McDowell and Co Vs. CTO, 154 ITR 148 SC is a watershed in the evolution of tax jurisprudence in India. For the first time, our Supreme Court took a serious view of tax avoidance devices, and held that such devices will not stand the scrutiny of law if the object is only tax avoidance.

It sought the aid of emerging techniques of interpretation in trying to relate such tax avoidance devices to existing legislation. It chose to rely on the famous British ruling in Ramsey's case, in order to expose the devices for what they really are, and to refuse to give judicial benediction. The tax department utilised the ruling to send tremors among corporate houses trying to take advantage of the legal framework of the law to reduce the tax burden.


And then came the Azadi Bachao case, also from the Supreme Court. It cried a halt to the indiscriminate application of the McDowell principle in all and sundry cases. The case related to investments through Mauritius, in order to take advantage of zero tax in Mauritius. The judgement of the court was very elaborate. Jurists thought that short of overruling McDowell, the Azadi case had practically done away with the useful tool of interpretation of tax laws made available by McDowell. But it was not so.

The McDowell judgement was rendered by a Bench of five judges, which was not so in the Azadi case. There can be no question of a three-member Bench overruling a decision of the Five-Bench Court. Courts were free to apply the McDowell case in particular situations. Such situations became few and far between.


The Punjab High Court relied on the McDowell case in order to hold that interest-free security deposit taken by an assessee landlord can be considered a device to circumvent liability to income tax. Such notional interest on security deposit can be treated as income from house property. In this case, the Streetlite Electric Corporation earned income from letting out factory, land, building and offices. It took interest-free security of Rs 35 lakh and showed a low rental income of Rs1.5 lakh, as annual letting value of these properties. There was no provision in the agreement for increasing the rent from year to year. The assessing officer determined the annual value at Rs 7,80,000, by adding notional interest of Rs 6,30,000, calculated at the rate of 18 per cent per annum on Rs 35 lakh being the deposit.

The first two appellate authorities deleted such addition. Revenue took up the matter in appeal. The High Court allowed the appeal and pointed out that the security deposit amounted to 140 times the monthly rent. It was disproportionate to the actual contractual rent of Rs 25,000 per month.

It had no rationale with the agreed rent. The assessee, pointed out the High Court, had adopted a device to circumvent its liability to tax. The lease deed contained no provision for increase of rent from year to year. The security deposit of Rs 35 lakh appeared dubious, when the value of the property let out was only 17.62 lakh. This can never be a genuine transaction. The security deposit was a false device to avoid tax and had no real basis with the actual rent that was received by the assessee.

This was meant to circumvent tax liability on the real rent and the notional rent would fall within the ambit of income from house property. The interest on security deposit of Rs 35 lakh, said the High Court, should be treated as assessee's income. It worked out interest at 9 per cent, as just and added the same to the income from property.


The judgement refers to other rulings holding that notional interest cannot be added as income from house property. The distinction arises from the fact that in the latest ruling, 336 ITR 348, P & H, reliance is placed on the principles laid down in McDowell's case. Where payment of security deposit is to circumvent the real rent, the same shall fall within the ambit of income from house property.

Recently, a full Bench of the Delhi High Court had considered a similar situation and ruled that no notional interest can be added on high security deposit received by landlord.

The Delhi Full Bench went into the methodology prescribed in Section 23 of the Income Tax Act, 1961, and held that the assessing officer made a mistake in not addressing the issue of fair rent determination.

The Punjab ruling discussed above is the only one of its kind in considering notional interest from deposits as income from property. The draftsman of the DTC will do well to take note of this ruling.

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