The Hindu Business Line : Exemptions versus deductions

Tax law contains chapters dealing with incomes which do not form part of total income. There are chapters dealing with deductions and allowances. Chapter III refers to various incomes which are exempt from tax. It excludes certain types of income from the ambit of ‘total income’ as defined under the Income-Tax Act, 1961.

The incomes enumerated in Section 10 of the Act are not only excluded from the taxable income of the assessee but also from his total income. They are not to be taken into computation for determining the taxable income. By their very nature certain classes of income are entitled to exemption — agricultural income and income held under charitable trust are cases in point.

Exemption is conferred indelibly on a particular kind of income and does not depend on the character of the recipient. There is a second category of exemption which depends on the character of the assessee. Incomes of local authorities and consuls are examples.

Chapter IV, on the other hand, deals with various heads of income and their computation. Chapter VIA deals with deductions to be made in computing total income.

The distinction between exemptions and deductions is crucial to an understanding of the computation provisions. Deduction is that which is deducted, the part taken away, an abatement. Deductions are made from gross income in arriving at the net income for tax purposes. Many of the deductions are itemised in detail under appropriate captions and subtracted to arrive at income subject to tax.

Lason India case

The distinction between exemptions and deductions was brought forth forcefully by the Madras Bench of the Income-Tax Appellate Tribunal (ITAT) in the Lason India (P) Ltd case. The company was engaged in the business of providing software services and claimed deduction to the extent of 90 per cent of the profits from the undertaking which were eligible for deduction under Section 10B.

The company had brought forward losses from earlier year amounting to Rs 34 lakh against the balance of 10 per cent profits. The assessing officer (AO) rejected the claim for set-off. Section 10B(6)(ii) does not permit such set-off insofar as the loss relates to the business of the undertaking.

The Bench pointed out that the restriction is applicable only in respect of loss which is directly relatable to the loss of the undertaking which is subject to the provisions of Section 10B. It is not applicable to the losses in respect of other businesses.

The question arose whether the 10 per cent profits remaining after the deduction under Section 10B should be treated as business profits.

The answer to this question depended on whether the benefits given under Section 10B represented an exemption or a deduction. The Section allows a deduction from profits of a 100 per cent export-oriented undertaking. Section 10B is in Chapter III dealing with incomes not forming part of total income. From April 1, 2003, the Section allows 90 per cent deduction.

This means the whole of the income is not exempt but only a part. It is not an exemption provision. Merely because Section 10B is placed in Chapter III containing exempt incomes, it does not mean that it related to exempted income, particularly as only 90 per cent of the profits from eligible undertaking is allowed to be deducted.

Whatever remains after allowing the deduction has to be treated only as business income. Once it is treated as business income, the provisions of Section 72 of the Act come into play. The losses belonged to the business and should be allowed against the business income of the company. The Bench directed the assessing officer (AO) to allow set-off of the loss claimed by the assessee (301 ITR 306 (AT)).

A key principle

The above ruling gives an original interpretation of tax law. The principle can be extended to several other cases. Section 10AA(7) deals with tax incentives for newly established units in special economic zones (SEZs) and software technology parks (STPs).

Only a percentage of profit is eligible for exemption and not the entire amount. Under the SEZ Act, profits earned by the unit are 100 per cent tax-exempt in the first five years and 50 per cent is taxed for the next five years.

These units are struggling to get the benefits of 100 per cent exemption extended. Even if they don’t succeed, wherever there is business loss from other units, they can reduce the taxable income from the partly exempt unit by applying the principles laid down in the Madras Bench ruling of the ITAT.

A provision does not become an exemption provision merely because the marginal notes to the section or the heading of the section call it an exemption provision. The contents of the Section will have to be analysed, as the Bench pointed out, to find out whether it is an exemption or a deduction provision.

(The author is a former Chief Commissioner of Income-Tax.)