws has been so designed so that it can be logically
reproduced and reflected in a Form.
iv.
Consolidation of Provisions: With an aim to better understand the law, provisions

pertaining to definition, exemptions, incentives and rates have been consolidated.
v.
Elimination of Regulatory Functions: The traditional mode of using taxing statute

as a regulatory tool has been eliminated. With withdrawal of regulatory function of the
taxing statute the law is expected to further simplify.
vi.
Less Ambiguity: With the rates of tax being prescribed in the First to the Fourth
schedule to the Code itself, the annual uncertainty prevailing the rate of taxes which
are pronounced by Annual Finance Acts is minimized.
See Annexure for Highlights of Direct Taxes Code Bill, 2009.
16.6 SUMMARY
The Income Tax Act, 1961 provides the basic framework and guidelines for the
determination of taxable income and tax liability.
Assessment year means the period of 12 months starting from April 1 of every year and
ending on March 31 of next year.
The year in which the income is earned is known as Previous Year. It is the financial year
immediately preceding the assessment year.
Sections 10 and 11 to 13A of the Income Tax Act deal with certain incomes that are not
part of the total income of an assessee or in other words incomes that are exempt from tax.
Salary includes basic salary, encashment of leave salary, advance of salary, arrears of
salary, various allowances such as dearness allowance, entertainment allowance, house rent
allowance, conveyance allowance and also includes perquisites by way of free housing, free
car, free schooling for children of employees.
Annual value of a house property consists of buildings or land adjacent thereto and is
owned by the assessee. The income from such property is taxable under the head Income
from House Property.
38
Direct Taxes
Business includes any trade, commerce, manufacture or any adventure or concern in the
nature of trade, commerce or manufacturing.
Rent, rates, taxes, land revenue, municipal taxes and repairs and insurance premium paid or
payable for business premises and machinery, plant and furniture are deductible from
business income.
Profit/Gain from the transfer or sale of a capital asset is chargeable to tax under the head
Capital Gain in the year in which capital asset is sold or transferred.
In order to obtain the amount of long-term capital gain on sale of a long-term capital asset,
from the sale proceeds the expenses on transfer are to be reduced. From the balance amount
the indexed cost of acquisition and indexed cost of improvement are to be deducted to get
the amount of taxable capital gains.
Incomes not chargeable under any specific heads i.e., salaries, houseproperty, business or
profession or capital gains are chargeable to tax under the head of Income from other
sources. Winnings from lotteries, crosswords, puzzles, races including horse races, card
games or other games of any sort or gambling or betting of any form or nature are taxable
under this head.
Aggregate of income under all heads will give the Gross Total Income. From that income
certain deductions are available on satisfaction of certain conditions.
As per the provisions of Wealth Tax Act, net wealth of an assessee on valuation date in
excess of Rs.15 lakh is taxable @ of 1%.
Net wealth means taxable wealth, it represents the excess of assets over debts. Assets
include deemed assets but do not include assets exempted under the Section 5.
The valuation of assets for Wealth Tax purposes will be made on the basis of provisions
laid down in the Schedule III to the Wealth Tax Act, on the valuation date.
16.7 GLOSSARY
Assessee means a person by whom any tax, or any other sum of money is payable under the Act.
Assessment Year means the period of 12 months commencing on the 1st day of April
every year. It is also called a financial year, but it immediately succeeds the relevant
previous year.
Cost Inflation Index for any Year means such index as the central government may,
having regard to 75% of average rise in the consumer price index for urban non-manual
employees for that year, by notification in the Official Gazette specify in this behalf.
Cost of Acquisition of an Asset means the value for which the asset was acquired by the
assessee. The expenses of capital nature for completing or acquiring the title to the property
are to be included in the cost of acquisition.
Depreciation means loss or decline in value, which occurs gradually over the useful life of
a material thing, due to physical wear, tear and decay, and is generally limited to losses or
declines in value which are not restored by current repairs and maintenance.
Gratuity denotes a gratuitous payment made by an employer to his/her employee for the
services rendered to him.
Long-term Capital Asset is a capital asset that is held for more than 36 months before the
date of its transfer.
Long-term Capital Gains means capital gain arising from the transfer of long-term capital
asset.
39
Pension is a periodical payment received by an employee after his/her retirement and is

taxed as salary.
Perquisite signifies some benefit in addition to the amount that may be legally due by way
of contract for the services rendered.
Previous Year means the financial year in which income earned is referred to as the
previous year. It also means the financial year immediately preceding the assessment year.
Recognized Provident Fund is a fund, which is recognized by the Commissioner of
Income Tax in accordance with the rules contained in Part A of the Fourth Schedule of the
Income Tax Act.
Short-term Capital Gain means capital gain arising on the transfer of a short-term capital
asset.
Dr. Singhania, V.K. and Dr. Kapil Singhania. Direct Taxes Law and Practice. 40th ed.
New Delhi: Taxmann Publications Pvt. Ltd., 2008.
Dr. Singhania, V.K. and Dr. Monica Singhania. Students Guide to Income Tax.
39th ed. New Delhi: Taxmann Publications Pvt. Ltd., 2008.
Dr. Singhania, V.K. and Dr. Monica Singhania. Direct Taxes Planning and
Management. 11th Ed. New Delhi: Taxmann Publications Pvt. Ltd., 2007.
Girish Ahuja, and Ravi Gupta. Direct Tax Laws and Practice. 17th Ed. New Delhi:
Bharat Law House Pvt. Ltd., 2008.

a.
The Income Tax Act, 1961 extends to whole of India. It came into on 1st April 1962.
b.
According to Section 2(9), assessment year means the period of 12 months starting from
April 1 of every year and ending on March 31 of the next year. Hence period from Jan
1st to December 31st cannot be considered as assessment year.
c.
Mr. X tax liability is

Income
Up to Rs.1,50,000
Rs.1,50,001 Rs.3,00,000
Rs.3,00,001 Rs.4,50,000
Cess @3%
Tax Rates
Nil
10%
20%
Nil
15,000
30,000
Total
45,000
1,350
46,350
40
a.
In the case of employees covered under Payment of Gratuity Act, 1972, the amount is
limited to 15 days salary, actual gratuity received or Rs.3,50,000 whichever is less.
Hence the monetary limit specified is Rs.3,50,000.
b.
50 percent of salary in case the residential house is situated at Mumbai, Delhi,

Kolkata, and Chennai.
c.
For the above purpose Reasonably expected rent means municipal valuation or fair
rent, whichever is higher subject to a maximum of standard rent under Rent Control
Act. In the case of Mr. Naidus let out Property though the fair value is Rs.1,10,000,
reasonable rent will be limited to Rs.95,000 (standard rent under Rent Control Act).
Direct Taxes
a.
House property held by X from March 10, 2006 to June 6, 2008 i.e., for 26 months
and 27 days is a short-term asset because the minimum period for which it should be
held to be a long-term asset is 36 months.
b.
Any sum paid on account of any tax levied on the profits or gains of any business or
profession is expressely disallowed as deduction under section 40(a). So, Rs.42,500
cannot be allowed as deduction.
c.
Sale consideration Rs.75,00,000

Less: Expenses on transfer (Rs.50,000)
Less: Indexed cost of acquisition (Rs.37,83,000)
(6,50,000 x 582/100)
Long-term capital gains Rs.36,67,000.
a.
Deduction under Section 80GG is least of the following:

i.
Rs.2,000 per month = Rs.24,000 per annum.
ii.
25% of total income (excluding long-term capital gains) i.e.,

Rs.2,30,000 x 25% = Rs.57,500.
iii. Excess of rent paid over 10% of total income (excluding long-term capital
gains)
= (Rs.3,500 x 12) (Rs.2,30,000 x 10%) = Rs.19,000.
Hence, deduction under Section 80GG is Rs.19,000.
b.
Ms. Latha can claim deduction of Rs.42,000 paid towards interest on loan under
Section 80E. Principle amount repaid on loan taken for education cannot be claimed
under Section 80E.
c.
Rs.15,000 or 33 1/3% of income in the nature of family pension under

Section 57(iia) whichever is less. Since the amount of Rs.15,000 is less than 33.33%
of Rs.1,00,000. Hence Rs.15,000 is allowed as deduction under the head of income
from other sources to Ms. Sheela.
a.
Any building or land appurtenant thereto hereinafter referred to as house, whether

used for residential or commercial purposes or for the purpose of maintaining a guest
house or otherwise including a farm house situated within twenty five kilometers from
local limits of any municipality whether known as municipality, municipal
corporation or by any other name or a cantonment board, but does not include any
house for residential or commercial purposes which forms part of stock-in-trade.
b.
The value of property is to be included in the net wealth of the husband Geet and not
in Geetas.
c.
Value of assets acquired by him out of money referred to in (i) and (iv) within one
year prior to the date of his return to India. Hence, in the above case the value of the
house will not be included as part of net wealth.
41

A. Multiple Choice
1.
2.
3.
4.
5.
Standard deduction under the head House property is:

a.
30% of gross annual value
b.
30% of net annual value
c.
33 1/3% of gross annual value
d.
33 1/3% of net annual value
e.
25% of income from house property.
According to Section 2(13), Business means:

a.
Trade
b.
Commerce
c.
Manufacture
d.
Adventure or concern in the nature of trade, commerce or manufacture
e.
All of the above.
Which of the following is not treated as a capital asset for the purpose of capital gains?
a.
Land and Buildings
b.
Plant and Machinery
c.
Goodwill of a Business
d.
Rural agricultural land in India
e.
Jewelry.
Identify the contribution which is not allowed as deduction under Section 80G?
a.
Interest on deposit with state housing board.
b.
Donations given to national defense fund.
c.
Donations given from non-taxable income.
d.
Both (b) and (c) of the above.
e.
Both (a) and (c) of the above.
Which of the following is not an asset u/s 2(ea) of The Wealth Tax Act, 1957?
a.
A commercial complex.
b.
A residential house.
c.
Jewelry.
d.
Cash in hand Rs.60,000.
e.
All of the above.
B. Descriptive
1.
What is an allowance? Briefly explain the taxability of various allowances under the
head Income from Salaries.
2.
What is a capital asset? What are the two kinds of capital assets?
3.
What are the assets exempt from wealth tax?
only.
42
Direct Taxes
Annexure
DIRECT TAXES CODE BILL HIGHLIGHTS
K.RAVI, BA, LLB, FCA,
Chairman, Central Taxes Committee, FKCCI
The Honourable Finance Minister released the draft Direct Taxes Code and the Discussion
paper on 12th August 2009. An attempt has been made to simplify the language to enable
better comprehension and to remove ambiguity to foster voluntary compliance.
1. PRELIMINARY
This Code shall be called the Direct Taxes Code, 2009
It extends to the whole of India.
It shall come into force on the 1st day of April, 2011; i.e. Financial Year 2011-12.
2. BASIS OF CHARGE
Residential Status: Only status of Non Resident and Resident of India exists.
The other status of resident but not ordinarily resident has been removed.
Total Income: Total Income to include income of any other person. Total Income to
include income of spouse, minor child etc. Also, the total income for a financial year
of any person shall not include any of the income.
3. COMPUTATION OF TOTAL INCOME
Classification of Sources of Income: For the purpose of computation of total income

of any person for any financial year, income from all sources shall be classified into :
a.
Income from Special sources are given no deduction and what is earned is taxed
directly.
The steps for computation of income from special sources are as under:
Step 1: Compute the income in respect of each of these special sources in
accordance with the provisions of the Fourth Schedule. The income so computed
with respect to each of such special sources shall be called current income from
the special source.
Step 2: Aggregate the current income from the special source with the
unabsorbed loss from that special source at the end of the immediate preceding
the financial year, if any. The result of such aggregation shall be the gross
income from the special source. If the result of aggregation is a loss, the gross
total income from the special source shall be nil and the loss will be treated as
the unabsorbed current loss from the special source, at the end of the financial
year. The gross total income from the special source shall be computed with
respect to each of the special sources.
Step 3: The gross total income from all such special sources and the result, of
this addition shall be the total income from special sources.
b.
Income from Ordinary sources are divided into further categories, namely:
1.
Income from employment (Presently called Salaries)
2.
3.
Income from Business

43
4.
Capital gains
5.
Income from Residuary Sources (Presently called other sources).
The steps for computation of income from ordinary sources are as under:
Step 1: Compute the income in respect of each of these sources. This could
either be income or loss (negative income). For example, if a person carries on
several businesses, the income from each and every such business will have to be
separately computed.
Step 2: Aggregate the income from all the sources falling within a head to arrive
at a figure of income assessable under that particular head. The result of such
computation may be a profit or loss under that head.
The aforesaid two steps will be followed to compute the income under each
head.
Step 3: Aggregate the income under all the heads to arrive at the current income
from ordinary sources.
Step 4: Aggregate the current income with the unabsorbed loss at the end of the
immediate preceding financial year, if any, to arrive at the gross total income
from ordinary sources. If the result of aggregation is a loss, the gross total
income from ordinary sources shall be nil and the loss will be treated as the
unabsorbed current loss from ordinary sources at the end of the financial year.
Step 5: Gross total income from ordinary sources, so arrived, will be further
reduced by incentives in accordance with sub-chapter I of Chapter III. The
resultant amount will be total income from ordinary sources.
Amount not Deductible where Tax is not Deducted at Source: Any amount on
which tax is deductible at source under Chapter XI during the financial year shall not
be allowed as a deduction in computing the total income if:
a.
the tax has not been deducted during the financial year; or
b.
the tax, after such deduction, has not been paid during the financial year, or in
the subsequent year, before the expiry of the time prescribed under sub section
(1) of Section 198.
However, the provision of sub section (1) shall not apply, if the tax has been
deducted during the last quarter of the financial year and the tax is paid before
the due date of filing the return of tax bases.
4. INCOME FROM EMPLOYMENT
44
Income from employment will be the gross salary on due or receipt basis, whichever
is earlier including value of perquisites and profits in lieu of salary as reduced by the
aggregate amount of the following permissible deduction:
a.
Professional Tax paid;
b.
Transport Allowance to the extent prescribed;
c.
Prescribed Special Allowance or benefit to meet expenses wholly and

exclusively incurred in the performance of duties, to the extent actually incurred;
d.
Compensation under Voluntary Retirement Scheme
e.
Amount of gratuity received on retirement or death;
f.
Amount received on commutation of Pension; and
g.
Pension received by gallantry awardees.
Direct Taxes
The value of rent free accommodation will be determined for all employees in the
same manner as is presently determined in the case of employees in the private sector.
All perquisites to be included in Salary Income.
There is no deduction on HRA and medical reimbursement.
5. INCOME FROM HOUSE PROPERTY
Income from house property, which is not occupied for the purpose of any business or
profession by its owner, will be taxed under the head Income from house property.
The income from property shall include income from the letting of any buildings
along with any machinery, plant, furniture or any other facility if the letting of such
building is inseparable from the letting of the machinery, plant, furniture or facility.
No deduction in respect of municipal taxes and interest for self occupied house whose
gross rent is taken as Nil.
Only Let out properties are considered and the Gross rent and specified deductions are
allowed. The Income from house property shall be the gross rent less specified
deductions.
The following deduction will be admissible against the gross rent:a.
Amount of taxes levied by a local authority and tax on services, if actually paid.
b.
Twenty per cent of the gross rent towards repairs and maintenance
c.
Amount of any interest payable on capital borrowed for the purpose of acquiring,
constructing, repairing, renewing or re-constructing the property.
6. INCOME FROM BUSINESS
Every business will constitute a separate source and, therefore, income will be
computed separately for each business.
A business will be treated as distinct and separate from another business if there is no
interlacing or independence or unity embracing the two businesses.
The computation of income from business under the Code will be based on the
income-expenses model where the taxable income under this head will be equal to
gross income minus allowance deductions.
Indefinite carry forward of business losses to be allowed.
7. CAPITAL GAINS
Income from transactions in all investment assets (i.e. any capital asset other than
business capital asset) will be computed under the head Capital Gains.
The present distinction between short term investment asset and long term investment
asset on the basis of the length of holding of the asset will be eliminated.
The Securities Transaction Tax will be abolished. Therefore, all capital gains (loss)
arising from the transfer of equity shares in a company or units of an equity oriented
fund will form part of the computation process.
8. INCOME FROM RESIDUARY SOURCES
The gross residuary income will comprise of any income which does not from part of
any other head of income.
Any amount exceeding Rs.20,000 taken or accepted or repaid as loan or deposit

otherwise than by account payee cheque or draft shall be deemed to be income from
residuary sources and taxed accordingly.
45
Any sum received under Life Insurance Policy, including any bonus, shall be exempt
from Income Tax, provided it is a pure life insurance policy (i.e. the premium payable
for any of the years during the terms of the policy does not exceed 5 percent of the
capital sum assured). Consequently, in all other cases, the sum received under the
policy, including any bonus, will be taxed as income from residuary sources.
9. EET METHOD OF TAXING SAVINGS
The Code proposes to introduce the Exempt-Exempt-Taxation method of taxation of

savings.
Only new contributions on or after the commencement of this Code will be subject to
the EET method of taxation.
An individual or HUF will also be allowed deduction for amount paid towards tuition
fees for children. The aggregate amount of deduction for payment into the account
maintained with any permitted savings intermediary and for tuition fees shall not
exceed Rs. 3 Lakhs.
10. TAX INCENTIVES
Major Deductions applicable under the Tax Incentives for an individual are:
a.
Investments through PFRDA approved agencies
b.
Payment of tuition fees
c.
Medical treatment
d.
Health insurance
e.
Donations
f.
Interest on loan taken for higher education
g.
Maintenance of a disabled dependant
h.
Interest income on Government Bonds.
Earlier terms Deductions under Chapter VI A will be treated as Tax incentives.
Medical treatment, higher education loan interest, donation and rent paid by
selfemployed individual are deductible.
New provision comes for Handicapped individuals to get deductions upto Rs.75,000.
11. TAXATION OF COMPANIES
Dividend Distribution Tax (DDT) to be retained. Dividends which suffered DDT to be

tax-free in shareholders hands.
The Code provides for Minimum Alternate Tax calculated with reference to the value
of the gross assets. The shift in the MAT base from book profits to gross assets will
encourage optimal utilization of the assets and thereby increase efficiency.
The rate of MAT will be 0.25 percent of the value of gross assets in the case of
banking companies and 2 percent of the value of gross assets in the case of all other
companies. Under the code, MAT will be a final tax. Hence, it will not be allowed to
be carried forward for claiming tax credit in subsequent years.
12. WEALTH TAX

The Code proposes to tax net wealth in the following manner:
46
Wealth-tax will be payable by an individual, HUF and private discretionary trusts.
Wealth-tax will be levied on net wealth on the valuation date i.e. the last day of the
financial year.
Direct Taxes
Net Wealth will be defined as assets chargeable to wealth-tax as reduced by the debt
owed in respect of such assets.
The net wealth of an individual or HUF in excess of Rs. 50 Crores will be chargeable
to wealth tax at the rate of 0.25 per cent.
The threshold limit of Rs. 50 Crores will not apply to a private discretionary trust.
13. NEW TAX RATES FOR INDIVIDUALS
In the case of every individual, other than women and senior citizen:
Slab
Income Between
0 - 1.60 Lakhs
1.60 Lakhs to 10 Lakhs
10%
10 Lakhs to 25 Lakhs
20%
Above 25 Lakhs
30%
0%
In the case of woman below the age of sixty five years at any time during the financial
year:
Slab
Tax Rate
Income Between
Tax Rate
0 - 1.90 Lakhs
0%
10%
20%
Above 25 Lakhs
30%
In the case of senior citizens:

Slab
Income Between
Tax Rate
0 - 2.40 Lakhs
0%
10%
20%
Above 25 Lakhs
30%
14. DUE DATE FOR FILING RETURNS OF TAX BASES

Sl. No
Type
Date
Non-Business / Non-Corporate
30th June
Others
31st August
First Filing
(under Direct Taxes Code)
30/06/2012
31/08/2012
15. OTHERS
The terms previous year and assessment year has been replaced with financial
year to eliminate confusion.
Income for the purposes of this Code will, in general, include all accruals and receipts
of revenue and capital nature unless otherwise specified.
Taxation for non-profit organizations rationalized.

Mutual Funds, Venture capital funds, Life Insurance Companies to be treated as
pass-thru entities.
47
Earlier Income Tax Act and Wealth tax Act (Covering Income Tax, TDS, DDT, FBT
and Wealth taxes) are abolished and single code of Tax, DTC in place.
Only status of Non Resident and Resident of India exists. The other status of
resident but not ordinarily resident has been removed.
Earlier the terminology of assessee was meant for the person who is paying tax and/or,
who is liable for proceeding under the Act. Now it has been added with 2 more
definitions namely a person, whom the amount is refundable, and/or, who voluntarily
files tax return irrespective of tax liability. This helps any person to file his returns and
maintain the record of tax return filing.
No changes in the system of Advance Tax, Self Assessment Tax and also TDS.
Amendment of TDS goes in line with earlier Notification 31/2009 which speaks of
Form 17/UTN/etc. In TDS, a new return, if found required, will be introduced for Non
TDS payments.
Government assessee is covered in Direct Tax Code. Even though they are not liable
for Income Tax/Wealth Tax, Government Assessees are required to Comply with
provision of TDS and TCS. (Current act was not covered with Government
Assessees).
General anti-avoidance rule introduced to combat tax avoidance.
Amalgamation and demerger provisions rationalized to allow for tax neutral business
reorganization.
Conclusion
To conclude, this code is broadly welcomed by the industry and the trade. However, there
are reactions on some points which are shown below:
Tax on interest on overseas borrowing is a negative factor and it may discourage

leveraging and reduce investment.
The proposal to apply MAT on Gross assets instead of book profit has come under
heavy criticism from industry because it is not a tax on income, which direct tax
should ideally be, but a tax on capital or assets. Also, because it is value of gross
assets, even loss making companies have to pay MAT.
MAT at 2% of gross assets is a very high rate.
The issue of MAT on financial companies has also come under criticism because
while MAT in the code for the Banking sector is set at 0.25%, it is at 2% for the
NBFCs (Non Banking Finance Companies).
Comments/feedback on the Direct Tax may be sent to FKCCI at dsm@fkcci.in
Source: Federation of Karnataka Chambers of Commerce and Industry, Bangalore, India.

www.fkcci.org/highlights_draft_direct09.pdf
48
UNIT 17 INDIRECT TAXES

Structure
17.1
Introduction
17.2
Objectives
17.3
Central Excise
17.3.1 Chargeability of Duty
17.3.2 Valuation of Excise Goods
17.3.3 Central Excise Procedures
17.3.4 Latest Amendments in Central Excise Act
17.4
Customs Duty
17.4.1 Nature of Duty
17.4.2 Valuation as per Customs Act
17.4.3 Dutiable Goods (Section 12)
17.4.4 Procedures for Import and Export of Goods
17.5
Service Tax
17.5.1 Chargeability
17.5.2 Valuation of Taxable Services (Section 67)
17.5.3 Service Tax Procedures
17.6
Value Added Tax (VAT)

17.6.1 Liability under VAT
17.6.2 VAT Procedures
17.7
Summary
17.8
Glossary
17.9

17.1 INTRODUCTION
As discussed in our earlier unit, the tax system in India has two important components. One
is Direct taxes and the other one is Indirect taxes. In our earlier unit, we have briefly
discussed the important provisions under the Income Tax Act, 1961 and provisions under
the Wealth Tax Act, 1957. Both these fall under the Direct tax category. In this unit, we
shall discuss the important provisions of indirect tax.
Indirect taxes are levied on a transaction and paid by a person by virtue of his involvement
in such transaction. The most important indirect taxes are the excise tax levied on the
manufacturers, sales tax levied on the sale of goods, service tax levied on rendering of
services, value added tax, a comprehensive tax levied on all sorts of transactions at retail,
wholesale or manufacturers level. In this unit, we shall discuss a few important provisions
pertaining to the Central Excise Act, 1944, the Sales Tax Act, 1935, the Customs Act,
1962, Value Added Tax and Service Tax.
17.2 OBJECTIVES
State the need, applicability and the various types of excise duties;
State the methodology for the valuation of excisable goods and the procedural aspects
pertaining to central excise;
Classify the various types of customs duties;
State the important provisions pertaining to exemption and valuation of goods for the
purpose of customs duty;
State the methodology for the valuation of services;
Discuss the procedural aspects pertaining to service tax; and
Discuss the important provisions under value added tax system.
17.3 CENTRAL EXCISE

Central excise is the duty that is collected on a product that is manufactured or produced in
India. It comes under indirect taxes as it is collected from the manufacturers or producers of
the goods. It is levied on every product that is manufactured or produced, irrespective of its
sale/realization of value. It is a duty that is levied on excisable goods that are
manufactured/produced in India. The levy of excise is connected only to the
manufacture/production of goods and is unrelated to the sale/realization of sale proceeds of
goods. It is governed by the Central Excise Act, 1944.
APPLICABILITY OF CENTRAL EXCISE
The power to levy central excise duties lies with the Central Government. Excise duties are
levied uniformly throughout the country and the duty rates/structure are governed through
the Tariff/Budget notifications.
The Central Government is vested with the power to levy excise duty by virtue of Entry 84,
List I, Schedule VII of the Constitution of India. However, the Central Government has no
power to impose duty on:
Alcoholic liquors for human consumption; and
Opium, Indian hemp and other narcotic drugs.
As alcoholic liquors, opium and other narcotic drugs found place in the States list, they are
eliminated from the Central Governments list.
TYPES OF EXCISE DUTIES
a.
Basic duty.
b.
Special duty of excise.
Basic Excise Duty: Basic excise duty (also termed as Cenvat as per Section 2A of CEA
added with effect from 12-5-2000) is levied at the rates specified in First Schedule to
Central Excise Tariff Act.
Special Duty of Excise: Some commodities like pan masala, cars etc., are leviable with
special duty which [Section 3(1)(b) of CEA] is levied at the rates specified in Second
Schedule to Central Excise Tariff Act.
50
Indirect Taxes
Excise Duty in case of Clearances by EOU: The EOU are expected to export all their
production. However, if they clear their final product in DTA (Domestic Tariff Area), the
rate of excise duty will be equal to customs duty on like article if imported into India.
[proviso to Section 3(1)]. Note that even if rate of customs duty is considered for payment
of duty, actually the duty paid by them is Central Excise Duty. The rate of customs duty is
taken only as a measure. The EOU can sell part of their final products in India at 50% of
customs duty or normal excise duty in certain cases.
National Calamity Contingent Duty: A National Calamity Contingent Duty (NCCD)
has been imposed vide Section 136 of Finance Act, 2001. This duty is imposed on pan
masala, chewing tobacco and cigarettes. It varies from 10% to 45%.
Duties under Other Acts: Some duties and cesses are levied on manufactured products
under other Acts. The administrative machinery of central excise is used to collect those
taxes. Provisions of Central Excise Act and Rules have been made applicable for levy and
collection of these duties/cesses.
Additional Duty on Goods of Special Importance: Some goods of special importance are
levied Additional Excise under Additional Duties of Excise (Goods of Special Importance)
Act, 1957.
Additional Duty on Textile Articles: Additional excise duty on certain textile and textile
articles like articles of silk/wool/cotton, man-made filaments, metallized yarn etc., is
imposed under Additional Duties of Excise (Textiles and Textile Articles) Act, 1978.
Duty on Medical and Toilet Preparations: A duty of excise is imposed on medical
preparations under Medical and Toilet Preparations (Excise Duties) Act, 1955.
Additional Duty on Mineral Products: Additional Duty on mineral products (like motor
spirit, kerosene, diesel and furnace oil) is payable under mineral products (Additional
Duties of Excise and Customs) Act, 1958.
Other Cesses: Cesses of excise duties are leviable on certain specified commodities under
various Acts. The products covered are, jute, automobile, sugar, vegetable oil, etc.
17.3.1 Chargeability of Duty

Section 3(1) of the Act states that They shall be levied and collected in such manner as
may be prescribed.
a.
Duty of excise on all excisable goods which are produced or manufactured in India as,
and at the rates, set forth in the first schedule to the Central Excise Tariff Act, 1985.
b.
A special duty of excise, in addition to the duty of excise specified in clause (a) above
on excisable goods specified in the second schedule to the Central Excise Tariff Act,
1985 which are produced or manufactured in India as and at the rates set forth in the
second schedule.
It is clear from Section 3(1) that in order to attract excise duty, the following conditions
need to be fulfilled:
a.
There should be goods;
b.
Such goods should be excisable goods; and
c.
Such goods should have been produced or manufactured in India.

51
GOODS
The Central Excise Act does not define the term goods. However, we shall look into the
meaning of goods as defined in the constitution and the Sale of Goods Act. The
Constitution defines goods in Article 366(12) as goods includes all materials, commodities
and articles. Under the Sale of Goods Act, goods have been defined as meaning every
kind of movable property (other than actionable claims and money) including crops,
grass and things attached to or forming part of the land which are agreed to be severed
before sale or under the contract of sale.
Basically, goods are classified into excisable goods and exempted goods for the purpose
of considering for levying excise duty. Depending upon the case laws and judicial
interpretations, goods for the purposes of levy of excise duty must satisfy two
preconditions their movability and marketability.
Movability: The goods must be movable. Thus, immovable property or property

attached to earth is not goods and hence duty cannot be levied on it. Various case
laws have reiterated that the word manufacture or production is associated with
being movable. On the other hand, immovable property like a building is constructed
and not manufactured or produced. For levying the excise duty the goods must fulfill
the following conditions:
i.
there should be goods;
ii.
such goods should be excisable goods; and
iii.
such goods should have been produced or manufactured in India.
Marketability: The item must be such that it is capable of being bought or sold.
This is the test of Marketability. The goods must be known in the market. Unless
this test of marketability is satisfied, duty cannot be levied as these will not be
goods. This is also termed as Vendibility Test. In a famous case, it was held that to
become goods an article must be something which can ordinarily come to market
to be bought and sold.
EXCISABLE GOODS
Having discussed the importance of goods being movable and marketable, let us now try to
understand the concept of excisable goods. Section 2(d) of the Central Excise Act, 1944
defines excisable goods as goods specified in the schedule to the Central Excise Tariff,
Act 1985 as being subject to a duty of excise.
It can thus be held that all those goods which are specified in the Tariff Schedule are
excisable goods. However, the question arises as to whether those goods which are
exempted from duty by a notification, but find a place in the tariff schedule are excisable
goods. The Allahabad Court held that goods exempted from duty were meant to be
removed from the Tariff Schedule and hence could not be treated as excisable goods.
Differing with this view, the Delhi, Andhra Pradesh and the Madras High Courts held
that fully exempted goods continued to be excisable goods. However, it was the Apex
Court decision in Wallace Flour Mills Limited vs. C.C.E (1989), which put to rest this
controversy. The Supreme Court held that even fully exempted goods are excisable goods
and will be liable to duty in case the exemption is withdrawn any time after manufacture
but before the removal of goods.
52
Indirect Taxes
MANUFACTURE AND MANUFACTURER

Once it is proved that the subject matter that comes up for assessment is excisable goods,
the question of manufacture arises. This is because as per Section 3, excise duty can be
levied on excisable goods that are manufactured or produced in India. Section 2(f) of the
Act defines manufacture to include any process:
a.
Incidental or ancillary to the completion of a manufactured product; and
b.
Which is specified in relation to any goods in the section or chapter notes of the
Schedule to the Central Excise Tariff Act, 1985, as amounting to manufacture.
Section 2(f) goes further and states that manufacturer, shall be construed accordingly and
shall include not only a person who employs hired labor in the production or manufacture
of excisable goods but also any person who is engaged in the production or manufacture on
his own account.
The inclusion of point (b) (as indicated above) in the definition of manufacture as given by
Section 2(f) took effect from 28.2.1986. Thus, the new definition has conferred legal
sanction upon deemed manufacture as well.
Points to be Noted
i.
Where a process is interlinked or connected to the manufacture of the final product it

will be said to be incidental or ancillary to the completion of the product. Such a
process will amount to manufacture no matter how inessential it is. On the other hand
where a process is not connected to the manufacture of the final product it cannot be
termed as incidental or ancillary.
ii.
The definition of manufacture as given by Section 2(f) would also mean that
manufacture can take place even at an intermediate stage provided the intermediate
product has a distinct character and is commercially identifiable as a different product.
iii.
In Khandelwal Metal & Engineering Works vs. Union of India, the Supreme Court
held that notwithstanding that waste and scrap arose as intermediate products,
chargeability to duty would arise if the waste/scrap was marketable. Thus, waste/scrap
would be chargeable to duty if it is marketable and is included in the tariff.
iv.
The phrase incidental and ancillary activities as contained in Section 2(f) also
includes packing activities. Packing is essential to put the final product in a
deliverable state. Even for the purpose of accounting in the statutory excise records,
goods in a packed state are taken into consideration. In other words, it is packing
which renders the final product marketable and hence the activity of packing can be
construed as manufacture.
CENTRAL EXCISE TARIFF ACT (CETA)

The excise duty payable on excisable goods is dependent on the rate of duty that is
indicated in the Tariff. The classification of goods assumes significance when it is
necessary to determine the rate applicable to a particular good. This would involve
identifying the headings and sub-headings of the Tariff under which the said goods are
covered. Classification is also important when eligibility to exemptions needs to be
determined.
Prior to 28th February, 1986, the duty was charged at rates indicated by the First Schedule
to the Central Excise Act, 1944. The Tariff Schedule was removed from the Act.
Subsequently since it led to lot of complication. In its place a new Tariff Schedule based
on the Harmonized System of Nomenclature (HSN) was brought into force under an
independent enactment called the Central Excise Tariff Act, 1985.
53
Features of the New Tariff

One of the distinguishing features of the new tariff is that it adopts the principles of
classifying all goods of a kind, beginning with the raw materials and ending with the
finished products within the same chapter. The new tariff is designed to group all goods
relating to the same industry and all goods obtained from the same raw material under one
chapter in a progressive manner.
The Central Excise Tariff Schedule consists of 96 Chapters, grouped into twenty sections.
Each of these sections relate to a broad class of goods. Each section has been divided into
various chapters and each chapter contains goods of a particular class. Each chapter has
been further divided into various headings, depending upon the different types of goods
belonging to the same class of products.
17.3.2 Valuation of Excisable Goods

BASIS OF CALCULATION OF DUTY PAYABLE
Excise duty is payable on one of the following basis:
a.
Specific duty.
b.
Duty as % of tariff value fixed under Section 3(2).
c.
Duty based on maximum retail price.
d.
Duty as % based on assessable value fixed under Section 4 (ad valorem duty).
Specific Duty
It is the duty payable on the basis of certain unit like weight, length, volume, thickness etc.
For example, duty on Cigarette is payable on the basis of length of the Cigarette, duty on
sugar is based on per kg. basis etc. The calculation of duty payable is comparatively simple
and easy. However, the disadvantage is that even if selling price of the product increases,
revenue earned by Government does not increase correspondingly. Frequent revision of
rates have to be done, which is a slow and time consuming process. Presently, specific
duties are in vogue for:
a.
Cigarettes (length basis),
b.
Matches (per 100 boxes/packs),
c.
Sugar (per quintal basis),
d.
Marble slabs and tiles (square meter basis),
e.
Color TV when MRP is not marked on the package or when MRP is not the sole
consideration (on the basis of screen size in cms.),
f.
Molasses resulting from extraction of sugar (per ton basis).
Tariff Value
In some cases, tariff value is fixed by Government from time to time. This is a Notional
Value for purpose of calculating the duty payable. Once Tariff Value for a commodity is
fixed, duty is payable as percentage of this Tariff Value.
Value based on Retail Sale Price
Section 4A of The Central Excise Act, 1944, empowers Central Government to specify
goods on which duty will be payable based on retail sale price. The provisions are as
follows:
i.
54
The goods should be covered under provisions of Standards of Weights and

Measures Act.
Indirect Taxes
ii.
Central Government can permit reasonable abatement (deductions) from the retail
sale price. While allowing such abatement, Central Government shall take into
account excise duty, sales tax and other taxes payable on the goods.
iii.
If more than one retail sale price is printed on the same packing, the maximum of
such retail price will be considered.
iv.
The retail sale price should be the maximum price at which excisable goods in
packaged forms are sold to ultimate consumer. It includes all taxes, freight, transport
charges, commission payable to dealers and all charges towards advertisement,
delivery, packing, forwarding charges etc.
v.
Central Government has to issue a notification in Official Gazette specifying the

commodities for which the provision is applicable and the abatements permissible.
Ad valorem Duty
Central Excise is payable on the basis of value. This is called ad valorem duty. The
assessable value is arrived at on the basis of Section 4 of the Central Excise Act and duty
is payable on the basis of such value.
TRANSACTION VALUE SECTION 4
As per the new Section 4, excise duty is payable on the basis of transaction value, if the
goods are sold at the factory gate to an unrelated buyer when price is the sole consideration.
If these requirements are not satisfied, valuation will be done as per Valuation Rules.
Under Section 4(3)(d), Transaction Value means the price actually paid or payable for the
goods, when sold, and includes in addition to the amount charged as price, any amount that
the buyer is liable to pay to, or on behalf of, the assessee, by reason of, or in connection
with the sale, whether payable at the time of the sale or at any other time, including but not
limited to, any amount charged for, or to make provision for, advertising or publicity,
marketing and selling organization expenses, storage, outward handling, servicing,
warranty, commission or any other matter; but does not include the amount of duty of
excise, sales tax and other taxes, if any, actually paid or actually payable on such goods.
INCLUSIONS IN TRANSACTION VALUE
Packing Charges: Cost of normal packing will be covered, if it is in connection with or in
respect of sales. In Union of India vs. Godfrey Philips Limited (1985), it was held that only
that packing which was essential to put the goods in a marketable state would be included
in the assessable value.
Warranty Charges: If any assessee recovers warranty charges for any goods in a particular
transaction, the warranty charges so recovered will be included in the transaction value for
such goods, for the purpose of payment of duty.
Advertisement Charges: If an assessee recovers advertising charges or publicity charges
from his buyers, or the dealer incurs any expenditure on advertising or publicity of goods
on behalf of the assessee, either at the time of sale of goods or even subsequently, such
charges or expenditure would be included in the transaction value.
EXCLUSIONS FROM TRANSACTION VALUE
Excise Duties, Sales Taxes and other Levies: Section 4(3)(d)(ii) states that the transaction
value in relation to any excisable goods does not include the amount of the duty of excise,
sales tax and other taxes, if any, payable on such goods.
Trade Discounts: A trade discount refers to a deduction from the regular catalogue price
allowed by a manufacturer to a dealer. As per Section 4(3)(d)(ii), trade discount will be
permitted as a deduction from the assessable value provided it is allowed in accordance
with normal practice, and is not refundable.
55
Quantity Discounts: It is not essential that a trade discount should always be in the form of
money. It can also be in the shape of goods. It is similar to a money discount as it has the
effect of reducing the price charged to the buyer. A quantity discount is an acceptable form
of discount and should be deducted from the assessable value.
Cash Discounts: A cash discount refers to a deduction given in the price charged to the
buyer when 100% payment is made in cash at the time of taking delivery. On the other
hand a prompt payment discount is one where the buyer gets a reduction in the price,
provided payment is made within a specified period.
Freight Charges: Where, in relation to any excisable goods the price thereof for delivery at
the place of removal is not known and the value thereof is determined with reference to the
price for delivery at a place other than the place of removal, the cost of transportation from the
place of removal to the place of delivery shall be excluded from such price [Section 4(2)].
Loading and Unloading Charges: Where loading and unloading charges are incurred by the
manufacturer outside the place of removal of the goods, such charges will be reduced from
the price to ascertain the assessable value. However, if such charges are incurred prior to
the removal of goods from the factory premises, no deduction can be claimed.
Depot and Other Expenses: Depot expenses are in no way connected with manufacture and
hence such expenses are not included in the assessable value.
TIME AND PLACE OF REMOVAL
The term place of removal is defined by Section 4(4)(b). Prior to the amendment made by
the Finance (No.2) Act, 1996, place of removal was the factory or the warehouse.
However, it now includes a depot, premises of a consignment agent or any other place or
premises from where the excisable goods are to be sold after clearance from the factory.
Thus the ex-factory price or the factory gate wholesale price is the basis for determining the
assessable value.
RELATED PERSONS
Where excisable goods are sold to related persons, the price at which such goods are sold
will not be considered as the assessable value. A related person is one who is so associated
with the assessee that they have interest directly or indirectly in the business of each other.
A related person is of an inclusive nature and includes the following within the category
of related person:
a.
Holding company.
b.
Subsidiary company.
c.
A relative and a distributor.
d.
A sub-distributor.
PRICE BEING THE SOLE CONSIDERATION FOR THE SALE

It should be noted that even though the assessee and the buyer are not related persons, the
price charged may not be acceptable as assessable value if it is not the sole consideration
for the sale.
DETERMINATION OF ASSESSABLE VALUE WHEN SECTION 4(1)(A) IS NOT
APPLICABLE
When the assessable value is not capable of being ascertained under Section 4, then it
should be determined as Central Excise Valuation Rules, 2000. Thus, the valuation rules
will come into force if the selling price is not acceptable as the assessable value or where
there is no selling price (i.e., goods have been captively consumed).
56
Indirect Taxes
Given below is an extract of the Valuation Rules:

Explanation to Rules 4 to 11
Rule 4
The value of the excisable goods shall be based on the value of such goods sold by the
assessee for delivery at any other time nearest to the time of the removal of goods under
assessment, subject, if necessary, to such adjustment on account of the difference in the
dates of delivery of such goods and of the excisable goods under assessment, as may appear
reasonable to the proper officer.
Rule 5
Section 4 provides that where the goods are sold from the place of removal (factory gate),
the actual price charged by the manufacturer to the buyer for such sale for each removal of
goods shall form the assessable value of the goods (Transaction Value). However, where
the goods are sold from a place other than the factory gate, then the price charged to the
buyer shall be considered as the value of the goods (Transaction Value).
Rule 6
This rule states that when the price is not the sole consideration for sale, the value of such
goods shall be deemed to be the aggregate of such transaction value and the amount of
money value of any additional consideration flowing directly or indirectly from the buyer
to the assessee. This implies that where any additional consideration is flowing directly or
indirectly from the buyer to the assessee over and above the price charged by the assessee
for such sale, the money value of such additional consideration shall be added, to the
transaction value to arrive at the value on which duty is charged.
There is also an explanation to the above rule, which provides that where goods and
services have been provided by the buyer either free of cost or at a reduced cost, for use in
connection with the production and sale of such goods, an appropriate apportioned value of
such goods and services provided by him to the manufacturer shall be treated to be the
amount of money value of additional consideration flowing directly or indirectly, in
relation to the sale of excisable goods.
Rule 7
When the goods are sold through depot, there is no sale at the time of removal from the
factory. In such cases, the price prevailing at the depot, at the time of removal from the
factory shall be the basis of assessable value. The assessable value for the purpose of duty
shall be the normal transaction value of such goods sold from the depot at the time of
removal or at the nearest time of removal from the factory.
Rule 8
This rule deals with a situation where the excisable goods are used for captive
consumption. Captive consumption means goods are not sold but consumed within the
factory. Where the goods are not sold but are used within the factory, the valuation shall be
done on the basis of the cost of production plus fifteen percent. This rule may also be
applied when the goods are sold to related persons and where the goods are not sold but
are consumed for captive consumption by such related person in his factory, then as per
Rule 8, the valuation shall be done on the cost of production or manufacture plus 15%.
57
Rule 9
The above rule deals with a situation where the excisable goods are sold by the assessee to
or through related persons. The price at which such related persons make the sale to an
independent buyer will be the Assessable Value. In case where such goods are sold by
such related person to another person who is related to him, the normal transaction value of
the goods at which the goods are sold by such related person to an independent buyer shall
be the Assessable Value.
Rule 10
This rule provides that where the goods are sold by the assessee to an interconnected
undertaking, the assessable value of such goods shall be the normal transaction value of
such goods sold by the said interconnected undertaking. However, where the interconnected
undertaking is related in a manner they have interest, directly or indirectly in the business
of each other, then the value shall be determined as prescribed in Rule 9.
Rule 11
This rule states that if assessment is not possible under any of the foregoing rules, it will be
done using reasonable means consistent with the principles and general provisions of these
rules and sub-section (1) of Section 4 of the Act.
For example, there are certain situations such as in the case:
a.
Of job-work.
b.
Where the assessee makes the sale partly to related persons and partly to others.
c.
When inputs or capital goods are cleared from factory but there was no sale.
d.
For any other purpose to another unit for further manufacture, for the purpose of
supply under warranty claims, for repairs or for any other reason.
e.
Where goods are produced on behalf of the loan license holder.
No method of valuation has been provided either under the above rules and the provisions
of sub-section (1) of Section 4, then in all such cases the valuation can be done under Rule 11.
EXEMPTION FROM EXCISE DUTY
The introduction of Section 5A in the Central Excise Act, 1944 has empowered the
government to reduce the rates of duty from what the statutory rates are. This power will
thus originate from a statutory provision itself and not from a rule.
The Central Government is authorized to exempt any excisable goods from the whole of the
excise duty prescribed or from a part of it. Such power is conferred upon it by Section
5A(1). Where the whole of the duty is exempted, it is referred to as total exemption, while
in the latter case, it is referred to as partial exemption.
The exemptions given may be either specific exemptions or general exemptions. Where
goods falling under a particular heading in the tariff and attracting a specific rate of duty are
given relief, such exemption is known as specific exemption. On the other hand a general
exemption is that exemption whose coverage extends to goods falling in several chapters
in the tariff.
Exemptions (whether specific or general) may be either straight or conditional exemptions.
Where no conditions are attached to the availment of the exemption, it is known as straight
exemption. Where certain conditions need to be fulfilled before the exemption can be
availed, such exemption is known as a conditional exemption.
58
Indirect Taxes
17.3.3 Central Excise Procedures

The Central Excise Rules, 1944 contained all provisions pertaining to all the aspects of
procedures. These procedures prescribed under the Central Excise Rules, 1944, have
considerably been simplified. New rules with effect from 1.3.2002 were framed to replace
the earlier rules.
CENTRAL EXCISE RULES, 2002
Some procedures are basic, which every assessee is required to follow. Besides, some
procedures are required to be followed as and when required.
Basic Procedures
i.
Every person who produces or manufactures excisable goods, is required to get

registered, unless exempted. [Rule 9 of the Central Excise Rules, 2002]. If there is any
change in information supplied in form A-1, the same should be supplied in form A-1.
ii.
Manufacturer is required to maintain the Daily Stock Account (DSA) of goods

manufactured, cleared and in stock. [Rule 10 of the Central Excise Rules, 2002].
iii.
Goods must be cleared under the invoice of assessee, duly authenticated by the owner
or his authorized agent. In case of cigarettes, invoice should be countersigned by the
Excise Officer. [Rule 11 of the Central Excise Rules, 2002].
iv.
Duty is payable on monthly basis through TR-6 challan/CENVAT credit. [Rule 8].
Manufacturers of matches have to pay duty by affixing the Central Excise Stamps.
[Rules 13 and 14 of the Central Excise Rules, 2002].
v.
CENVAT records and return by 5th of the following month [CENVAT Credit Rules,
2001].
vi.
Monthly return in form ER-1 should be filed by 10th of the following month. [Rule
17(3) of the Central Excise Rules, 2002] [EOU/EPZ/STP units to file return in form
ER-2].
vii. Every assessee is required to submit a list in duplicate of records maintained in respect
of the transactions of receipt, purchase, sales or delivery of goods including inputs and
capital goods [Rule 22(2)].
viii. Inform the change in boundary of premises, address, name of authorized person,
change in name of partners, directors or Managing Director in form A-1.
These are the core procedures which each assessee has to follow:
Procedures which are not Routine
a.
Export without payment of duty or under claim of rebate [Rules 18 and 19 of the
Central Excise Rules, 2002].
b.
Receipt of goods for repairs/reconditioning [Rule 16 of the Central Excise Rules,

2002].
c.
Receipt of goods at concessional rate of duty for manufacture of excisable goods.
d.
Payment of duty under the compounded levy scheme.
e.
Provisional assessment [Rule 7 of the Central Excise Rules, 2002].
f.
Warehousing of goods.
g.
Appeals and settlement.

59
Following changes have been made in Central Excise Rules, 2002 w.e.f. 1-3-2007:
i.
Payment of Amount by 5th /15th of Following Month: An explanation has been

inserted in Rule 8 to provide that for the purposes of this rule, the expressions duty
or duty of excise shall also include the amount payable in terms of the CENVAT
Credit Rules, 2004. Therefore, all amount payable like payment under Rule 6(3) of the
CENVAT Credit Rules, 2004 etc., can be paid along with duty payable by 5th or 15th
of the next month.
ii.
Mandatory E-payment if Annual Excise Duty Exceeds Rs.50 Lakh: Rule 8 has
been amended to make e-payment mandatory for payment of duty by all assessees
who have paid excise duty of Rs.50 lakh or more in cash during the preceding
financial year. This provision would come into effect from 01-04-2007.
iii.
Invoice to Contain Address of Jurisdictional Central Excise Division: Rule 11(2)

has been amended to provide that the invoice shall also contain address of the
jurisdictional Central Excise Division to be a legally valid document. This change will
come into force from 01.04.2007.
iv.
Powers of Granting Remission of Duty Enhanced: Powers of granting remission

from duty under Rule 21 of Central Excise Rules has been enhanced.
Quantum of Remission
Less than Rs.10,000
Authority to Grant Remission

Superintendent
(present limit is Rs.1,000).
Between Rs.10,000 and Rs.1,00,000
Deputy Commissioner
(present limit Rs.2,500).
Between Rs.1,00,000 and Rs.5,00,000 Joint/Additional Commissioner

(present limit Rs.5,000).
Exceeds Rs.5,00,000
v.
Commissioner.
Penalty Provisions: Minimum penalty has been reduced from Rs.10,000 to Rs.2,000.
Rule 26(2) has been inserted to provide for penal action against the person who issues
CENVAT invoices without delivery of goods mentioned therein and also against the
person who is involved in fabricating Central Excise documents or any other
document like shipping bill, bill of lading, etc., based on which the user of said
document is likely to take or has taken any ineligible benefits like CENVAT credit,
refund, etc.
vi.
Chief Commissioner can Transfer case to another Commissioner: Notification

11/2007-CE(NT) dated 1-3-2007 empowers Chief Commissioner of Central Excise to
transfer any case for adjudication to another Commissioner. It is not necessary that
another Commissioner should be within his jurisdiction.
CENVAT CREDIT RULES, 2004

Highlights of CENVAT Scheme are as follows:
Credit of Duty Paid on Input
The CENVAT scheme is principally based on the system of granting credit of duty paid on
inputs and input services. Under CENVAT, a manufacturer has to pay duty as per normal
procedure on the basis of Assessable Value (which is mainly based on selling price).
However, he gets credit of duty paid on inputs and input services.
60
Indirect Taxes
Inputs Eligible for CENVAT

Credit will be available for duty paid on:
a.
Raw materials (excluding few items).
b.
Material used in relation to manufacture like consumables, etc.
c.
Packaging materials.
d.
Paints.
Inputs should be used in or in Relation to Manufacture

CENVAT credit is available only on inputs used in or in relation to the manufacture of a
final product.
Input may be used Directly or Indirectly
The input may be used directly or indirectly in or in relation to manufacture. The input need
not be present in the final product.
No Credit on Hsd and Petrol
Duty paid on high speed diesel, light diesel oil and motor spirit (petrol) is not available as
CENVAT credit, even if these are used as raw materials.
No Credit if Final Product is Exempt from Duty
No credit is available if the final product is exempt from duty or final service is exempt
from service tax Rule 6(1) of CENVAT Credit Rules, 2002 [earlier, Rule 57AD(1)]. If a
manufacturer manufactures more than one product, it may happen that some of the products
are exempt from duty. In such cases, duty paid on inputs used for manufacture of exempted
products cannot be used for payment of duty on other products which are not exempt from
duty. However, if the manufacturer uses common inputs both for exempted as well as unexempted goods, he has to pay an amount of 10% of the price of exempted goods.
Credit on the basis of Specified Documents
Credit is to be availed only on the basis of specified documents as proof of payment of duty
on inputs or tax on input services.
Credit Available Instantly
Credit of duty on inputs can be taken up instantly, i.e., as soon as inputs reach the factory.
In case of capital goods, 50% credit is available in the current year and balance 50% in the
subsequent financial year. In case of input services, credit is available only after the amount
of bill is paid to the person who provided the service.
No Cash Refund
In some cases, it may happen that duty paid on inputs may be more than duty payable on
final products. In such cases, though the CENVAT credit will be available to the
manufacturer, he cannot use the same and the same will lapse. There is no provision for
refund of the excess CENVAT credit. However, the only exception is in case of exports
where duty paid on input material used for exported goods is refundable. Other exception
is tribunal can order, when CENVAT credit cannot be availed due to fault/wrong action
of the department.
61
One to One Correlation not Required

CENVAT rules do not require input-output correlation to be established.
CENVAT on Capital Goods
Credit of duty paid on machinery, plant, spare parts of machinery, tools, dies, etc., is
available. 50% credit is available in the current year and the balance 50% in the subsequent
financial year.
CENVAT available only if there is Manufacture
CENVAT on inputs or input services is available only if the process amounts to
manufacture. Otherwise, CENVAT is not available. [In fact, in such cases, no duty is
payable on the final product and the question of CENVAT does not arise at all].
CENVAT Credit is Indefeasible
In CCE vs. Dai Ichi Karkaria Ltd. 1999 (112), it was held that CENVAT credit validly
taken is indefeasible. It was also observed that correlation between the final product and
raw materials is not required in the CENVAT scheme.
OTHER PROVISIONS PERTAINING TO CENTRAL EXCISE ARE CONTAINED IN
Central Excise (Appeal) Rules, 2001.
Central Excise (Settlement of Cases) Rules, 2001.
Central Excise (Removal of Goods & Concessional Rate of Duty for Manufacture of
Excisable Goods) Rules, 2001.
17.3.4 Latest Amendments in Central Excise Act

The Central Government has amended the Central Excise Act, 1944 through the Finance
Bill, 2005. The following are the major changes:
Changes with Respect to SSI:
Increase in Limit for Determining Eligibility for the Exemption: With effect from
1.04.2005, the value of clearances in the preceding financial year, for determining
eligibility for the exemption, is increased to Rs.4 crore from Rs.3 crore.
Exemption Withdrawn: With effect from 1.4.2005, exemption scheme of concessional
rate of 60% of normal rate with CENVAT credit up to clearances of Rs.1 crore has been
withdrawn.
Declaration required by SSI: Small Scale Industrial units whose turnover exceeds
Rs.40 lakh per annum have to give a declaration in prescribed form.
Insertion of Rule 12AA: Rule 12AA has been inserted after Rule 12 vide Notification No.
12/2005 CE (N.T.), dated 01.03.2005 to prescribe a special procedure for this purpose.
Under this procedure, the duty liability, accountability and responsibility for complying with
the excise procedures would be on the person who gets the articles of jewelry manufactured
on job-work. The job-worker, however, at his option, can also undertake to comply with the
excise law and pay duty.
62
Indirect Taxes
a.
The Central Government would like to impose excise duty on alcoholic liquor for
household consumption. Can they do? Justify.
..
..
..
b.
Mr. Pradeep a manufacturer of iron and steel rods is of the opinion that steel scrap
is not chargeable to excise duty. Is he correct? Justify.
..
..
..
c.
Duty on cigarette is payable on the basis of length of the cigarette and not on the
value. What class of duties does this fall under?
..
..
..
17.4 CUSTOMS DUTY

Customs duty is another part of the indirect taxes. This duty is collected by the Central
Government on every product that is exported or imported from India. This duty is
governed by the Customs Act, 1962. This duty is levied as a percentage on the assessed
value of the product that is exported or imported from India.
Customs duty is applicable equally to all over India at the time of importing or exporting
the goods in India. Customs duty is applicable on transporting of goods by land, air and
water, including the Indian Territorial Waters. Indian Territorial Waters spread around
12 nautical miles from the sea coast of India. The jurisdiction of the Customs authorities
extends up to border of Indian waters. If they found any illegal transit is going on, the
authorities have powers to search, confiscate, arrest and even shoot out the vessel if it is
not stopped.
RESTRICTIONS ON IMPORTS AND EXPORTS
Section 11 of the Customs Act, 1962 gives power to the Central Government to prohibit
import or export of goods of specified description, by notification in the Official Gazette,
for certain purposes. The purposes for which such prohibitions can be made are provided in
sub-section (2) of Section 11 of the Act, which are as follows:
a.
The maintenance of the security of India;
b.
The maintenance of public order and standards of decency or morality;
c.
The prevention of smuggling;
d.
The prevention of shortages of goods of any description;
e.
The conservation of foreign exchange and safe-guarding of balance of payments;
f.
The prevention of injury to the economy of the country by the uncontrolled import or
export of gold or silver;
63
g.
The prevention of surplus of any agricultural product or fisheries;
h.
The maintenance of standards for the classification, grading or marketing of goods in

international trade;
i.
The establishment of any industry;
j.
The prevention of serious injury to domestic production of goods of any description;
k.
The protection of human, animal or plant life or health;
l.
The protection of national treasures of artistic, historic or archaeological value;
m.
The conservation of exhaustible natural resources;
n.
The protection of deceptive practices;
o.
The carrying on of foreign trade in any goods by the State, by a corporation owned or
controlled by the State to the exclusion, complete or partial, of the citizens of India;
p.
The fulfillment of obligations under the Charter of the United Nations for the
maintenance of international peace and security;
q.
The implementation of any treaty, agreement or convention with any country;
r.
The compliance of imported goods with any laws which are applicable to similar
goods produced or manufactured in India;
s.
The prevention of dissemination of documents containing any matter which is likely

to prejudicially affect friendly relations with any foreign state or is derogatory to
national prestige;
t.
The prevention of the contravention of any law for the time being in force; and
u.
Any other purpose conducive to the interest of the general public.
17.4.1 Nature of Duty

It is a complete code that provides machinery for dealing effectively with the problems
relating to levy and collection of duties. The rapid development of science and technology
and the consequent industrial development and expansion of manufacturing as well as
trading activities necessitated further reform and legislation. Thus the Customs Tariff Act,
1975 passed the recommendations of the Tariff Revision Committee in favor of adoption of
Harmonized System of Nomenclature (HSN) to keep pace with the changing pattern of
international trade. It contains two Schedules. Schedule I gives classification of goods and
rates of duty as to imports, while Schedule II is concerned with classification of goods and
rates of duty in case of exports.
The objective of levying customs duty is:
64
To restrict imports to preserve foreign exchange.
To protect Indian Industry from undue competition.
To prohibit imports and exports of goods for achieving the policy objectives of the
Government.
To regulate exports.
To co-ordinate legal provisions with other laws dealing with foreign exchange such as
Foreign Trade (Development & Regulation) Act, Foreign Exchange Management Act,
Conservation of Foreign Exchange Prevention of Smuggling Act, etc.
Indirect Taxes
TYPES OF CUSTOMS DUTIES

The following are the various types of duties that are levied during importation and
exportation of goods:
Basic Customs Duty
This is the duty levied under Section 12 of Customs Act, 1962.
Normally, it is levied as a percentage of value as determined under Section 14(1). Peak
rate of duty on most non-agricultural products has been reduced from 12.5% to 10%
w.e.f. 1-3-2007.
Additional Customs Duty (CVD)
This is often called Countervailing Duty (CVD). Additional duty is levied under Section
3(1) of Customs Tariff Act. This duty is imposed when excisable articles are imported, in
order to counter balance the excise duty, which is leviable on similar goods if manufactured
within the State.
Protective Duties
If the Tariff Commission recommends and Central Government is satisfied that immediate
action is necessary to protect interests of Indian industry, protective customs duty at the rate
recommended may be imposed under Section 6 of Customs Tariff Act.
Countervailing Duty on Subsidized Goods
If a country pays any subsidy (directly or indirectly) to its exporters for exporting goods to
India, Central Government can impose Countervailing duty upto the amount of such
subsidy under Section 9 of Customs Tariff Act.
Anti-Dumping Duty on Dumped Articles
Often, large manufacturer from abroad may export goods at very low prices compared to
prices in his domestic market. Such dumping may be with intention to cripple domestic
industry or to dispose of their excess stock. This is called dumping. In order to avoid such
dumping, Central Government can impose, under Section 9A of Customs Tariff Act, antidumping duty upto margin of dumping on such articles, if the goods are being sold at less
than its normal value. Levy of such anti-dumping duty is permissible as per WTO
agreement. Anti-dumping action can be taken only when there is an Indian industry
producing like articles.
Safeguard Duty
Central Government is empowered to impose safeguard duty on specified imported goods
if Central Government is satisfied that the goods are being imported in large quantities and
under such conditions that they are causing or threatening to cause serious injury to
domestic industry.
With effect from 11-5-2002, specific safeguard duty imposed on the goods imported from
Peoples Republic of China by inserting Section 8C to Customs Tariff Act.
NCCD of Customs
A National Calamity Contingent Duty (NCCD) of customs has been imposed from 2003 on
pan masala, chewing tobacco and cigarettes and 1% on PFY, motor cars, multi-utility
vehicles and two wheelers. NCCD of Rs.50 per ton is imposed on domestic crude oil.
NCCD is calculated same as CVD.
65
Export Duty
Export duty of 15% is levied only on hides, skins and leather, and duty of 10% is levied on
snakeskins, hides, skins and leathers, and fur lambskins. There is no export duty on any
other product. It is charged on very few items. It can be refunded if,
a.
goods are re-imported within one year,
b.
the goods returned are not re-sale, and
c.
refund claim is lodged within six months from date of clearance by customs officer for
re-importation.
17.4.2 Valuation as per Customs Act

For the purpose of Customs Act, Customs duty is generally payable as a percentage of
Assessable Value. The value may be either (a) Value as defined under Section 14(1) of
Customs Act or (b) Tariff Value prescribed under Section 14(2) of Customs Act.
Tariff Value: Tariff Value is generally set by the CBE&C in case of any imported goods
and export goods. Government should take into consideration the trend of value of such
goods or like goods before fixing the tariff value. Fixing tariff value is not in convergence
with the GATT convention, hence it is used very rarely.
Customs Value [Section 14(1)]
According to Section 14(1), the following are the main criteria for fixing the value for the
purpose of customs duty:
i.
The Price at which such or like goods are ordinarily sold or offered for sale.
ii.
The terms of the price should be for delivery at the time and place of importation or
exportation, as the case may be.
iii.
The sale or offer for sale should be in the course of international trade.
iv.
There should be no mutuality of interest between the seller and the buyer.
v.
Price should be the sole consideration for sale or offer for sale.
vi.
Rate of exchange as on the date of presentation of bill of entry as fixed by CBE&C

(Board) by notification should be considered.
The above mentioned elements may be better understood with the help of the explanation
given below:
66
i.
Price of such or like Goods: The price of such or like goods means the price
of identical or similar goods. If the price of relevant goods are not available, prices of
identical goods can be considered provided the sale should be at substantially same
quantity, imported from the same country to India, sold at about the same time and
produced by the same manufacturer.
ii.
Goods should be Ordinarily Sold at that Price: Goods should be ordinarily sold at
that price as per Section 14(1). Any abnormal discounts or reduction from ordinary
competitive price or special discounts limited to exclusive agents cannot be accepted.
iii.
Price Offered for Sale can be Considered: In case a sale price is not available, the
offer for sale price may be construed as the basis for determining the assessable value.
For example, in case a price list is available, such price list is the quotation as well.
iv.
Price should be for Delivery at the Place and Time of Importation: Price at the
place of importation does not mean that only expenses till goods enter Indian
Customs Waters should be included but all expenses upto the destination port
including freight, insurance, unloading and handling charges are to be included.
Time of importation means price prevalent on the date of importation is relevant and
not the date of contract.
Indirect Taxes
v.
Price should be in the Course of International Trade: In Satellite Engineering

Limited vs. Union of India (1983). It was held that the price indicated in the two
quotations were in the course of international trade and hence that rate will form the
basis for determining the assessable value.
vi.
There should not be Mutuality of Interest between the Buyer and the Seller:
As per Section 14(1) as amended w.e.f. 11-5-2002, transaction value can be accepted
if (a) Seller and buyer do not have interest in business of each other or (b) One of
them has no interest in the other.
vii. Price being the Sole Consideration: Price should be the sole consideration for sale.
If there is other consideration, it should be added to the transaction value.
viii. Rate of Exchange for Valuation: Exchange rate as applicable on the date of
presentation of bill of entry should be considered. These rates are prescribed
periodically by CBE&C (Board) by way of a notification.
ix.
WTO Valuation Agreement: General Agreement on Tariff and Trade (GATT) was a
global forum for discussion on custom and other related problems in order to create
conducive environment to world trade. At the present there is no GATT and it is
replaced by World Trade Organization (WTO). GATT Valuation Code was formed
to set a common code for valuation to provide for greater certainty and utility. As per
the WTO valuation agreement, the transaction value is considered as the yard stick.
The transaction value involves the price at which the goods are sold.
CUSTOMS VALUATION RULES, 1988

Valuation in Customs Act is done as per the Customs Valuation Rules of 1988. The
foundations for these rules are from WTO Valuation Agreement previously which was
known as GATT Valuation Code. The applicability of these rules is only for valuation of
imported goods and not in case of export goods. Transaction Value or the price at which
the goods are actually sold is key benchmark under the WTO valuation agreement. Let us
discuss these rules in the following section:
Rule 4: Transaction Value: Transaction value is the price actually paid or payable for the
goods sold for export in India after the adjustment provided in Rule 9. It is not mandatory
that the payment should be in money and it may be by way of letter of credit or negotiable
instrument. The payment can be direct or indirect.
Eight circumstances under which transaction value can be accepted.
a.
The sale must be in the ordinary course of trade under fully competitive conditions.
b.
There should not be any abnormal discount or reduction from the ordinary competitive
price.
c.
There should not be any special discount limited to exclusive agents.
d.
Transaction value under Rule 4 should be adjusted according to Rule 9 for such
adjustments; there should be objective and quantifiable data. So if there is no reliable
data for adjustment under Rule 9, the transaction value has to be rejected.
e.
There should not be any restriction on the disposition or use of the goods by the user.
It means there should not be any condition for the sale.
f.
The sale price or the sale should not be subject to any condition or consideration
whose value cannot be determined. For instance, the price quoted is with a condition
that the buyer should buy some other goods in specific quantity.
g.
Any part of the money realised by the buyer by way of sale, disposing or using the
goods shall accrue to the seller. This condition will not apply if the benefit enjoyed by
the seller is quantifiable and the adjustments as per Rule 9 are made.
67
h.
The seller and buyer should not be related. If their relationship did not make any
influence on the price, then transaction value can be accepted. However, if the
relationship between buyer and seller does not make any influence on the price, then
transaction value can be accepted.
Rule 5: Transaction Value of Identical Goods

Rule 5 of Customs Valuation Rules provide that if valuation on the basis of Transaction
Value is not possible, the Assessable Value will be decided on basis of transaction value
of identical goods sold for export to India and imported at or about the same time, subject
to making necessary adjustments.
The identical goods considered for consideration should be at same commercial level and in
substantially the same quantity as the imported goods are valued.
In applying this rule, if more than one transaction value of identical goods is found, the
lowest of such value shall be used to determine the value of imported goods.
Rule 6: Transaction Value of Similar Goods
Subject to the provisions of Rule 3 of these rules, the value of imported goods shall be the
transaction value of similar goods sold for export to India and imported at or about the
same time as the goods being valued. Rule 2(1)(e) defines similar goods as alike in all
respects, have like characteristics and like components and perform same functions.
The major distinction between identical goods and similar goods is that the identical
goods should be same in all respects, except for minor differences in appearance, while in
case of similar goods, it is enough if they possess like characteristics and like components
and perform same functions.
Rule 7: Deductive Value
Rule 7 of Customs Valuation Rules deals with the deductive value. This method should be
applied if transaction value of identical goods or similar goods is not available; but these
products are sold in India. The assumption made in this method is that identical or similar
imported goods are sold in India and its selling price in India is available.
Under this method the value is arrived by inference. It starts with the price at which the
importer sells the goods locally in the highest aggregate quantity. The deductions should
be made from this price are, commission paid or payable, additions made for profit and
general expenses and customs duty and sales tax payable in India. This method involves a
reverse calculation which starts from sale point to import point.
Rule 7A: Computed Value
This rule is applied when the Rules 4, 5, 6, and 7 is tried and exhausted. Computation under
this rule starts with the cost of production of imported goods in the country of export.
The method will start with the raw material and the cost of processing in the manufacturing
of imported goods is added. The profit and general expenses are added as usual in the
country of exportation to India. The additions will be as for the same class or kind of goods
in that country. Then additions as per Rule 9 are made. The result of this computation will
be the value of imported goods.
Rule 8: Residual Method
This is the sixth method and it is also called fall back method. Sub-rule(1) of this rule
provides that the value shall be determined by using reasonable means which are consistent
with the principles and general provisions of these rules and Section 14 and on the basis of
data available in India. The rule also provides items which should not be considered to
arrive at best judgement price.
68
Indirect Taxes
Rule 9: Cost of Services

According to Rule 9, there are provisions for adding some costs and services which are
incurred by the buyer and not included in the price actually paid or payable by the buyer in
the price of imported goods. These costs include, commissions and brokerages, costs of
containers, cost of packing, and proportional value of goods and services directly or indirectly
by the buyer free of charge at a reduced cost which is connected with the production and sale
for export of imported goods to the extent that such value has not been included in the price
actually paid or payable.
Rule 10: Declaration by the Importer
The importer or his agent shall furnish
a.
A declaration disclosing full and accurate details relating to the value of imported
goods; and
b.
Any other statement, information or document including an invoice of the

manufacturer or producer of the imported goods where the goods are imported from or
through a person other than the manufacturer or producer as considered necessary by
the proper officer for determination of the value of imported goods under these rules.
Rule 10-A: Rejection of Declared Value

If the proper officer feels that the declaration made under Rule 10 are hard to believe, he
can reject it as not appropriate in the determination of transaction value under Rule 4. The
rejection mentioned in shall be after show cause notice. At the request of an importer, the
proper officer, shall intimate the importer in writing the grounds for doubting the truth or
accuracy of the value declared in relation to goods imported by such importer and provide a
reasonable opportunity of being heard, before taking a final decision.
Rule 11: Settlement of Disputes
In case of dispute between the importer and the proper officer of customs valuing the
goods, the same shall be resolved consistent with the provisions contained in Sub-section
(1) of Section 14 of the Customs Act, 1962.
17.4.3 Dutiable Goods (Section 12)

Section 12(1) of Customs Act is the charging section, which provides duty on imports as
well as exports. The liability to pay duty on dutiable goods will be attracted the moment the
goods touch the land mass in India. If the goods are ordered to be confiscated, the goods
will not be liable to duty. The rate of duty is as prescribed in Customs Tariff Act 1975, read
with relevant exemption notifications. Customs duty is also payable by government. Thus
there is no exemption to goods imported by government. However, various exemption
notification have been issued and imports by Indian Navy, specific equipments required by
police, ministry of defense, costal guards etc., are fully exempt from custom duty.
Payment of customs duty may be exempted in the following cases:
Duty on Pilfered Goods (Section 13): As per this Section if any goods are pilfered
after the unloading thereof and before the proper officer has made an order for
clearance for home consumption or deposit in a warehouse, the importer shall not be
liable to pay the duty leviable on such goods except where such goods are restored to
the importer after pilferage.
Goods Derelict, Wreck, etc. (Section 21): All goods, derelict, jetsam, flotsam and
wreck brought or coming into India, shall be dealt with as if they were imported into
India, unless it be shown to the satisfaction of the proper officer that they are entitled
to be admitted duty free under this Act.
69
The term derelict refers to any property, whether vessel or cargo, left or abandoned
in the open sea by persons incharge of it without any hope of recovering or intention
of returning to it. Jetsam is where the goods are thrown into the sea with a view to
lighten the ship in order to prevent it from sinking.
Flotsam is where the goods having been at sea in a ship, are separated from it by
some peril.
Wreck refers to the property cast ashore within the ebb and flow of the tide after
shipwreck.
Abatement of Duty on Damaged or Deteriorated Goods (Section 22): Where it is

shown to the satisfaction of the Assistant Collector of Customs that any imported
goods had been damaged or had deteriorated at any time before or during the
unloading of the goods in India; or that any imported goods, other than warehoused
goods, had been damaged at any time after the unloading thereof in India but before
their examination not due to any willful act, negligence or default of the importer, his
employee or agent; or that any warehoused goods have been damaged at any time
before clearance for home consumption. Duty to be charged on such goods shall bear
the same proportion to the duty chargeable on the goods before the damage or
deterioration which the value of the damaged or deteriorated goods bear to the value
of the goods before the damage or deterioration.
Remission of Duty on Lost, Destroyed or Abandoned Goods (Section 23): Without

prejudice to the provisions of Section 13, where it is shown to the satisfaction of the
Assistant Collector of Customs that any imported goods have been lost otherwise than
as a result of pilferage or destroyed at any time before clearance for home
consumption, the Assistant Collector shall remit the duty on such goods.
The owner of any imported goods may, at any time before an order for clearance of
goods for home consumption under Section 17 or an order for permitting the deposit
of goods in a warehouse under Section 60 has been made, relinquish his title to the
goods and thereupon he shall not be liable to pay the duty thereon.
Denaturing or Mutilation of Goods (Section 24): There are instances where goods
when imported in the condition they are in, attract a higher rate of duty. However, the
same goods could be charged with a lower rate of duty in case their nature is different
(i.e. if they are either denatured or mutilated). Section 24 permits change in the form
of such goods to the other form and charging of lower rate of duty on such goods. This
process may be carried out only on a request by the owner.
EXEMPTION FROM CUSTOMS DUTY

As per sub-section (1) of Section 25, the Central Government can provide a general
exemption to all imports of specified goods subject to the following norms:
70
i.
The exemption, if granted, should be in public interest;
ii.
Exemption from duty may be granted wholly or partially;
iii.
Exemption may either be conditional or unconditional;
iv.
Exemption should be in respect of goods of specified description; and
v.
Exemption should be granted by issue of a notification in the Official Gazette.
Indirect Taxes
Apart from the power to grant a general exemption, the Central Government also has power
to grant ad hoc exemption in each individual case. While granting this exemption, the
following conditions should be fulfilled:
a.
Circumstances should be of an exceptional nature.
b.
The circumstances should be stated in the exemption order.
Also, the Central Government cannot only reduce the rate of duty, but can also modify the
form and method of duty. For example, an ad valorem rate may be changed to a specific rate.
17.4.4 Procedures for Import and Export of Goods

PROCEDURES FOR IMPORT OF GOODS
The person-in-charge is responsible for following the import or export procedure.
According to Section 2(31), person-in-charge means (a) In case of a vessel its master,
(b) In case of aircraft its commander or pilot in charge, (c) In case of train its conductor
or guard and (d) In case of vehicle or other conveyance its driver or other person in
charge. A person-in-charge is responsible for the following:
i.
Submitting Import or Export Manifest: The person-in-charge of a vessel or aircraft

carrying imported goods, is required to deliver to the proper officer of customs, prior
to the arrival of the conveyance at a customs station, an import manifest, and in the
case of a vehicle, within twelve hours of arrival, an import report. The IM/IR should
be delivered within twelve hours after the arrival of the conveyance.
ii.
Ensure that the conveyance is arriving through the approved route to the approved
destination.
iii.
Ensure that Goods are Unloaded after Written Order at the Proper Place:
Except, with the permission of the proper officer no imported goods shall be
unloaded, and no export goods shall be loaded, at any place other than a place
approved under clause (a) of Section 8 for the unloading or loading of goods.
iv.
Ensure that Goods are not Sent without the Written Order: The person-in-charge
of the conveyance which has brought any imported goods or has loaded any export
goods at a customs station shall not cause or permit the conveyance to depart from
that customs station until a written order to that effect has been given by the proper
officer, and
v.
He can be penalized for, (a) Giving false declaration and statement, and (b) Shortages
or non-accounting of goods in conveyance.
PROCEDURES FOR EXPORT OF GOODS

Export procedures are to be followed by the person-in-charge and the exporter. As per this
section, the person-in-charge of a conveyance shall not permit the loading at a customs
station
a.
Of export goods, other than baggage and mail bags, unless a shipping bill or bill of
export or bill of transhipment, as the case may be, duly passed by the proper officer,
has been handed over to him by the exporter; and
b.
Of baggage and mail bags, unless their export has been duly permitted by the proper
officer.
Further, Section 39 stipulates that export goods are not to be loaded on a vessel until
the entry outwards is granted by the proper officer:
i.
Loading of goods can start only after entry outward is granted. Steamer agents
can file application for entry outwards 14 days in advance so that intending
exporters can start submitting shipping bills. This ensures that formalities are
completed as quickly as possible and loading in ship starts quickly.
71
ii.
Export manifest in the prescribed should be submitted before departure. Such

manifest is similar to import manifest and can be amended or supplemented with
permission, if there is no fraudulent intention. Such report should be declared as
true by the person-in-charge signing the export manifest. Along with the export
manifest, shipping bill for export by sea or air and bill of export for export by
road are to be submitted by the exporter.
iii.
It should be submitted in quadruplicate. If drawback claim is to be made, one

additional copy needs to be filed. This form contains details of the name of the
exporter, consignee, invoice number, details of packing, description of goods,
quantity, FOB value etc. Customs authorities give serial number to the shipping
bill, when it is presented.
iv.
Exporter also has to prepare other documents like (a) Four copies of commercial
invoice (b) Four copies of packing list (c) Certificate of origin or preshipment
inspection where required (d) Insurance policy (e) Letter of credit (f) Declaration
of value (g) Excise ARE-1/ARE-2 forms as applicable (h) GR/SDF form
prescribed by RBI in duplicate (i) Letter showing BIN number.
v.
After shipping bill is passed by export department, the goods are presented to
appraiser in dock for examination. This inspection is necessary to ensure that
prohibited goods are not exported, goods tally with the description and invoice
and duty drawback is correctly claimed.
vi.
Customs Officer on verification of the contents and after he is satisfied that

goods are not prohibited for exports and that export duty if applicable is paid,
will permit clearance by giving let ship or let export order. Export duty is
levied only on some articles, although a cess is levied on export of certain
commodities under various acts.
vii. The vessel or aircraft which carry export goods cannot leave that customs station
unless a written order is given by Customs Officer. Such order is given only after
the submission of the export manifest; shipping bills; duties on stores consumed
are paid; no penalty is leviable and export duty is paid.
OTHER PROVISIONS
72
i.
The provisions relating to goods in transit are contained in Sections 52 to 56 of

Chapter VIII. Any goods imported in a vessel or aircraft and mentioned in the import
manifest as for transit in the same vessel or aircraft to any port or airport outside India
or any customs port or customs airport, may be allowed to be so transited without
payment of duty.
ii.
The provisions relating transshipment of goods is contained in Section 54 of Chapter

VIII. Transhipment means transfer from one conveyance to another. Goods imported
in any customs station can be transhipped without payment of duty, under Section 54
of Customs Act.
iii.
Provisions relating to coastal goods and vessels carrying coastal goods are contained
in Chapter XII, Sections 91 to 99. Coastal goods means goods transported from one
port in India to another port in India, but does not include imported goods. No export
or import duty is levied, but control is necessary to ensure that coastal goods are not
diverted illegally for export.
iv.
The provisions relating to warehousing are contained in Chapter IX

(Sections 57 to 73). The term warehouse has been defined by Section 2(43). As per this
Section Warehouse means a public (bonded) warehouse appointed under Section 57 of
the Customs Act or a private (bonded) warehouse licensed under Section 58 of the
Customs Act, 1962. A public warehouse is one that is owned and managed by a
government body and in most of the cases it is the central warehousing corporation.
A private warehouse is one that is licensed in places where there is no public warehouse.
Indirect Taxes
v.
Duty drawback refers to the refund/rebate of duties of customs and central excise
allowed to the exporter at the time of export which has been paid on imported goods
or the indigenous inputs used in the manufacture of export goods. The main objective
of duty drawback is to relieve the export goods from the duty burden and reduce the
import duty loaded with the export goods. The duty drawbacks help the export goods
more competitive in the foreign market. The duty drawback provisions are discussed in
Sections 74 and 75 of the Customs Act 1962.
vi.
The term baggage is defined by Section 2(3) as including unaccompanied baggage

but excluding motor vehicles. Baggage includes all dutiable articles and personal
effects imported by passenger or a member of a crew in his baggage. It may be
accompanied unaccompanied. The baggage does not include motor vehicles, alcoholic
drinks and goods imported through courier, articles imported under an import licence
for his own use or on behalf of others. Provisions pertaining to baggage are contained
in Sections 77 to 80 of the Customs Act, 1962.
vii. Just like baggage and courier, the import and export can be by post. Sections 82, 83,
and 84 deal with the provisions related to postal parcels.
viii. The term stores has been defined by Section 2(38) as goods for use in a vessel or
aircraft, and includes fuel and spare parts and other articles of equipment, whether
or not for immediate fitting. When a vessel enters into the territorial waters of
India, the stores will be treated as imported goods and the customs duty will be
levied. The provisions related to stores are dealt with in Sections 85 to 90 of the
Customs Act, 1962.
ix.
The provisions relating to search, seizure, arrest and confiscation are contained in
Chapter XIII of the Customs Act. These provisions are dealt with in Sections 100
to 110.

CHANGES MADE BY FINANCE ACT, 2007
Presently, the customs value is deemed value. Now it is proposed to change the concept
to valuation on basis of transaction value.
Customs valuation on basis of transaction value customs proposed Section 14(1) now
states that value of imported and export goods will be transaction value of such goods as
determined in accordance with Rules.
Addition to Transaction Value: Proviso to proposed Section 14(1) states that such
transaction value in the case of imported goods shall include, in addition to the price
actually paid or payable for the goods when sold for export to India, any amount that the
buyer is liable to pay for costs and services, including commissions and brokerage, assists,
engineering, design work, royalties and licence fees, costs of transportation to the place of
importation, insurance, and handling charges.
Rate of Foreign Exchange: Second provision to proposed Section 14(1) states that such
price shall be calculated with reference to the rate of exchange as in force on the date on
which a bill of entry is presented under Section 46, or a shipping bill or bill of export, as
the case may be, is presented under Section 50. The rate of exchange will be determined
by CBE&C.
Tariff Value: Proposed Section 14(2) empowers CBE&C to fix tariff values of imported
goods or export goods by issuing a notification.
Valuation Rules if Transaction Value is not Determinable: If transaction value is not
determinable, value of the goods will be determined as per valuation rules.
73
a.
The Airlines staff carry a few personal effects in a bag when on duty on
International flights. Do such personal effects when carried to India from other
countries attract customs duty?
..
..
..
b.
When applying Rule 5 of Customs Valuation Rules that provide that if valuation on
the basis of Transaction Value is not possible, the Assessable Value will be
decided on basis of transaction value of identical goods, it was found that there
were two identical goods. One with higher value and another with lower value.
Which identical good should be selected?
..
..
..
c.
A ship containing goods was stationed at 8 nautical miles away from Indian sea
coast in Indian territorial waters. The customs authorities charge the goods to
customs duty. Mr. A the capital and owner of the goods refutes the authorities
demand. Is he justified?
..
..
..
17.5 SERVICE TAX

Service tax is a form of indirect tax levied on specified services called taxable services. It
is levied on the gross or aggregate value of services provided. As service tax is an indirect
tax, though the tax is payable by the service provider it is ordinarily recovered from the
recipient of services. If there are no services rendered, then there is no service tax.
The provisions relating to service tax were brought into force with effect from 1st July
1994. It extends to whole of India (India includes territorial waters) except the state of
Jammu & Kashmir. Administration of service tax has been vested with Central Excise
Commissionerates who work directly under the Central Board of Excise and Customs,
Department of Revenue, Ministry of Finance, Government of India.
Previously the power to levy service tax was exercised by the parliament in terms of entry
97 (a residuary entry) of the union list since there was no specific entry in the union list for
levying service tax. Later on as per the recommendations of the various expert committees
the seventh schedule to the constitution was amended by introducing in the parliament, the
constitution (92nd amendment) Act, 2003. This enabled the parliament to formulate
principles for determining the modalities of levying the service tax by the Central Govt. and
collection of the proceeds there of by the Central Govt. and the State.
As a result of this, entry 92C has been inserted in the Schedule VII to the constitution of
India for taxes on services as well as article 270 of the constitution the clause (1) was
amended to insert a new article 268A.
74
Indirect Taxes
There is no separate enactment for service tax since it was introduced in 1994. It is still
governed by Finance Act, 1994; Finance Act, 2003; Rules; Notifications; Circulars; Orders
and Trade Notices.
17.5.1 Chargeability
Service tax shall be levied at the rate of twelve per cent of the value of taxable services
provided under section 65(105). A per section 65(105) taxable service shall not only
include service provided but also the service to be provided. In addition education cess
of 3% is also payable on the service tax. Thus the effective rate of service tax payable
will be 12.36%.
17.5.2 Valuation of Taxable Services (Section 67)

The value of taxable service shall be determined as per the provisions made under Section 67
of the Finance Act, read with Service Tax (Determination of Value) Rules, 2006. The
provisions of section 67 is discussed below:
i.
Where the provision of service is for a consideration in money, the value of service
shall be the gross amount charged by the service provider for such service provided or
to be provided by him.
ii.
Where the provision of service is for a consideration not wholly or partly consisting of
money, be such amount in money, with the addition of service tax charged, is
equivalent to the consideration.
iii.
Where the provision of service is for a consideration which is not ascertainable, the
value of such service may be determined as per the provisions of the Service Tax
(Determination of Value) Rules, 2006.
iv.
Where the gross amount charged by a service provider, is inclusive of service tax
payable, the value of such taxable service shall be such amount as, with the addition
of tax payable, is equal to the gross amount charged.
v.
The gross amount charged for the taxable service shall include any amount received
towards the taxable service before, during or after provision of such service.
For the purposes of this section,

a.
consideration includes any amount that is payable for the taxable services provided
or to be provided;
b.
money includes any currency, cheque, promissory note, letter of credit, draft, pay
order, travellers cheque, money order, postal remittance and other similar instruments
but does not include currency that is held for its numismatic value; and
c.
gross amount charged includes payment by cheque, credit card, deduction from
account and any form of payment by issue of credit notes or debit notes and book
adjustment.
Service Tax (Determination of Value) Rules, 2006

These rules were issued by the Central Government through Notification No.12/2006-ST
dated 19-04-2006 and has been given in the Appendix-II.
17.5.3 Service Tax Procedures

1.
Registration: Every person liable to pay the service tax shall, within 30 days from the
date on which the service tax is levied or within 30 days from the date of
commencement of business, whichever is later, make an application in Form ST-1 for
registration to the Superintendent of Central Excise. [Section 69(1), Rule 4 of Service
Tax Rules, 1994].
75
2.
The following person or class of persons has been notified through Service Tax
(Registration of Special Category of Persons) Rules, 2005 by the Central Government
who shall make an application to the jurisdictional Superintendent of Central Excise
for registration under Section 69(2).
i.
The input service distributor shall make an application for registration within a
period of 30 days of the commencement of business.
ii.
Any provider of taxable service whose aggregate value of taxable service in a

financial year exceeds Rs.700,000 shall make an application within a period of
30 days of exceeding the aggregate value of taxable service of Rs.700,000.
3.
Payment of Service Tax: Every person providing taxable service to any person shall
pay service tax at the rate of 12% of the value of taxable services received and not on
the value of taxable services billed to the client.
4.
The service tax on the value of taxable services received during a particular month or
quarter shall be paid to the credit of the Central Government by the 5th of the month
following the said month or the said quarter. However, tax for the month of March is
required to be deposited by March 31 in case duty is deposited electronically through
internet banking then it has to be paid by the 6th of the month. Due dates for payment
of service tax.
Service Tax Payable
on Amounts Received During
1st April to 30th April
1st May to 31st May
1st June to 30th June
1st July to 31st July
1st August to 31st August
1st September to 30th September
1st October to 31st October
1st November to 30th November
1st December to 31st December
1st January to 31st January
1st February to 29th February
1st March to 31st March
5.
76
Other
Assessees
5th May
5th June
5th July
5th August
5th September
5th October
5th November
5th December
5th January
5th February
5th March
5th April
Amount Payable by
Individuals, Proprietary
Concerns and Partnership Firms
5th July
5th October
5th January
5th April
Return to be Filed: Every person liable to pay the service tax shall himself assess the
tax due on the services provided by him and shall submit a half yearly return in Form
ST-3 or ST-3A, as the case may be, along with a copy of the Form TR-6, in
triplicate for the months covered in the half-yearly return to the Superintendent of
Central Excise. A single service tax return should be filed in respect of all taxable
services provided by an assessee. Due dates are as follows:
Half Year Ended
Return to be Filed by
1st April to 30th September
25th October
1st October to 31st March
25th April
6.
Record to be Maintained: The records including computerized data as maintained by

an assessee in accordance with the any other law in force from time to time shall be
acceptable for the purpose of service tax.
7.
Issuance of Invoices, Bills, Challans, Consignment Notes and other Documents:

Every person providing taxable service/input service distributor is required to issue a
invoice, bill or challan within 14 days from either the date of completion of such
taxable service or receipt of any payment towards the value of such taxable service
Indirect Taxes
8.
Deposit of Service Tax Collected: Any person who is liable to pay service tax under
the provisions of this chapter or the rules made thereunder, and has collected any
amount in excess of the service tax assessed or determined and paid on any taxable
service under the provisions of this chapter or the rules made thereunder from the
recipient of taxable service in any manner as representing service tax, shall forthwith
pay the amount so collected to the credit of the Central Government.
EXEMPTION FROM SERVICE TAX

As per section 93 of Finance Act, 1994 if it is necessary in the public interest, Central
Government can grant partial or total exemption from service tax, by issuing an exemption
notification in the Official Gazette. Such exemption may be partial or total, conditional or
unconditional. The only limitation is that exemption cannot be granted by Central
Government with retrospective effect.
The following general exemptions are available to the assessee subject to the conditions
specified in the respective notifications:
1.
Small service providers whose aggregate value of taxable services is less than
Rs.8 lakh in a financial year are exempt from service tax. [Notification No. 4/2007-ST
dated 1.3.2007].
2.
If service is exported as per Export of Service Rules 2005, then the services are
exempt from service tax.
3.
Services provided to UN or International Agencies are exempt from service tax

[Notification No. 16/2002-ST dated 2-8-2002 in respect of UN and International
Agencies].
4.
Services provided to supplies to SEZ or developer of SEZ are exempt from service tax
[Notification No. 4/2004-ST dated 31-3-2004 in respect of SEZ earlier No. 17/2002ST dated 21-11-2002].
5.
All taxable services provided by Reserve Bank of India is exempt from service tax
[Notification No. 7/2006-ST dated 1.3.2006].
6.
Service tax is not payable on value of goods and material sold by the service provider
to the service recipient. Such exclusion is permissible only if CENVAT credit on such
goods and material is not taken [Notification No. 12/2003-ST dated 20.6.2003].
7.
Services provided by a banking company or a financial institution including

non-banking financial company or any other body corporate or a commercial
concern, to the government of India or government of a state, in relation to
collection of any duties or taxes leived by government of India or government of a
state, is exempt from tax.
8.
With effect from 1st April, 2007, exemption from service tax has been provided to
i.
Services provided by resident welfare associations to their members, where the

monthly contribution does not exceed Rs.3,000 per month.
ii.
All taxable services provided by Technology Business Incubators (TBI)/Science

and Technology Entrepreneurship Parks (STEP), recognized by National Science
and Technology Entrepreneurship Board of Department of Science and
Technology, also known as incubators.
iii.
Taxable services upto Rs.50 lakh in a financial year provided by incubatee

entrepreneur who is located within the premises of an incubator where the total
business turnover of the incubatee entrepreneur does not exceed Rs.50 lakh in
a financial year/preceding financial year. Exemption is available to an
incubatee for a period of three years w.e.f. the date of signing an agreement
with the incubator.
77
9.
iv.
Technical testing and analysis services provided in relation to testing of newly

developed drugs including vaccines and herbal remedies on human participants
by a clinical research organization approved to conduct clinical trials by the
Drugs Controller General of India.
v.
Services provided in relation to delivery of content of cinema in digital form

after encryption, electronically.
Apart from above, abatement from the value of taxable services is allowed for certain
specified services.
SPECIFIC EXEMPTIONS
In case of some services, partial abatement from the value of taxable services is allowed for
certain specified services as a result of which, service tax is payable at lower rates, i.e.
partial abatement is available from gross value. The lower rate is applicable if the service
provider does not avail CENVAT credit of duty/tax on inputs, input services and capital
goods. Given below are some important exemptions where partial abatement is available.
Taxable
Service
Partial Abatement
Available
Relevant Notification w.e.f.

1.3.2006
Accommodation booking service by

tour operator
10% of gross amount charged
1/2006-ST dated 1-3-2006.
Air Travel Agent
Option to pay service tax at flat rate Rule 6(7).

on basic fare @ 0.6% in case of
domestic booking and 1.2% in case
of international booking
Business auxiliary service in relation

to processing of parts and
accessories used in manufacture of
cycle, cycle rickshaws and hand
operated sewing machines
Tax on 70% of gross amount if gross 1/2006-ST dated 1-3-2006.

amount is inclusive of cost of inputs
and input services, whether or not
supplied by the client (Is it exemption
or punishment?)
Commissioning and installation

services

amount includes value of material
Construction service

amount includes value of material
Goods Transport Agency (GTA)
Tax only on 25% amount in his 1/2006-ST dated 1-3-2006.

invoice [Payment will be made by
consignor/consignee who is actually
paying freight]
Mandap keeper, hotels and

convention services, providing full
catering services
Tax on 60% gross amount charged
Outdoor caterer
Tax on 50% amount if he provides full 1/2006-ST dated 1-3-2006.

and substantial meal
Package tours and other than

package tour
Tax is payable only on 40% of gross 1/2006-ST dated 1-3-2006.

amount charged
Pandal and shamiana service
70% of gross amount charged if full 1/2006-ST dated 1-3-2006.

catering service provided
Rent-a-cab operator
Tax payable on 40% of gross amount 1/2006-ST dated 1-3-2006.

charged
1/2006-ST dated 1-3-2006.
Transport of goods in container by rail Tax payable on 30% of gross amount 1/2006-ST dated 1-3-2006.
charged
The exemptions provided above are based on the assumption that service tax is otherwise
payable on the value of goods used in providing taxable service. This assumption seems to
be of doubtful validity because section 67 makes it clear that tax is payable on gross
amount charged for the taxable service. Service tax is not payable on total value of contract.
78
Indirect Taxes
CREDIT OF SERVICE TAX

The CENVAT scheme is principally based on system of granting credit of duty paid on
inputs, input services and capital goods. The provisions relating to credit of service tax paid
on inputs, input services and capital goods are dealt in CENVAT credit Rules, 2004.
Duties that can be availed as CENVAT Credit: An output service provider has to charge
service tax in his invoice as per normal procedure. However, he can take credit of
(a) Excise duty and countervailing customs duty paid on inputs and capital goods, and
(b) Service tax paid on input services for payment of service tax on his output services.
Similarly the credit of education cess paid on service tax can be utilized only for payment
of education cess on final product or output services. Further, no separate registration is
required for the purpose of availing CENVAT Credit.
Cenvat Credit on Capital Goods: The credit with respect to capital goods can be availed
only upto 50% in current year immediately on receipt of capital goods along with relevant
documents and balance in subsequent financial year or years. A service provider can take
out capital goods from his premises, provided that he brings them back within 180 days.
This period can be extended by Assistant/Deputy Commissioner.
Utilization of CENVAT Credit: The Cenvat Credit can be utilized for payment of any of
following:
i.
ii.
Payment of service tax on output services.

Payment of amount if inputs are removed as such or after partial processing [Rule
3(4)(b)].
iii.
Payment of
amount on
capital goods if they
are
removed
as such
[Rule 3(4)(c)].
iv.
Payment of amount if goods sent for job work are not returned within
180 days Rule 4(5)(a).
Documents prescribed for availment of the CENVAT Credit: The CENVAT credit
shall be availed by the manufacturer or the provider of output service or input service
distributor, as the case may be, on the basis of an invoice issued by a manufacturer for
clearance of inputs or capital goods from his factory or depot. An invoice issued by an
importer from his depot or from the premises of the consignment agent or the premise.
Invoice issued by a first stage dealer or a second stage dealer; A bill of entry; supplementary
invoice or TR-6 challan of payment of tax where service tax is payable by other than input
service provider.
No Cenvat Credit if Output Service Exempt from Service Tax: As per basic principle of
VAT, credit of duty or tax can be availed only for payment of service tax on output
services. As a natural corollary, if no duty is payable on final product or output services,
credit of duty/tax paid on inputs or input services cannot be availed.
No Cash Refund, Except in Case of Exports: In some cases the duty paid on inputs and
service tax paid on input services may be more than tax payable on output services.
In such cases, though the CENVAT credit will be available to the service provider, he
cannot use the same and the same will lapse. There is no provision for refund of the
excess CENVAT credit.
79
a.
The due date for payment of service tax in respect of receipt received on December
31, 2008 by a company for rendering of service is?
..
..
..
b.
An incubatee entrepreneur is located within the premises of an incubator. The total

business turnover of the incubatee entrepreneur is Rs.40 lakh in the financial
year/preceding 2008-09. Is service tax chargeable on incubate entrepreneur?
..
..
..
c.
What is the threshold limit provided for exemption under service tax of small
service providers?
..
..
..
17.6 VALUE ADDED TAX (VAT)

Value Added Tax, widely known as VAT, is a special type of indirect tax which is
imposed on goods and services at each stage of production, starting from raw materials to
final product. VAT is levied on the value additions at different stages of production. VAT
is the most progressive way of taxing consumption rather than business.
Definition of sale under the VAT may include:
The conventional sale, i.e., transfer of property in goods.
Supply of goods by a society, club, firm and company to its members.
Transfer of property in goods involved in execution of works contract.
Delivery of any goods on hire purchase or any other system of payment by installments.
Transfer of right to use any goods for any purpose, whether or not for a specified period.
Supply, by way of or as part of any service or in any other manner whatsoever, of

goods being food or any other article for human consumption of any drink (whether or
not to intoxicating).
Figure 1: VAT System

80
Indirect Taxes
This indicates that VAT is collected at each stage of production and distribution process
and in principle, its burden falls on final consumers only. Thus, it is a broad-based tax
covering the value added of each commodity by a firm during all stages of production and
distribution. It is the multi-point taxation which levy tax at every time value is added to a
product whether by manufacturer or trader with set-off for tax paid on purchases. The tax is
collected in installments at each transaction in the production-distribution cycle and does
not have cascading (tax on tax). In many respects it is equivalent to a last point sales tax.
The advantages of value added tax are:
i.
No Tax Evasion: Under VAT, credit of tax paid on purchases is allowed against the
liability on the final product manufactured or sold. Therefore, unless proper records
are kept in respect of various inputs, it is not possible to claim credit. Hence,
suppression of purchases or production is difficult as it leads to loss of revenue.
ii.
Transparency: Under the VAT system, the buyer knows the tax component in the
total consideration paid for purchase of material. Thus, the system ensures
transparency also.
iii.
Neutrality: The greatest advantage of the system is that it does not interfere in the
choice of decision for purchases. This is because the system has anti-cascading effect.
How much value is added and at what stage it is added in the system of
production/distribution is of no consequence. The system is neutral with regard to
choice of production technique, as well as business organization.
iv.
Certainty: VAT system is simply based on transactions. Thus, there is no need of

complicated definitions like sales, sales price, turnover of purchases and turnover of
sales. It is also broad-based and applicable to all sales in business leaving little room
for different interpretations. Thus, this system brings certainty to a great extent.
v.
Better Accounting Systems: Since the tax paid at an earlier stage is to be received
back, the system promotes better accounting systems.
17.6.1 Liability under VAT

VAT is tax on value addition to the goods and the essence of VAT is in providing set-off
for the tax paid earlier. Therefore the VAT liability of the dealer is the net tax payable by a
registered dealer for a tax period. It is the difference between the output tax and the input
tax credit, which can be determined from the following formula.
Net tax payable = O I
Where O denotes the output tax payable for any tax period, and I denotes the input tax
paid or payable for the said tax period.
The net tax payable by a dealer liable to pay tax but not registered under this Act for a tax
period shall be equal to the output tax payable for the said tax period.
If the amount calculated above is negative, the same shall be carried forward to the next tax
period or periods for adjustment against the output tax payable.
81
TAX RATES
There are only two basic rates under VAT namely 4% and 12.5% on goods.
1.
4% Rate
4% rate is levied for the following items:
2.
i.
Goods of basic necessities.
ii.
Industrial and Agricultural inputs.
iii.
Declared goods.
iv.
Capital goods.
v.
Drug and medicine.
12.5% Rate
For all other goods there will be a general VAT rate of 12.5% as per consensus among
the states.
3.
Exceptions Special Rate

Gold and silver ornaments and articles thereof, precious and semi-precious stones will
have a VAT rate of 1%.
INPUT TAX CREDIT (ITC)

One of the distinguishing aspects of VAT from traditional method of levying tax on sales is
allowing the registered dealer credit for tax paid on input. The whole concept of VAT is
based on the basic principle of levying tax on value added. There are various methods for
arriving at the amount of value added by the selling registered dealer. However, the most
common method prevailing amongst various countries is tax credit method or invoice
method which allows credit for tax paid on the goods purchased from the tax payable on
sales consideration. Thus, input tax credit is at the core of VAT System.
Input tax credit is an aggregate total amount of tax paid by a registered dealer on the total
purchases made by him within the State from other registered dealers (for a particular
period); but not eligible in some cases. The input tax credit can be adjusted against the tax
payable by the purchasing dealer on his sales.
Where the purchased goods are used partially for the purpose of taxable goods and partially
for tax free goods, input tax credit shall be allowed proportionately to the extent the
purchases are used for the purposes of taxable goods.
One of the important conditions for set-off under VAT is that, the set-off on any goods should
not exceed the tax received on the same goods in government treasury. That is the dealer will
not be entitled to set-off more than the amount received in the government treasury. Therefore
the purchasing dealer, desirous of claiming the set-off, should also look into the credentials of
the vendor so as to be sure that he will get the set-off of tax paid to him. Because, if the
vendor fails to make the payment of tax to the Government, the purchasers claim of set-off
will be denied in spite of the fact that he has paid the tax to the vendor.
ELIGIBILITY
The dealers are not eligible for input tax credit on all inputs. There are certain restrictions
and conditions on eligibility of input tax credit.
Purchases Eligible for Input Tax Credit
Input tax credit shall be allowed for the purchase of goods made within the State from a
registered dealer and which are for the purpose of
82
i.
sale or re-sale by him within the State;
ii.
use as inputs in the manufacturing or processing of goods in the State;
Indirect Taxes
iii.
use as containers, labels and other materials for packing of goods in the State;
iv.
use as capital goods in the manufacture of taxable goods;
v.
transfer of stock of taxable goods other than by way of sale, to any place outside the
State; and
vi.
sale of goods subject to levy of tax at zero rate under section 18.
Input tax credit on capital goods shall be allowed only after the commencement of
commercial production and shall be adjusted against the output tax over a period not
exceeding three years. After the expiry of three years, the unavailed input tax credit shall
lapse to Government.
Input tax credit on purchases intended for the purpose of stock transfer to any place outside
the State shall only be allowed in respect of the amount of tax paid or payable in excess of
tax @ 4%.
Purchases Not Eligible for Input Tax Credit
a.
Sale of exempted goods.
b.
Purchase of goods from outside the State.
c.
Goods purchased in the course of business, but used for personal facility of proprietor,
partner or director.
d.
Goods damaged in transit.
e.
Goods stolen, destroyed or lost.
f.
Goods sold in the course of inter-state sale without support of C form.
g.
Goods transferred to outside the State for sale either by branch or agent without
support of Form F.
h.
Goods returned.
i.
Goods used for self consumption or as gift.
Exempted Goods
i.
Natural and Unprocessed products which are in un-organized sector.
ii.
Items which are legally barred from taxation on sale.
iii.
Items which have social implications.
iv.
AED goods, namely sugar, textile and tobacco.
Goods outside VAT

Liquor, petrol, diesel, aviation turbine fuel and other motor spirit will remain outside VAT.
Those will continue to be taxed under the sales tax act. These commodities will be
subjected to tax @ 20% floor rate.
Other Goods
All other goods including declared goods will be subjected to VAT and will get the benefit
of input tax credit.
Stock Transfer
Inter-state transfers are not considered as sale and they are therefore not subjected to VAT.
However the input tax credit will be available after retention of 4% of such tax by the State
Government on tax paid on
i.
inputs used in the manufacture of finished goods which are stock transferred, or
ii.
purchase of goods which are stock transferred.

83
17.6.2 VAT Procedures

1.
Registration: Small dealers whose total turnover in respect of purchase and sales in
the State is not less than Rs.10 lakh for a year, other dealers whose total turnover for a
year is not less than Rs.5 lakh, casual traders, agent of non-resident dealer and dealers
irrespective of quantum of turnover shall obtain registration. If the dealer fails to
obtain the registration, then the commissioner may compulsorily register the dealer
and assess the tax due from the dealer based on the evidence available with him.
2.
Maintenance of Accounts: Every registered dealer shall maintain true, correct and
complete account showing the goods produced or manufactured, bought, sold,
delivered or supplied. Accounts maintained by a registered dealer shall be preserved
by him for a period of five years from the date of assessment.
3.
Issue of Invoice: Invoices are crucial documents for administering VAT. In the
absence of invoice VAT paid by the dealer earlier cannot be claimed as set-off.
Therefore, every registered dealer shall issue invoice for each sale in triplicate
showing the particulars of goods and quantity sold with its value, one copy of which
must be retained for check by the officials of the commercial taxes department, the
original for purchaser and another to be retained by the selling dealer. The invoice
shall contain the rate and tax charged, the Taxpayer Identification Number (TIN) of
the seller and that of the buyer, in case the buyer is a registered dealer.
4.
VAT Account: Every registered dealer, who claims input tax credit shall maintain an
input tax adjustment account with details of month, input tax credit brought forward,
total input tax credit, output tax, tax payable and other details.
5.
Filing of Returns: Every dealer, liable to pay tax under this Act, shall file return
monthly/quarterly/annually as per the provisions of the state Act/Rules, in the
prescribed form showing the total and taxable turnover within the prescribed period in
the prescribed manner, along with proof of payment of tax.
6.
Assessment: All the assessments are self-assessments as all returns filed are to be
accepted. The dealers need not appear before assessing authority or produce the
accounts for annual assessments. The assessing authority shall accept the returns filed
by the dealer and pass assessment order after the assessment year is over.
7.
Audit: Apart from the routine assessment work, considerable weightage has been
placed on audit work. The correctness of self-assessment procedure that is
self-determination of tax liability by dealer through periodical returns is checked
through a system of departmental audit.

Empowered Committee of State Finance Ministers was set up by the Union Finance
Minister to examine all aspects of sales tax reform, including the introduction of VAT.
The major recommendations of the committee included
84
i.
Simplification of the rate structure the adoption of four general rates (0,4,8,12) and
two special floor rates (1 and 20) in place of existing multiple rates levied in
different States.
ii.
Minimization of the Exemptions: Preparing a list of exempt goods and fixing a

target date beyond which no State/Union Territory should exempt goods other than
those mentioned in the list thereby keeping the exemptions to a minimum.
iii.
Doing away with sales tax incentives for industrialization.
iv.
Enhancement of transparency.
Indirect Taxes
Through repeated discussions and collective efforts of the Empowered Committee within a
period of one and a half-year the committee was able to achieve remarkable success in the
area of harmonization of sales tax structure through implementation of uniform floor rates
of sales tax and discontinuation of sales tax related incentive schemes. After reaching this
stage, steps were initiated by the Committee for the systematic preparation for the
introduction of state-level VAT.
The Empowered Committee of State Finance Ministers with repeated discussions and
collective efforts brought out a White paper on 17.01.2005, which provided a base for the
preparation of various State VAT legislations. The White paper consists of the following:
i.
Justification of VAT and background.
ii.
Design of state-level VAT.
iii.
Steps taken by the States.
Thus the implementation of VAT is a milestone in the tax reforms process initiated by the
Government to make India a competitive global economy.
a.
What are the two basic rates under VAT?

..
..
..
b.
What is the threshold limit for small dealers in a State for registration under VAT?
..
..
..
c.
What is the VAT rate on gold and silver ornaments?

..
..
..
17.7 SUMMARY
Excise duty is a duty on goods that are indigenously manufactured. It is a duty on

manufacture.
Section 4 of the Central Excise Act, 1944 provides that the value of the goods for levy
of excise duty as the price as determined by the Central Excise Valuation Rules.
The CENVAT scheme is principally based on the system of granting credit of duty
paid on inputs and input services. A manufacturer will get credit on duty paid on
inputs and input services at the time of payment of duty on final products.
Section 11 of the Customs Act, 1962 gives power to the Central Government to
prohibit import or export of goods of specified description, by notification in the
Official Gazette for certain purposes.
Duties of Custom shall be levied at such rates as may be specified under the Customs
Tariff Act, 1975.
85
Section 25 of the Customs Act, 1962 empowers the Central Government to grant
exemption from customs duty in public interest.
Service tax is a form of indirect tax levied on specified services called taxable
services. It is levied on the gross or aggregate value of services provided. As service
tax is an indirect tax, though the tax is payable by the service provider it is ordinarily
recovered from the recipient of services. If there are no services rendered, then there is
no service tax.
Value Added Tax, widely known as VAT, is a special type of indirect tax which is
imposed on goods and services at each stage of production, starting from raw
materials to final product.
VAT is tax on value addition to the goods and the essence of VAT is in providing
set-off for the tax paid earlier. Therefore, the VAT liability of the dealer is the net tax
payable by a registered dealer for a tax period. It is the difference between the output
tax and the input tax credit.
There are only two basic rates under VAT namely 4% and 12.5% on goods. Stringent
penal provisions have been introduced to discourage the evasion of taxes because the
dealer is also allowed the benefit of input tax credit which was not allowed earlier.
17.8 GLOSSARY
Appellate Tribunal means the Customs, Excise and Gold (Control) Appellate constituted
under section 129 of the Customs Act, 1962 (52 of 1962).
Assessee means a person liable to pay the service tax and includes his agent.
Board means the Central Board of Excise and Customs constituted under the Central
Boards of Revenue Act, 1963 (54 of 1963).
Body Corporate has the meaning assigned to it under Section 2(7) of the Companies Act,
1956 (1 of 1956).
Exported Goods (According to Section 2(19)) means any goods, which are to be taken out
of India to a place outside India. They include: goods exported by sea, air, land, post,
passengers as baggage and stores and fuel supplied to foreign going vessel/ aircraft/etc.
which are considered to be exports.
Export (According to Section 2(18)) means any goods which are to be taken out of India to
a place outside India.
Exporter (According to Section 2(20)), exporter in relation to any goods at any time
between their entry for export and the time when they are exported includes any owner or
any person holding himself out to be the exporter.
Goods have the meaning assigned to them in clause (7) of Section 2 of the Sale of Goods
Act, 1930 (3 of 1930).
Import (According to Section 2(23)), means goods bringing into India from a place outside
India.
Imported Goods (According to Section 2(25)), means any goods brought into India from a
place outside India, but do not include goods, which have been cleared for home
consumption. They include: goods imported by sea, air, land, post, passengers as baggage
and ship stores considered to be imported and charged to customs duty.
Information has the meaning assigned to it in clause (v) of sub-section (1) of Section 2 of
the Information Technology Act, 2000 (21 of 2000).
86
Indirect Taxes
Datey. V.S. Indirect Taxes Law and Practice. 21st Ed. New Delhi: Taxmann
Publications. Pvt. Ltd., 2008.
Datey. V.S. Students Workbook on Indirect Tax Laws. 3rd Ed. New Delhi: Taxmann
Publications. Pvt. Ltd., 2008.
Vaitheeswaran. K. Students Hand Book on Indirect Taxes. 7th Ed. Mumbai: Snow
White Publications Pvt. Ltd., 2008.

a.
The Central Government is vested with the power to levy excise duty by virtue of
Entry 84, List I, Schedule VII of the Constitution of India. However, the Central
Government has no power to impose duty on:
Alcoholic liquors for human consumption; and
Opium, Indian hemp and other narcotic drugs.
As alcoholic liquors, opium and other narcotic drugs found place in the States list,
they are eliminated from the Central Governments list.
b.
In Khandelwal Metal and Engineering Works vs. Union of India, the Supreme Court
held that notwithstanding that waste and scrap arose as intermediate products,
chargeability to duty would arise if the waste/scrap was marketable. Thus, waste/scrap
would be chargeable to duty if it is marketable and is included in the tariff.
c.
This falls under the specific duty of excise. It is the duty payable on the basis of certain
unit like weight, length, volume, thickness etc. For example, duty on cigarette is payable
on the basis of length of the cigarette, duty on sugar is based on per kg. basis etc.
a.
The term baggage is defined by Section 2(3) as including unaccompanied baggage

but excluding motor vehicles. Baggage includes all dutiable articles and personal
effects imported by passenger or a member of a crew in his baggage. It may be
accompanied unaccompanied. The baggage does not include motor vehicles, alcoholic
drinks and goods imported through courier, articles imported under an import licence
for his own use or on behalf of others. Provisions pertaining to baggage are contained
in sections 77 to 80 of the Customs Act, 1962.
b.
In applying this rule, if more than one transaction value of identical goods is found,
the lowest of such value shall be used to determine the value of imported goods.
c.
Customs duty is applicable on transporting of goods by land, air and water, including
the Indian Territorial Waters. Indian Territorial Waters spread around 12 nautical
miles from the sea coast of India. The jurisdiction of the Customs authorities extends
up to border of Indian waters.
a.
In case of a company, service tax for a calendar month is payable by the 5th of the
month immediately following the said calendar month. Therefore, the due date for
payment of service tax in respect of receipt received on December 31, 2008 is
05.01.2009.
87
b.
Exemption is provided in respect of taxable services upto Rs.50 lakh in a financial

year provided by incubatee entrepreneur who is located within the premises of an
incubator where the total business turnover of the incubatee entrepreneur does not
exceed Rs.50 lakh in a financial year/preceding financial year. Exemption is available
to an incubatee for a period of three years w.e.f. the date of signing an agreement with
the incubator. Hence in the above case, no service tax is chargeable.
c.
Small service providers whose aggregate value of taxable services is less than Rs.8 lakh
in a financial year are exempt from service tax. [Notification No. 4/2007-ST dated
1.3.2007].
a.
There are only two basic rates under VAT namely 4% and 12.5% on goods eligible for
input tax credit.
b.
Registration: Small dealers whose total turnover in respect of purchase and sales in
the State is not less than Rs.10 lakh for a year, other dealers whose total turnover for a
year is not less than Rs.5 lakh, casual traders, agent of non-resident dealer and dealers
irrespective of quantum of turnover shall obtain registration. If the dealer fails to
obtain the registration, then the commissioner may compulsorily register the dealer
and assess the tax due from the dealer based on the evidence available with him.
c.
Gold and silver ornaments and articles thereof, precious and semi-precious stones will
have a VAT rate of 1%.

A. Multiple Choice
1.
2.
3.
88
Special additional duty of customs is imposed with object of:

a.
Off-setting the effect of local sale tax
b.
Off-setting the effect of excise duty
c.
Protecting the interests of Indian industry
d.
Preventing the act of dumping from the foreign large manufacturers
e.
Countervailing the subsidies given by foreign countries to its exporters.
This term refers to any property, whether vessel or cargo, left or abandoned in the
open sea by persons incharge of it without any hope of recovering or intention of
returning to it:
a.
Derelict
b.
Jetsam
c.
Flotsam
d.
Wreck
e.
Seizure.
Which of the following will not be included while arriving at the assessable value in
order to determine the excise duty payable?
a.
Cost of secondary but returnable packaging.
b.
Sales tax paid.
c.
Quantity discount.
d.
All of the above.
e.
Both (a) and (c) of the above.
Indirect Taxes
4.
5.
What is the due date for filing service tax returns for the half year ended
September 30th?
a.
October 25th.
b.
September 30th.
c.
June 30th.
d.
December 31st.
e.
March 31st.
Basic exemption limit in case of small service providers is

a.
Rs.4,00,000
b.
Rs.5,00,000
c.
Rs.6,00,000
d.
Rs.10,00,000
e.
Rs.8,00,000.
B. Descriptive
1.
What are the purposes for which the Central Government can exercise the power to
prohibit the import and export of goods?
2.
What are the situations where transaction value under Section 4 of the Central Excise
Act does not apply?
3.
What are the advantages of VAT?
practice only.
89
NOTES
90
DIRECT TAXES CODE BILL HIGHLIGHTS

K.RAVI, BA, LLB, FCA,
Chairman, Central Taxes Committee, FKCCI
The Honourable Finance Minister released the draft Direct Taxes Code and the Discussion paper
on 12th August 2009. An attempt has been made to simplify the language to enable better
comprehension and to remove ambiguity to foster voluntary compliance.
1. PRELIMINARY
This Code shall be called the Direct Taxes Code, 2009
It extends to the whole of India.
It shall come into force on the 1st day of April, 2011; i.e. Financial Year
2011-12.
2. BASIS OF CHARGE
RESIDENTIAL STATUS: Only status of Non Resident and Resident of

India exists. The other status of resident but not ordinarily resident has
been removed.
TOTAL INCOME: Total Income to include income of any other person.

Total Income to include income of spouse, minor child etc. Also, the total
income for a financial year of any person shall not include any of the income.
3. COMPUTATION OF TOTAL INCOME:
CLASSIFICATION OF SOURCES OF INCOME: For the purpose of

computation of total income of any person for any financial year, income
from all sources shall be classified into :
a)
Income from Special sources are given no deduction and what is earned is
taxed directly.
The steps for computation of income from special sources are as under:
STEP 1: Compute the income in respect of each of these special sources in
accordance with the provisions of the Fourth Schedule. The income so
computed with respect to each of such special sources shall be called current
income from the special source.
STEP 2: Aggregate the current income from the special source with the
unabsorbed loss from that special source at the end of the immediate
preceding the financial year, if any. The result of such aggregation shall be
the gross income from the special source. If the result of aggregation is a
loss, the gross total income from the special source shall be nil and the
loss will be treated as the unabsorbed current loss from the special source,
at the end of the financial year. The gross total income from the special
source shall be computed with respect to each of the special sources.
STEP 3: The gross total income from all such special sources and the result,
of this addition shall be the total income from special sources.
b)
Income from Ordinary sources are divided into further categories, namely:
1.
Income from employment (Presently called Salaries)
2.
3.
Income from Business
4.
Capital gains
5.
Income from Residuary Sources (Presently called other sources)
Annexure (Direct Taxes)
The steps for computation of income from ordinary sources are as under:
STEP 1: Compute the income in respect of each of these sources. This could
either be income or loss (negative income). For example, if a person carries on
several businesses, the income from each and every such business will have to be
separately computed.
STEP 2: Aggregate the income from all the sources falling within a head to arrive
at a figure of income assessable under that particular head. The result of such
computation may be a profit or loss under that head.
The aforesaid two steps will be followed to compute the income under each head.
STEP 3: Aggregate the income under all the heads to arrive at the current income
from ordinary sources.
STEP 4: Aggregate the current income with the unabsorbed loss at the end of the
immediate preceding financial year, if any, to arrive at the gross total income
from ordinary sources. If the result of aggregation is a loss, the gross total
income from ordinary sources shall be nil and the loss will be treated as the
unabsorbed current loss from ordinary sources at the end of the financial year.
STEP 5: Gross total income from ordinary sources, so arrived, will be further
reduced by incentives in accordance with sub-chapter I of Chapter III. The
resultant amount will be total income from ordinary sources.
AMOUNT NOT DEDUCTIBLE WHERE TAX IS NOT DEDUCTED

AT SOURCE: Any amount on which tax is deductible at source under
Chapter XI during the financial year shall not be allowed as a deduction in
computing the total income if:
a.
the tax has not been deducted during the financial year; or
b.
the tax, after such deduction, has not been paid during the financial
year, or in the subsequent year, before the expiry of the time prescribed
under sub section (1) of Section 198.
However, the provision of sub section (1) shall not apply, if the tax has been
deducted during the last quarter of the financial year and the tax is paid before the
due date of filing the return of tax bases.
4. INCOME FROM EMPLOYMENT:
Income from employment will be the gross salary on due or receipt basis,
whichever is earlier including value of perquisites and profits in lieu of salary
as reduced by the aggregate amount of the following permissible deduction.
a.
Professional Tax paid;
b.
Transport Allowance to the extent prescribed;
c.
Prescribed Special Allowance or benefit to meet expenses wholly and

exclusively incurred in the performance of duties, to the extent actually
incurred;
d.
Compensation under Voluntary Retirement Scheme
e.
Amount of gratuity received on retirement or death;
f.
Amount received on commutation of Pension; and
g.
Pension received by gallantry awardees.
The value of rent free accommodation will be determined for all employees
in the same manner as is presently determined in the case of employees in the
private sector.
All perquisites to be included in Salary Income.
There is no deduction on HRA and medical reimbursement.
5. INCOME FROM HOUSE PROPERTY:
Income from house property, which is not occupied for the purpose of any
business or profession by its owner, will be taxed under the head Income
from house property.
The income from property shall include income from the letting of any
buildings along with any machinery, plant, furniture or any other facility if
the letting of such building is inseparable from the letting of the machinery,
plant, furniture or facility.
No deduction in respect of municipal taxes and interest for self occupied

house whose gross rent is taken as Nil.
Only Let out properties are considered and the Gross rent and specified
deductions are allowed. The Income from house property shall be the gross
rent less specified deductions.
The following deduction will be admissible against the gross rent:a.
Amount of taxes levied by a local authority and tax on services, if

actually paid.
b.
Twenty per cent of the gross rent towards repairs and maintenance
c.
Amount of any interest payable on capital borrowed for the purpose of

acquiring, constructing, repairing, renewing or re-constructing the
property.
6. INCOME FROM BUSINESS:
Every business will constitute a separate source and, therefore, income will
be computed separately for each business.
A business will be treated as distinct and separate from another business if

there is no interlacing or independence or unity embracing the two businesses.
The computation of income from business under the Code will be based on
the income-expenses model where the taxable income under this head will be
equal to gross income minus allowance deductions.
Indefinite carry forward of business losses to be allowed.
7. CAPITAL GAINS
Income from transactions in all investment assets (i.e. any capital asset other
than business capital asset) will be computed under the head Capital Gains.
The present distinction between short term investment asset and long term
investment asset on the basis of the length of holding of the asset will be
eliminated.
The Securities Transaction Tax will be abolished. Therefore, all capital gains
(loss) arising from the transfer of equity shares in a company or units of an
equity oriented fund will form part of the computation process.
8. INCOME FROM RESIDUARY SOURCES
The gross residuary income will comprise of any income which does not
from part of any other head of income.
Any amount exceeding Rs.20,000 taken or accepted or repaid as loan or

deposit otherwise than by account payee cheque or draft shall be deemed to
be income from residuary sources and taxed accordingly.
Any sum received under Life Insurance Policy, including any bonus, shall
be exempt from Income Tax, provided it is a pure life insurance policy (i.e.
the premium payable for any of the years during the terms of the policy does
not exceed 5 percent of the capital sum assured). Consequently, in all other
cases, the sum received under the policy, including any bonus, will be taxed
as income from residuary sources.
9. EET METHOD OF TAXING SAVINGS
The Code proposes to introduce the Exempt-Exempt-Taxation method of

taxation of savings.
Only new contributions on or after the commencement of this Code will be

subject to the EET method of taxation.
An individual or HUF will also be allowed deduction for amount paid

towards tuition fees for children. The aggregate amount of deduction for
payment into the account maintained with any permitted savings
intermediary and for tuition fees shall not exceed Rs. 3 Lakhs.
10. TAX INCENTIVES:
Major Deductions applicable under the Tax Incentives for an individual are:
a.
Investments through PFRDA approved agencies
b.
Payment of tuition fees
c.
Medical treatment
d.
Health insurance
e.
Donations
f.
Interest on loan taken for higher education
g.
Maintenance of a disabled dependant
h.
Interest income on Government Bonds.
Earlier terms Deductions under Chapter VI A will be treated as Tax

incentives.
Medical treatment, higher education loan interest, donation and rent paid by
selfemployed individual are deductible.
New provision comes for Handicapped individuals to get deductions upto

Rs.75,000.
11. TAXATION OF COMPANIES:
Dividend Distribution Tax(DDT) to be retained. Dividends which suffered

DDT to be tax-free in shareholders hands.
The Code provides for Minimum Alternate Tax calculated with reference to
the value of the gross assets. The shift in the MAT base from book profits
to gross assets will encourage optimal utilization of the assets and thereby
increase efficiency.
The rate of MAT will be 0.25 percent of the value of gross assets in the case
of banking companies and 2 percent of the value of gross assets in the case of
all other companies. Under the code, MAT will be a final tax. Hence, it will
not be allowed to be carried forward for claiming tax credit in subsequent
years.
12. WEALTH TAX:

The Code proposes to tax net wealth in the following manner:
Wealth-tax will be payable by an individual, HUF and private discretionary

trusts.
Wealth-tax will be levied on net wealth on the valuation date i.e. the last day
of the financial year.
Net Wealth will be defined as assets chargeable to wealth-tax as reduced by

the debt owed in respect of such assets.
The net wealth of an individual or HUF in excess of Rs. 50 Crores will be

chargeable to wealth tax at the rate of 0.25 per cent.
The threshold limit of Rs. 50 Crores will not apply to a private discretionary
trust.
13. NEW TAX RATES FOR INDIVIDUALS:
In the case of every individual, other than women and senior citizen:
Slab
Tax rate
0 - 1.60 Lakhs
10%
20%
Above 25 Lakhs
30%
0%
In the case of woman below the age of sixty five years at any time during the
financial year:
Slab
Income Between
Income Between
Tax rate
0 - 1.90 Lakhs
0%
10%
20%
Above 25 Lakhs
30%
In the case of senior citizens:

Slab
Income Between
Tax rate
0 - 2.40 Lakhs
0%
10%
20%
Above 25 Lakhs
30%
14. DUE DATE FOR FILING RETURNS OF TAX BASES:

Sl. No Type
Date
1
Non-Business / Non-Corporate
30th June
Others
31st August
First filing
(under Direct Taxes Code)
30/06/2012
31/08/2012
15. OTHERS:
The terms previous year and assessment year has been replaced with
financial year to eliminate confusion.
Income for the purposes of this Code will, in general, include all accruals and
receipts of revenue and capital nature unless otherwise specified.
Taxation for non profit organizations rationalized.
Mutual Funds, Venture capital funds, Life Insurance Companies to be treated

as pass thru entities.
Earlier Income Tax Act and Wealth tax Act (Covering Income Tax, TDS,
DDT, FBT and Wealth taxes) are abolished and single code of Tax, DTC in
place.
Only status of Non Resident and Resident of India exists. The other
status of resident but not ordinarily resident has been removed.
Earlier the terminology of assessee was meant for the person who is paying
tax and/or, who is liable for proceeding under the Act. Now it has been added
with 2 more definitions namely a person, whom the amount is refundable,
and/or, who voluntarily files tax return irrespective of tax liability. This helps
any person to file his returns and maintain the record of tax return filing.
No changes in the system of Advance Tax, Self Assessment Tax and also
TDS.
Amendment of TDS goes in line with earlier Notification 31/2009 which

speaks of Form 17/UTN/etc. In TDS, a new return, if found required, will be
introduced for Non TDS payments.
Government assessee is covered in Direct Tax Code. Even though they are
not liable for Income Tax / Wealth Tax, Government Assessees are required
to Comply with provision of TDS and TCS. (Current act was not covered
with Government Assessees).
General anti avoidance rule introduced to combat tax avoidance.
Amalgamation and demerger provisions rationalized to allow for tax neutral

business reorganization.
Conclusion
To conclude, this code is broadly welcomed by the industry and the trade.
However, there are reactions on some points which are shown below:
Tax on interest on overseas borrowing is a negative factor and it may

discourage leveraging and reduce investment
The proposal to apply MAT on Gross assets instead of book profit has come
under heavy criticism from industry because it is not a tax on income, which
direct tax should ideally be, but a tax on capital or assets. Also, because it is
value of gross assets, even loss making companies have to pay MAT.
MAT at 2% of gross assets is a very high rate
The issue of MAT on financial companies has also come under criticism
because while MAT in the code for the Banking sector is set at 0.25%, it is at
2% for the NBFCs (Non Banking Finance Companies)
Comments / feedback on the Direct Tax may be sent to FKCCI at dsm@fkcci.in

Block Unit
Nos.
I
Unit Title
1.
2.
3.
4.
II

5.
6.
7.
Trade Environment
8.
BUSINESS
III
9.
10.
Tax Environment
11.
Ethical Environment
IV
BUSINESS CONTRACTS
12.
Law of Contracts
13.
Special Contracts

14.
15.
VI
TAX LAWS
16.
Direct Taxes
17.
Indirect Taxes

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Business Environment & Law

Prof. Loveraj Takru

Course Preparation Team

Ms. Hadiya Faheem

Prof. Debapratim Purkayastha

Ms. Pushpanjali Mikkilineni

Prof. Tarak Nath Shah

Mr. Mrinmoy Bhattacharjee

Ms. Anurita Jois

The ICFAI University Press, All rights reserved.

The ICFAI University Press, Hyderabad

Business Environment & Law

The Social and Political Environment of Business

Business Environment: An Introduction

Dimensions of the Business Environment

Importance of the Business Environment

Components of the Business Environment

External and Internal environment

10. Suggested Readings/Reference Material

3. Dimensions of the Business Environment

The Social and Political Environment of Business

4. Importance of the Business Environment

Business Environment: An Introduction

Check Your Progress

is constituted by an aggregate of all conditions, events, and

In which of the following basic categories can business environment be divided?

includes social, cultural political, legal, and technological factors.

The Social and Political Environment of Business

5. Components of the Business Environment

6. External and Internal Environment

Business Environment: An Introduction

Check Your Progress

Use of advanced technology in the manufacturing process

Seeking expert advise for re-launching a product

Improvement in the air and road links

Increasing bulk purchases of raw materials and components

The Social and Political Environment of Business

refers to a favorable condition in the environment of an

What is the inherent capacity of an organization which can be used to gain

6.1 External Environment

Business Environment: An Introduction

The Social and Political Environment of Business

Check Your Progress

Business Environment: An Introduction

The Social and Political Environment of Business

Business Environment: An Introduction

Check Your Progress

The Social and Political Environment of Business

refers factors related to the management of public affairs and

factors are related to applied knowledge and the materials and

Business Environment: An Introduction

The Social and Political Environment of Business

Business Environment: An Introduction

The Social and Political Environment of Business

Check Your Progress

The constitutional framework, directive principles of state policy and the

Policies related to distribution and pricing, and their control.

iii. Policies related to imports and exports.

Only ii, iii, and iv

i, ii, iii, and iv

An organizations growth and profitability depends on its understanding of the