UNSCIENTIFIC MODE OF COMPUT.ATION OF SALARY: IMPACT ON PROGRESSION

CHAPTER IV

UNSCIENTIFIC MODE OF COMPUTATION OF SALARY:

IMPA<:T ON PROGRESSION

The source of income is an important element of progressivity.' The present

Income Tax Act provides for tlssessment of total income on scheduler basis, with

each head having its own definitions, conditions and deductions. The definition of

tax base is singular in determining the effective progressivity of taxation, than the

shape of tax structure. The tax base is modified by existence of a number of

allowances by way of deductions for computation under each head. One of the chief

factors that influence progres.siveness of salaried employees is computation of

taxable salary. Anomalies amoilg taxpayers arise because the way in which income

from different sources is taxed.' Since computation relates to taxable salary the

scope and definition of the tenn 'salary' analyzed. Though income from salary and

income from profession are earned income, the relationship of employer and

employee is a must for any receipt to be treated as salary. The statutory provision

and case law regarding scope of the definition of 'salary', the employer- employee

relation test, defects in the computation of salary and comparison of the same with

other sources, are dealt in the chapter.

Under the I.T. Act, section 4 levies the charge on total income, section 5

defines the range, section 14 qualifies it, and sections 15 to 59 quantify it.' Section

15 contemplates every kind of employee, irrespective of any prior profession or

vocation followed by them4. The section deals separately with salary chargeable on

1 Marina Kesner Skreb et al "Progressivity of Income Tax in Croatia During 1995 to 1999 Peroid" p.2. http://www. ~rlfhr/en~~trarivanjdprogresivnostZOOO. hfm visited on 19.1 1.2004

2 Interim Report of Tax Reform Ccmmittee (1991), p.72.

3 Venktaraman & Co. (P.) Ltd. v. Madras (1966) 60 I.T.R. 112, 129 (S.C.). 4 C.I.T. v. Bachu BhaiNagindashrrh. (1976) 104 I.T.R. 551 (Guj.).

the due basis, receipt basis, and also salary received in arrears5. If an amount

received in advance has been included in the total income of the previous year in

which the amount was received then it is not to be included again in the total income

of another previous year on due basis.

In order to come within the purview of section 15, there must be employer-

employee or master and servant relationship between assessee and the person

making the payment6 It is not enough for the department to demonstrate that

assessee would not have received the sums had he not been an employee. The law

on the subject is mostly controlled by decisions from industrial jurisprudence.' The

industrial law in turn heavily depends on English law. It must be established that the

service agreement was the cau::a causans and not merely causa-sine-qua-non of the

receipt of the profit.' The law on this point has been summarized in Halsbury's laws

of England, as thus:

Whether or not in any given case the relation of master and servant exists is a question of fact; but in all cases the relation imports the existence of power in the employer not only to direct what work the servant to be done but also the manner in which the work is to be done.9

It is a question of fact in each case whether relationship of master and servant exists.

In C.I. T v. West Bengal State Electriciv Board, 'O a foreign engineer deputed by

5 Section 15 reads thus: "The following income shall be chargeable to income-tax under the head "Salaries" - (a) any salary due from an employer or a former employer to an assessee in the previous year, whether paid or not; @) any salary paid or allowed to him in the previous year by or on behalf of an employer or a former emplo:yer though not due to before it became due to him; (c) any arrears of salary paid or allowed to him in the previous year by or on behalf of an employer or a former employer, if not charged to income-tax for any earlier previous year."

Qumar Shafi Tyabji v. C.E.P.Y(l960) 39 ITR 61 l(SC) 7 See Dharangadhra Chemical Work Ltd. v. Saurashtra A.I.R. (1957) S.C,264, 268. Agarras

working in salt works were held workmen within the meaning of union rules and was held to be professional labours. The cou~t was of opinion that the nature and extent of control that is requisite to establish the relationship of employer and employee vary from business to business and is by its very nature incapable of precise definition.

A Hochstraser v. Mayes (1961) 42 I.T.R. 457,472 (H.L).

Halsburys law's of England ,(Lord Hailsham Fourth edition,) Vol. 22, p.112, 'O (1987) 166 I.T.R. 507,514 (Cal.).

Japanese company to supervise an electricity project of the Board was held to be not

an employee of the Board.

Test that is usually applied in order to determine the relationship is the

existence of a right to control and the manner in which the work is to be done. A

servant acts under the direction and supervision of the master, and is bound to

conform to all reasonable orders given to him in the course of his work. An

independent contractor, on the other hand is independent of any control or

interference, and merely undertakes to produce a specified result, employing his own

means to produce the result.''

The remuneration which a director or managing director may receive from

the company may either fall under section 15 as salary income or under section 56 as

income from other sources, according to the terms of agreement. It is not the name

of the office in relation to which the income is derived which would determine the

true nature of the head of the iricome, but the power and duties of the office holder,

under the terms of agreement with a company would be decisive in the matter.12

The director of a company is ordinarily not its servant but it does not prevent

a director or managing director from entering into a contractual relationship with the

company, so that quiet apart from his office becomes entitled to remuneration as

employee of the company. In C. I. T. v. Travuncore Chemical Mfg. Co. l 3 the terms of

contract of employment of the managing director provided for recompense for

services at fixed percentage of the turnover in the business achieved by him.

Provisions in the article of the company stipulated that duties and functions of the

managing director were subject to the supervision, control and direction of the board

of directors. The Court held that the payment received by the managing director

takes the color of salary.I4 This dual capacity must not be mere paper work, rather it

" Chandir PrasadSingh v. Uttar Prodesh, A.I.R. (1956) S.C. 149. 12 K.R.Kothanda Raman v. C.I. T. (1966) 62 I.T.R. 348,352 (Mad.). I3 C.I.T. v. Travancore Chemical Mfg. Co. (1982) 133 I.T.R. 818 (Ker.).

" Ibid at 827.

should be proved on record as a fact.'' The dual capacity depends upon the nature of

his work, the terms of employment and articles of association of the company.I6

In Inder Chand Hari Ram v. C.LT1' the court was of opinion that the

assessee though designated as a managing agent, the powers conferred upon him

under the articles of association were more in the nature of powers given to a

servant. He was held to be a sei~ant of the company and hence salary taxable under

the head 'salary'. The incentive allowance in addition to salary derived by

development officers of the Life Insurance Corporation was held to be salary and not

profits and gains of business or profession.18 The incentive bonus paid was treated as

part of salary in C. I. T. Pune v. (;opalakrishna Suri.I9

The question whether a particular income is salary or business is not always

free from difficulty. A film artiste takes up employment under picture wise

contracts. They are free after the contracts. 'The income of such artistes from acting

is not from salary but from profe~sion.~' An assessee deriving income from

profession as musician, incidentally rendering services to a college of music could

not be said to be an employee of the college2'. In Max Muller Bhavan, In ReU

honorarium paid to part-time teachers on contract basis to teach German came up for

consideration. It was held that mere fact that teachers were engaged on part-time

basis and were free to accept other assignments, and were not entitled to avail

benefits of regular employees as per agreement with the institution, would not

militate against the relationship of master and It was opined that the

l5 CIT v Smt. Santhi Devi (1991) 164 ITR 800 (Ori.)

Rarnaprasadv.C.I.T. (1972)861.T.R. p122,127(S.C.). 17 (1952) 22 I.T.R. 116, 117 (All.). " C.1.T v. Kiran Bhai H. Shelat, (1999) 235 I.T.R. 635 (Guj.).

l 9 (2001) Tax.L.R. 143 (Bom.). 20 C.I.T. v . Mrs.Durgo Khote, (195:!) 2 I.T.R. 22,26.(Bom.). ' C.I. T. v . Jnan Prakash Ghosh, (1992) 62 Taxman 152 (Cal.)

(2004) 138 Taxman 113 (AAR) New Delhi, J Syed Shah Mohammed Quadri, Chairman

23 Ibid at 1 14.

institution (non-resident) was the employer and should deduct tax at source from the

honorarium of the part time teachers."

The issue of taxability of salary of judges of High courts and Supreme Court

was considered in Justice Devaki Nandan Aganvala v. Union of It was

contended that judges were not employees and the remuneration was not taxable

under the head 'salary'. The apex court rejected the argument and held that judges

receive salary and is taxable under the head salaries.16 The taxability of payments

made to the Advocate General came for the consideration of the court in CIT v.

Govinda~warninathan.~' The Court was of opinion that amount paid was retainer fee

to retain his services and should be assessed under the 'head profits and gains of

business or professi~n'.~'

Analysis indicates that tests evolved entirely depend upon the facts and

circumstance of each case and .no uniform formula emerges. It consequently results

in multiplicity of litigation. It further reveals that taxpayers strive to establish their

status as professionals rather than as employees. It may be inferred that they were

allured by the deductions under the head income from profession and business. The

tests based on supervision, direction and control seems to be inadequate to solve tax

avoidance through 'consultation' by employees.

In Gestetner Dup1ication.r (P) Ltd v CIT l9 the apex Court interpreted the

meaning of 'salary' as to comprises in its fold, all ordinary connotation plus the

extended inclusions enumerated in Section 17(1) sub clause (i) to (vii)?' In ordinary

l4 Ibid

24 (1999) 237 I.T.R.872, (S.C.).

25 Ibid at 875.

26 ((1998) 233 ITR 264(Mad)

'' Ibid at 268.

Ibid. l9 (1979) 1 17 1TR I (SC).

30 Ibid at l I .

parlance salary connotes remuneration or payment for work done or service

rendered. The Court further held that conceptually there is no difference between

salary and wages. Both are compensation for work done or services rendered,

though ordinarily salary is paid in connection with services of non-manual type of

work, while wages one paid in connection with manual services3'. Scope of

definition of salary again csune up for the consideration of apex Court in

Karmachari Union v Union of India & others.32 It was interpreted to include wages,

annuity, pension, gratuity, fees, commissions, perquisites or profit in lieu or in

addition to any salary or wages, advance of salary, payment received by an

employee in respect of any period of leave not availed of by him and any other

payments mentioned in sub clauses v(a) (vi) and (vii). It was further observed that

the legislature intended to include in salary the specified or named amount paid to

the employee in respect of the services rendered by him.I3

The Act has given an inclusive definition of the term 'salary'" in section

17(1). In C.I.T. v. T. Abdul Wahid and Co." the Madras High Court was of opinion

that the delinition was couchecl in wide terms to take into account all remuneration

paid to employee, whether labeled as salary or otherwise by employer.36

' Ibid.

(2000) 243 ITR 143 (SC).

Ibidat151. 34 Section17 (I) reads thus: "'Sala~y' includes - (i) wages; (ii) any annuity or pension; (iii) any

gratuity; (iv) any fees, commi~s~~ons, perquisites or profits in lieu of or in addition to any salary or wages; (v) any advance of salary; (va) any payment received by an employee in respect of any period of leave not availed of by him; (vi) the annual accretion to the balance at the credit of an employee participating in a recognized provident fund, to the extent to which it is chargeable to tax under rule 6 of Part A of the Fourth Schedule;(vii)the aggregate of all sums that are comprised in the transferred balance as referred to in sub-rule (2) of rule I lof part A of the Fourth Schedule of an employee participating in a recognized provident fimd to the extent to which it is chargeable to tax under sub rule (4)thereof; (viii) the contribution by the cenual Government in the previous year, to the account of an employee under a pension scheme referred to in section SOCCD."

35 (2000) 243 I.T.R. 467 (Mad.).

36 Ibid at 472.

Section 17(I)(ii) includes any annuity" or pension in the definition of the

term 'salary'. In Bhagavathi v. Union of india,'We apex court considered the

meaning of the term 'pension' and was of opinion that it signified a periodical

allowance or a stipend granted or not in respect of any right, privilege, perquisite or

status, but on account of past :services of particular merit. Pension is a bounty for

past services. It was also he1.d that pension included salary though employer-

employee relation did not exist ;it the time ~f'payment. '~

Gratuity is taxable as salary under section 15 read with section 17(l)(iii).

Gratuity means some thing given freely without recompense, a gift, or some thing

voluntarily given in return for service rendered by him to the employer."O The object

is to provide a retiring benefit to workmen who have rendered long and unblemished

service to the employer and thereby contributed to the prosperity of the employer. It

is instrumental to eliminate the superannuated, disabled, weakened or non-

productive human resources liom the industry and maintain its efficiency and

productivity. Gratuity is viewed as an incentive for them to retire. Gratuity has

become a statutory liability of' employees as per the Gratuity Act, 1972. In Smt.

Dhirajben.R. Amin v. C.1 T. it was held that if no service had been rendered, the fact

that payments were made as a result of a resolution by the board of directors of the

company wherein the assessee was having a substantial interest, could not convert

the payments into salary."'

The term 'fee'42 or 'commission' is included in the definition of 'salary'

under section 17(l)(iv). In .David Michel v. C.I.T. the Calcutta High Court

37 Jowitt's Dicionary ofEnglish Lcw Vol.1, 1977 "Annuity is a yearly payment of certain sum of money granted to another for a period or for life either payable under a personal obligation of the grantor or charged obligation of the grantor or charged upon his pure personally although it may be made a charge upon fiee land, in which latter case it is called rent charge."

A.I.R. (1989) S.C. 2088

39 Ibid. at 2090. 40 Garment Cleaning Works v. Workman A.I.R. (1962) S.C. 673. " (1968) 70 I.T.R. 194, 197 (Guj.).

"'Fee' in a generic sense, implies compensation or salary; but if used in its narrow, distinctive sense it signifies the compensation for particular acts or services rendered in the line of official duties". It has been defined as a charge fixed by law for the service of a public officer or for the

interpreted 'fee' to mean a reward or compensation for professional services

rendered or to be rendered; especially payment for professional services, of optional

amount, or fixed by custom or laws; charge; pay. In order that any fee, commission,

perquisite or profits paid to an ~:mployee by employer, be taxable as salary - such as

fees, commission, perquisite profits must be in lieu of or in addition to any salary or

wages?'

The taxability of fees paid in addition to salary came for consideration in C.I. T.

v. Dr. Mrs. Usha Verma." The assessee serving in the government medical college

was permitted to work in the pi3ying clinic run by the college. She received share in

the fees from the paying clinic. The court held that the share of fee was determined

by employer and was salary under section 17(l)(iv) of the Act?'

'Commission' means the percentage of allowance made to an agent for

transacting business for another. When a servant is employed by a businessman and

as a condition of his employment, is paid for his services at a fixed rate of

percentage of the turnover or profit, the commission payable represents salary drawn

by him for his services. The payment on percentage basis will only determine the

measure of the salary.46

In C.1 T v. T. Abdul Wahid and Co.'" the question of commission paid to the

employees came up for consideration of the Madras High Court. Two employees of

the respondent had been paid commission in addition to salary for securing export

orders. The company treated the commission paid to employees as business income,

which was objected by the tax authorities. The court held that the commission paid

was to be regarded as part of the: salary. The Court fisther observed:

use of a privilege under the control of the government; a charge for services; a charge or emolument!' See Corpus Juris se8-undum Vol. 36, p.628.

43 (1956) 30 I.T.R. 701. 714 (Cal.). 44 (2002) Taxation 726 (Punj. & Hai-.)

Ibid. at 730. 46 Raja Ramkurnar Bhargava v. C.1.T (1963) 41 I.T.R. 680,694 (All.).

47 (2000) 243 I.T.R. 467(Mad.)

The mere fact that two agreements existed does not necessarily imply that the payments made under one agreement is not to be regarded as part of salary, when undisputedly all the work done under the agreement was performed by the employee for the benefit of the employer. The fact that the employer utilized the same employee to perform different types of work under two agreements does not give such payments a character other than that of 'salary', having regard to the wide definition of the term in section 17(1).4

The nature of commission paid by company to managing directors in the

form of single premium deferred annuity policies was considered by the Supreme

Court in Commissioner of Income Tar v. Navnit La1 Sanker LaL" The assessees

were entitled for additional reinuneration by way of commission. Subsequently a

restriction was imposed that the amount of commission should be expended in the

purchase of single premium deferred annuity policies from the L.I.C. of India on the

life of the concerned managing director so as to provide for payment of annuity. It

was held that commission at the end of the relevant financial year was salary?'

In Raja Ramkumar Bhargava v. C.I.T." a servant was paid at a fixed rate of

percentage of the turn over 01. profit. It was held that the commission payable

represented salary drawn by him for his s e~ ices . ' ~

Salary includes the value perquisitesJ3 and fringe benefitsJ4 excluding the

fringe benefit chargeable to tax under chapter XILH.5J Any sum paid by employer in

respect of any obligation which: but for such payment, would have been payable by

assessee is also included in the definition of' ~alary.'~. The amount received by way

of city compensatory allowana:, house rent allowance and other payments to the

lbid at 472. 49 (2001) 247 I.T.R. 70 (S.C.)

'"bid at 75

(1963) 41 I.T.R. 680 (All.).

' Ibid at 694.

" Section 17 (2).

54 section 17 (2) (iv).

" See chapter V. '6 Section 17 (2) (vi).

employee came for the consideration of the apex Court in Karmachari Union v.

Union of Indi~. '~ It was held that after the addition of clauses (iiia) and (iiib) to

section 2(24), the word 'income' included any special allowance or benefit

specifically granted to the assessee to meet expenses wholly, necessarily and

exclusively for the purpose of the duties of an office?' The court also considered the

meaning if the terms 'profit' and 'gain' in section 17 and observed thus:

... applying the general meaning of the word 'profits' and considering the dictionary meaning given to it under section 17(l)(iv) and (3)(ii), it can be said that advantage in terms of employment of money received by the employee from the employer in relation or in addition to any salary or wages would be covered by the inclusive definition of the word salary because of the inclusive meaning given to the phrase 'profits in lieu of salary' and would include any payment due to or received by an assessee from the employer and hence the city compensatory allowance, house rent allowance and dearness allowance wen: held to be taxable?9

Until 1955 compensation for termination of employment was not considered

to be an income but as ~ a p i t a l . ~ Payment received for surrender of rights acquired

under a service agreement was excluded from taxation of income.61 Amount of

compensation paid by emplo!~er for compulsory cessation of employment was

treated as a capital receipt and exempt from tax?2 The Income Tax Act, 1961 made a

departure and made taxable any compensation due to or received by an assessee

from his employer or former employer at or in connection with termination of

em~loyment .~~

57 (2000) 243 I.T.R. 143.(S.C.). 58 Inserted by Direct Tax Laws (Amendment) Act, 1989with retrospective effect from 1.4.1962. 59 Karrnachari Union v. Union OfIndia (2000) 243 I.T.R. 143, 156 (S.C.). 60 Section 5 of the Finance Act, 1955 substituted a new section 7 in the Income Tax Act,1922

Explanation 2(1) to sub section (1) provided for inclusion of any compensation. in connection with termination of employment h m the employer or former employer, in the taxable income.

C.I.T. v. Captain H.C.Dhanda,. (1970) 76 I.T.R. 404 (M.P.).

Section 17(3) "profits in lieu of salary" includes - (i) the amount of any compensation due to or received by an assessee from his employer or fonner employer at or in connection with the termination of his employment or the modification of the terms and conditions relating thereto; (ii) any payment [other than any payments referred to in clause (lo), clause (IOA), clause (lOB),

In J. K. Helene Curtis Ltd. v. C.I. T"' amount paid by assessee company to

the executive director, at the time of leaving the company as special bonus for

exceptional services rendered by him was held to be profit in lieu of salary?' Afier

the introduction of clause (iii), even payment from a prospective employer is also

included within the scope of section 17(3).66

Thus the scope of the te:m 'salary' under section 17 is very wide enough to

rope in any payment or benefit received by an employee from an employer and

leaves little scope for tax evasion.

Rate is applied to total income computed after adding net income under

different heads. Hence computation of net income under each head is an important

factor affecting progression. To study the vertical equity among the various heads

comparison of computation of net salary with other sources are made. For

computation of total income id1 income shall be classified under heads A-F of

section 14 of the Act. For each head of income, the statute has provided the mode of

computation and it varies with the nature of the class of such income?' Deductions

permissible under the law in computing the income under each head bear a particular

relevance to the nature of income?' The statute permits specified deductions from

gross income in order to compute the net income. The net income under the different

clause ( l l ) , clause (12) clause 13 or clause (13A) of section 10, due to or received by an assessee from an employer or a former employer or from a provident or other fund, to the extent to which it does not consist of ccatributions by the assessee or interest on such contributions or any sum received under a Keyman insurance policy including the sum allocated by way of bonus on such policy.(iii) any amount due to or received, whether in lump sum or otherwise, by any person (A) before his joining any employment with that person or (B) after cessation of his employment with that person.

(1999) 103 Taxman 162 (Bom.).

Ibid at 164

Clause (iii) was added by Finance Act, 2001.w.e.f:I .4.2002.

Brook Bond & Co Ltd v. C.I.T. (1986) 162 I.T.R. 373,379 (S.C.) Claim for carrying forward the loss arising from business in the assessment year 1955-'56 against the dividend income for the assessment year 1956-'57 was allowed by the court.

lbid

heads is then pooled together to constitute the total income.69 Salaries are grouped

under the head A of section 14.

Section 5 defines the scope of total income referred to in the principal

charging section. Under the section70 the basis of inclusion is either accrual or

receipt and such receipt or accrual may be actual or by legal fiction. Section 5(2)

restricts the scope of total income of a nonresident to income, which is received or

deemed to be received in India or which accrues or deemed to have accrued during

such year. Section 9(l)(ii) lays down that income falls under the head salaries if it is

earned in India shall be deemed to have accrued in India. The section brings in

certain types of incomes, which may not come under section 5, into the definition of

'total income'. The section read with explanation provides for an artificial place of

accrual for income if it is earned in India or if services under the contract for

employment are rendered in 1nclia7'. In C.I. T. v. Halliburton Offshore Services Inc.

the assessee was a non-resident foreign technician employed by a foreign company,

which executed contracts in India claimed that salary paid to him for offshore period

outside India was not chargeable to tax. The court held that the payment of salary for

" Ibid 70 section 5 reads thus: "(I) Subjecf to the provisions of this Act the total income of any previous

year of a person who is a resident includes all income from whatever source derived which - (a) is received or is deemed to be received in lndia in such year by or ob behalf of such person; or (b) accrues or arises or is deemed to accrue or arise to him in lndia during such year; or (c) accrues or arises to him outside lndia during such year: Provided that, in the case of a person not ordinarily resident in India within the meaning of sub-section (6) of section 6, the income which accrues or arises to him outside India shall not be so included unless it is derived from a business controlled in or a profession set up in India.

(2) Subject to the provisions of this Act, the total income of any previous year of a person who is a non-resident includes all income from whatever source derived which -(a) is received or is deemed to be received in lndia in such year by or on behalf of such person; or (b) accrues or arises or is deemed to accrue or arise to him in India during such year.

Explanation 1. - Income accruing or arising outside lndia shall bought be deemed to be received in India within the meaning of this section by reason only of the fact that it is taken into account in a balance-sheet prepared in India.

Explanation 2. - For the removal of doubts, it is hereby declared that income which has been included in the total income of a person on the basis that it has accrued or arisen or is deemed to have accrued or arisen to him shall not again be so included on the basis that it is received or deemed to be received by him in lndia."

71 C.I.T. v. SEDCO Forex Inlernotional Drilling Co. Ltd, (2003) 264 I.T.R. 320. '' (2004) 140 Taxman 405,408 (Uttaranchal).

off period was income earned in India under section 9(l)(ii) for services rendered in

India and the entire salary was taxable. Salary paid by government to an national is

deemed to accrue or arise in India even if service is rendered outside India.73The

allowances and perquisites paid or allowed by government to such persons are

exempt under section lO(7).

Chargeability varies with residence. All income received or deemed to be

received in India or which accnles or arises or is deemed to accrue or arises in India

to residents and non-residents are included within the scope of total income. Income

which accrues or arises to a resident but not ordinarily resident, outside lndia is not

covered by section 5 unless it is derived from a business controlled in or a profession

set up in India.

The incidence of tax is highest on residents and ordinarily residents. section

5 classifies assessees into three categories. (1) residents and ordinarily residents, (2)

residents but not ordinarily residents, and (3) non residents. The criteria for

classifications are laid down in section 6. If any of the conditions mentioned in

clause (a) (b)" or (c) of section 6(1) is fulfilled, the assessee will be resident7' within

the meaning of the A ~ t . 7 ~ An individual who does not satisfy the two additional

conditions is treated as resident but not ordinarily resident.77

73 Section 9 (I) (iii). 74 Section 6 (I) (b) of 1.T. Act, was 1961 deleted by Finance Act, 1982 w.e.f. 1-4-1983. 75 Section 6 (1) An individual is said to be resident in lndia in any previous year, if he - (a) is in

lndia in that year for a period or periods amounting in all to one hundred and eighty two days or more; or (c) having within the four years preceding that year been in India for a period or periods amounting in all to three hundred and sixty-five days or more, is in lndia for a period or periods amounting in all to sixty days or more in that year.

76 C.N.Townsendv. C.I.T. (1974) 97 I.T.R. 185 (Pat). 77 "A person is said to be "not ordinarily resident" in lndia in any previous year if such person is -

(a) an individual who has not been resident in India in nine out of the ten previous years preceding that year, or has not during the seven previous years preceding that year been in lndia for a period of, or periods amounting in all to, seven hundred and thirty days or more; or (b) a Hindu undivided family whose manager has not been resident in lndia in nine out of the ten previous years preceding that year been in lndia for a period of, or periods amounting in all to, seven hundred and thirty days or more." See section 6 (6).

The language of section 6 lays down a technical test of territorial connection

amounting to residence applicable to all foreigner^.'^ Whether the person is

employed in India or outside is a question of fact in each case depending on the

terms and conditions of the contract. In C.I. ir. v. Indo Oceanic Shipping Co. Ltd.m it

was held that the terms of contract, the nature of work, the nature of business and all

relevant facts had to be considered to decide the place of employment. It was further

held that mere entering in to contract in India would not be a conclusive test to

decide as to whether a person is employed in India or outside.

The Act gives a list of chargeable income under the head 'salary'. Sectinl6

specifically deals with deductions from salary .A taxpayer has allowed a deduction

of a certain percentage of salary income subject to a maximum amount as standard

deduction in the computation of taxable salary. It was allowed to cover expenditure

incidental to the employment of the taxpayer. An analysis of the issue whether

withdrawal of standard deduction for computation of salary amounts to

discrimination is made here.

The issue of standard deduction was first raised by the Shome Panel

constituted by Planning Commission, which recommended scaling down of the

deduction to Rs.15,000/-.80 0 e task force was fully in agreement with

recommendation of the panel and went one step further in recommending the

dispensation of it." The recommendations of the two committees were studied and

analyzed. For correct understanding of the present issue it would be helpful to

review the history of legislation of standard deduction, which is dealt below.

Section 16 of the Act before its substitution in 1974 permitted besides

expenses for entertainment, a deduction for expenditure on books and other

publications which were necessary for the purpose of duties, taxes on profession,

" C.I.T. V. Ratnaswamy (1980) 122 I.T.R. 217,223 (S.C.).

(2001) 114 Taxman 722 (Bom.) 80 Reporf of the Advisory Group on Tax Policy and Tax Administration for the Tenth Plan,,

(Planning Commission, Government o f India, 2001), p. 9 . 81 Report of the Task Force on Direct Taxes 2002, p. 84.

conveyance allowance, and announts actually expended by the employee by the

condition of his sewice was required to spent out of the remuneration for the

performance of dutiesu2 This system underwent a vital change and standard

deduction replaced the above four separate deductions. The Finance Minister

Y.B.Chavan explained the reason for the change as follows:

In order to simplify the assessment procedure in the case of salaried taxpayers, I propose to substitute the separate deductions in respect of traveling, books, taxes on professions and expenditure incurred in the performance of duties by a standard deduction up to a maximum of Rs 3500/-.83

Hence it is clear from the :statement of the minister that substitution of standard

deduction in lieu of employmeint related expenses under section 16 of the Act was

for administrative reasons.

The standard deduction allowable for assessment years 1975-76 to 1981-82,

was an amount equal to twenty per cent of the salary up to Rs.10, 000/- and ten per

cent of the salary in excess thzreof subject to an overall limit of Rs.3,500/-. The

pattern prevailed for mainly two decades except for raising the percentage of salary

qualified for standard deduction and increase in the ceiling limit (Table -1).

The Finance Act, 199:3 based on the aggregate salary of the assessee,

inducted progression in allowing standard deduction. Higher deduction was allowed

for low paid and it was denied to high paid employees. The standard deduction of

Rs.25,0001- was available for employees having salary up to rupees one lakh. For

assessees drawing salary between one lakh and five lakhs, the standard deduction

was limited to Rs. 20,0001-. The benefit of standard deduction was withdrawn for

employees having salary income more than five lakhs." The succeeding Finance

82 Clauses (i) to (iv) of section 16 before its substitution by the Finance Act, 1974.Clause (i) was substituted by new clause and clauses (iii)(ivXv) were omitted.

u3 Budget Speeches of Union Finance Ministers1947 to 1990-91 (Government of India), p. 382. para 44. The speech of Finance Minister Y.B. Chavan while introducing the budget for the year 1974-75.

84 Finance (No. 2) Act, 1998 w.e.f. 1-4-1999.

Acts followed the pattern." ' l l~e Finance Act, 2000 left the provision of standard

deduction untouched.

Table -- 1

Standard deduction from 1974 to 2002

to Iln respect of the expenditure incidental to the employment of the taxpayer

(A standard deduction on a presumptive basis which is Ule lest of, Rs.3.500 a an amount calculated in

Assessment Vr., .- , Standard deduction

upto 1974-75

A sum equal to twenty petcent ofthe salary or Rs.5.000, whichever is less.

A sum equal to twenty five percent of the salary or Rs.6,000,whichever is less.

fiii:$ to A sum cqual to twenty five percent of the salaryor Rs.10.000, whichever is less.

Any amount not cxcceding Rs.500. expended by the wpaycr on the purchmc of book and othc publicattons n-sary lot the purpose ofhis duties

1981-82

~-

A sum equal to thirty-threc and one-third percent of the salary or Rs. l2.000. whichever is less.

and one-third percent of the salary or Rs.12.000, whichever is less. If the taxpayer is a woman. and her income fmm salarv is Rs.75.000 or less. a deduction of a sum eoual to

the following manner: 20 &rccnt of the salary if the salary doe. not exceed Rs.10,000/-: Rs.2,OW plus 10 percent of the amount by which the salary exceeds Rs.lO.000 if the salary exceeds Rs. 10,000.

lthlny l h w and one-thud pelcent ofthc salary or RS 15,000, whlchcver is less IA sum equal to th~rty-three and one-third percent of the salary or Rs 15.000, wh~chcver ts lcss I f the taxpayer i s a woman, and her income fmm salary is Rs.75.000 or less, a deduction of a sum equal to

inwme from salaries exceeds Rs.60,000 a deduction of a sum equal to thirty thw and one-third F n t o f the sa lw or Rs.lS.000, v~hichever is less. If the taxoaver is a woman. and her income from salsrv is

~ ~ -~~~

Rs.75.000 or less, a deduction of a sum equal to th&; three and one4hird percent of the sal& o

A deduction of a sum equal to thirty three and one-third percent of the salary Rs.20,000, whichever is

deduction o f a sum equal to is less. For taxpayas whose

Rs.1.00.000 but d m not exceed Rs.5,00,000, a deduction of a sum equal percsnt of the salary or Rs.25.000. whichever is less. No deduction i s

Source: Prepared by reference to Finance Ac;h of relevant yean

Finance Act, 2001 introduced more categories into the gradation scheme of

allowing standard deduction based on the increase of salary. A sum of Rs.30,000/-

or an amount equal to 33'1, per cent of the salary whichever is less, was allowed for

employees whose salary did not exceed rupees one lakh. Assessees whose salary

exceeded rupees one lakh but did not exceed rupees three lakhs, a deduction of

Rs.25,000/- was permitted. The standard deduction was limited to Rs.20,0001- where

" Finance Act, 1999 w.e.f. 1-4-200 i

the salary exceeded rupees three lakh but did not exceed rupees five lakhs.

Assessees having salary above 5 lakh was not entitled to standard deduction at all.=

The Finance Act, 2002 left the standard deduction untouched. The marginal impact

due to steep gradation is illustrated with the help of Table- 2.

Table -- 2

Incidence ol'tax on gradated standard deduction

for assessment year 2001-2002 (Rs) Salary without arrears

Standard deduction

Arrears

Salary with arrears

Standard deduction with mews

Loss of standard deduction

Incidence of tax due to arrears

Table - 3 Standard deduction for the assessment years 2002-2003 and 2003-2004

86 Salary, standard deduction: (A) up to 1.5 lakh - 33 '1, per cent or a sum of Rs.30.0001- which ever is less. (B) 1.5 lakhs to 3 lakhs - A sum of Rs.25.0001- (C) 3 lakhs to 5 lakhs - A sum of Rs.20,000/-. See section 16 (1).

of standard deduction Income for 2002-2003

of salary or Rs 30,000 1,50,000 whichever is less

Exceeds Rs. I ,50,000 but

Rs 25,000 does not exceeds Rs.3,00.000

Exceeds Rs.3,00,000 but

Rs 20,000 does not exceeds Rs.5,00,000 Exceeds Rs

5,00,000

I Source: prepared by reference to Finance Act, 1,500 2001 1,500 6.000

1,50,000

30,000

5000

155,000

25000

5,000

Amount of standard deduction for 2003-2004

40% of salary or Rs 30,000 whichever is less

40% of salary or Rs 30,000 whichever is less

40% of salary or Rs 30,000 whichever is less

Source : Finance Act, 2002 and Finance Act of 2003 I Nil

3,00,000

25000

5000

305000

20,000

5000

Rs 20,000

5,00,000

20,000

5000

5,05,000

Nil

20000

It is seen that an addition of small amount of five thousand rupees of arrears

at the marginal slabs deprived the employee from claiming the relief of standard

deduction of an amount of Rs.5,000/- to Rs.20,000/-.The tax incidence due to arrear

also increases by an amount of Rs.1,500/- to Rs.6,000/-. From the progressive angle

the impact is sharp and steep. The scheme of gradation in the computation of taxable

income is singular for salary income and the same is not applied for the computation

of income under other heads. Hence salaried class is exposed to the impact of

marginal rates. Tax experts and, academicians viewed sharp gradation and denial of

standard deduction for high salaried group (above five lakh) as an instance of

violation of vertical equity.

The government rectified these defects through Finance Act, 2003 by

reducing the gradation to two categories." The gradation of standard deduction for

the assessment year 2002-'03 and 2003-'04 are given in table 3. The standard

deduction was restored for employees having income above five lakhs. Employees

with lesser salary were allowed a sum equal to forty percent or thirty thousand

rupees whichever is less. Standard deduction is allowable in respect of pensioners

alsos8. Where salary is due from more than one employer the deduction shall be

computed with reference to the aggregate from all the employers and income

exceeding the amount specified under this clause shall not be all~wed. '~

The standard deduction uncler section 16(1) has become a matter of debate since

reports by the Shome Committee and Task Force. The committee vehemently

criticized the provision for st,andard deductiong0 and lamented over the loss of

87 Amended by section 13 of Finance Act, 2003. 88 C.I.T. v. Brigadier B.D. Khurna (1996) 217 1,'T.R. 381 (All.) 89 Explanation to section 16 ( I ) . 90 Report of the Task Force (2002), p. 82, reads thus: "The levels of standard deduction have

increased substantially over the years both in terms of percentage and the overall ceiling and is almost out of sync with the actual employment related expenses. The level of Rs,500 in 1974-75 allowable as standard deducting would now be equivalent to approximately Rs.5000Iin current terms. Once conveyance expenditure is separately exempted from taxation, it is difficult to visualize any other employmen-t related expenditure other than personal in nature. This is particularly so when most employers provide for books and periodicals in the place."

revenue due to it.9' The Finance Act, 2005 carried out the recommendation.P2

Whether the withdrawal can be justified on legal and equitable base is analyzed

here.

Tax is on total income and is computed in the manner stipulated in the

Act.P3For the purpose of computation, total income is classified under different

heads, A to F of section 14.94 Computation of different sources are studied and

compared with that of salary as part of the study.

Income form house property is classified under section14 (B). The annual

value of the house property is computed after making deductions enlisted under

section 24 of the Act. It stipulates for a standard deduction of thirty per cent of the

annual value and also for deduction of interest on borrowed capital for the

acquisition or construction of house property. For tax purposes only the net annual

value of the house property is taken into account. In the computation of total income

the loss in respect of house property can be set off against income from other

The net income from profits and gains of business and profession grouped

under section 14(D), is computed after making deductions under sections 30 to

43D.96 Any expenditure laid out or expended wholly and exclusively for the purpose

of the business or profession is allowed as deduction for computing the income

chargeable under this head9' and no ceiling is stipulated under the section. Since

spending is equated to current value of money inflation and devaluation is set off. In

91 Ibid at 83. "The loss in revenue on account of standard deduction is substantial-more so because conveyance allowance is exempt from tax. Also standard deduction of this relative scale is not in line with the international practice and our recommendations on enhancing the general exemption limit".

92 Section 6 of Finance Act, 2005 w.e, f. I- 4 - 2005. 93 Section 2 (45) reads thus: 'Total income means the total amount of income referred to in section

5,computed in the manner laid down in this Act.

" Section 14.

95 Section 71.

% Section 29.

97 Section 37.

the absence of any ceiling limit the mode computation is sufficient enough to

counter the inflation impact. Committee recommended for stipulating a ceiling in the

light of international practice, which was not implemented. If the expenses incurred

in earning the income are more than the income, the assessed can return a loss9',

which can be carried forward arid set off against future year's income.99 Depreciation

is allowed for buildings, machioery, plant and furniture used for the purpose of the

business of profession or business."'"

Similarly income chargeable under the head 'capital gain' is computed by

deducting from the full value of the consideration, the expenditure incurred wholly

and exclusively in connection with such transfer and the cost of acquisition and the

cost of impro~ement.'~' A syste:m of indexation was introduced under which long-

term capital gains are now computed by allowing the cost of acquisition and the cost

of improvement of the asset to be adjusted for general inflation.'02 Capital gains are

reckoned with reference to the difference between net sale consideration and the

indexed cost. The indexed cost is the cost as increased by an allowance for

inflation.'03

Income under the heed 'income from other sources' (section 14(F) is

computed after making deductio'ns for expenditure expended wholly and exclusively

for earning it.Iffl The expenditure: is at real value of money and the net income left is

not reduced due inflationary pressures especially in the absence of ceiling limit for

the deduction.

In contrast to the computation of taxable income under the aforementioned

categories computation of taxable salary stands on a different footing. Though salary

Section 70. 99 Section 72. I M Section 32 .Income Tax Act, 1961.

lo' Section 49. Io2 Substituted by the Act 18 of 1992. 103 Cost of inflation index for the year 2003-04 was 463.

I f f l Section 57.

is ranked as the first item (A) in section14 only deduction allowable to this category

is deduction for professional tax and deduction in respect of entertainment allowance

was restricted to government employee by the Finance Act, 2002 which was finally

taken away in 2004. The Finance Act, 2005 withdrew the standard deduction. The

provision for set off against salary is also denied by amending section 71 as to

deprive any set off against salary. This is the only head under which deduction of

expenses incurred for earning is not allowed whereas all other heads are taxed on net

income after deducting expenditure connected with earning.

Analysis of the relevant provision indicates that the scheme of Income Tax

Act, 1961 is not to tax gross !income but income that remains after deduction of

expenses incurred in earning the same. Comparison of computation of income of

five classes (A to F) of section 14 shows that salaried class alone are denied the

opportunity of deduction of expenditure incurred in earning it and the rest are

permitted to deduct such expenses. Hence the salaried class is discriminated in the

matter of computation of tax.

Kelkar Committee Report states that section lO(14) provides for conveyance

allowance and there is no necessity for further standard deduction.'"' The result of

analysis of the statement is given below.

Section 10(14)(i) permits deduction of special allowance or benefit

specifically granted to meet expenses wholly, necessarily and exclusively incurred in

the performance of duties of the employment as prescribed by income tax Rules.

The section has application only if the employee is in receipt of any special

allowance. It is not providing :for expenses incurred for employment generally by

employees. The section is teclinically worded and restricts the benefit to a few

employees receiving allowance ear marked for the purposes. Before its amendment

'"' Report of the Task Force on Direct Tmes (2002), p. 85 states as follows: " The Task Force, therefore, recommends that standard deduction under section 16 (1) of the Income Tax Act should be eliminated. However, the exemption of conveyance allowance subject to a ceiling of Rs.9,600/- should be continued. This should serve as a reasonable deduction for employment related expenses. The additional liability of a tax payer on this account will be more than met by the reduction in rates of personal income tax proposed by the Task Force."

in 1974 section 16 provided for deduction of expenses incurred in connection with

employment without any qualification as in section lO(14). Clause (ii) though

provides for deduction of allov~ance granted to meet personal expense at the place

where the duties are performed or to compensate for the increased cost of living .

The scope of the provisi~on is further restricted by the proviso qualifying the

performance of duty as of special nature. The Central Board of Direct taxes was

authorized by clause (i) and (ii) to frame rules to lay down the items, manner and

extent of amount qualified for deduction. The Board formulated Rule 2BB for

carrying out the purpose of the section. Rule 2BB(1) enumerates five items viz. any

allowance granted to meet expenditure for cost of travel on tour or transfer, ordinary

daily charges on account of absence from ordinary place of work, cost of

conveyance, for engaging the service of helper, expenses for academic research

purposes and purchase and mair~tenance of uniform.IM

Sub clause (2) gives th~: items of prescribed allowances and extent for the

purpose of section 10(14)(ii), ie. hill allowance (Rs.8001-), Boarder area allowance

(Rs.13001-), tribal area comperisatory allowance (Rs.2001-), allowances granted to

employees working in transport system (Rs.60001-) child education allowance

(Rs.1001-), hostel allowance (Ib.3001-), field area allowance (Rs.26001-), counter

insurgency allowance (Rs.39001-), transport allowance (Rs.8001-), underground

allowance (Rs.8001-), high altitude allowance (Rs.10601-), special allowances to

members of armed forces (Rs.42001-).

Analysis reveals that the cumulative impact of section 10(14) read with Rule

2BB is that the provision has no general application for deductions of amount spent

for purposes of employment. d stipulates for the precondition of allowance being

granted by the employer. It is rather unfortunate that the two committees lost sight of

the scope of these provisions when they recommended withdrawal of standard

deduction for the reason that section lO(14) provides for deduction of expenditure in

connection with employment. Standard deduction was available for all employees

whereas conveyance allowance .was available only when it was specifically given.

I" Sub-clauses (a) to ( f ) of clause ( I ) of Rule 288.

A field study was conducted in this regard. Sample consisted of one hundred

employees selected as follows: 40 of state government, 30 of central government

and 30 of private sector. The response to the question whether they are receiving any

conveyance allowance was as fc~llows: None of the state government employees was

receiving any such amount by way of conveyance allowance. Central government

staff get small amount between Rs.1801- to Rs.3001- towards this item. In the private

sector some were getting conveyance allowance around Rs.5001- to Rs.50001-.

The data indicate that majority was not getting any conveyance allowance.

They have to spend money from, salary for commuting for employment and were not

able to get deduction under section lO(14). Hence denial of standard deduction on

that ground is unjustifiable.

The next issue taken up is the sustainability of certain observations of the

two committees. The Shome Committee stated thus:

Further the provision of a standard deduction to salaried taxpayers over and above the basic exemption limit is iniquitous in as much as non- salaried taxpayers with similar level of income is subjected to a higher level of tax. It also encourages people to seek employment rather than be self-empl~yed.'~'

The task force also made similar observations. It observed that "the provision of

standard deduction to salaried e~nployees over and above the basic limit is iniquitous

inasmuch as it discriminates against self empl~yment."'~~

The basic exemption lilrdt is available to all taxpayers irrespective of source.

All other individual taxpayers except salaried class are eligible for deductions under

respective heads in addition to the general exemption. Hence to argue for denial of

standard deduction on the ground of general exemption is specious. Analysis of rate

compliance shows that at all point of time salaried classes are demonstrating high

107 Report of the Advisory Group on Tax Policy and Tar Administration for the Tenth Plan (2001) p.96. 108 Report of the Task Force on Direct Taxes (2002), p. 83.

rate compliance than the non-~dkiried.'~~ Hence there is no logic in the above quoted

statements of the committees.

The two committees have not demonstrated by any evidence, empirical or

otherwise on which the pinion was formed. The previous committees had

highlighted the allurement of chances of evading tax in the case of self-employed.

The Kelkar committee pointed out only the missing middle.""The analysis of the

case law indicates that the tendency is very strong on the part of employees to brand

themselves as self-employed due to the lenient deductions available to the latter

class. It is an accepted fact thai. world over employees have lesser chances for tax

evasion hence there is a tendency on the part of the employees to come under the

head of independent professional."' In United Kingdom some employees were

entering into highly artificial, marketed schemes, such as composite companies to

utilize the tax advantages of not being direct ernp10yees.l'~ Legislations were made

by introducing personal service intermediary's legislation to counter such avoidance,

which applies to engagements under which the worker would be regarded as

employee if his services were provided direct to the client rather than through an

intermediary company or partnership."' If an engagement is caught by new rules,

the gross income received by tlhe intermediary is treated as a schedule E payment

made by intermediary to the ~,orker."' In the light of the above facts it is to be

concluded that the statements of these committees are not sustainable.

Next issue probed is whether employees incur any expenditure for the

performance of their duties and if so, the extent of such expenditure.

A survey was conductell to find out the items and amount of expenditure

incurred by employees in c'onnection with employment. Questionnaire was

log See chapter 3 for details.

Report of the Task Force on Direct Taxes (2002). p. 78. "I J. Freedman. "Personal Service Companies-the Wrong Kind of Enterprise" (2001) B.T.R 1,3.

\ I 2 Ibid. 113 Finance Act, 2000, section 60 and schedule 12.

' I 4 Supran 110.

circulated among 125 employees during 2005. The present writer was able to get

responses from 93. The employees were asked to enlist the items of expenditure

connected with employment. The items enlisted by them were expenses for

commutation to office, maintt:nance of telephone, photocopying charges, travel

expenses, maintenance of computer, intemet facilities, fee for attending seminars

and conferences, purchase of books, journals and periodicals connected with

employment etc. Seventy-eight out of ninety-three were not receiving any allowance

towards these expenditure. The:! were incurring approximately 15% to 28% of their

emoluments towards employment related expenditure. Some of them were selected

for interview. The outcome of the interview may be summarized as follows.

Some of the low paid employees were forced to occupy houses in the

outskirts of the city owing to high cost rent and incurred considerable amount by

way of commutation to work place. They were not getting any conveyance

allowance. All the employees observed that maintenance of telephone at home was a

must for carrying out the duties of ofice efficiently. Private sector employees were

complaining about insecurity of'job and requirement of expenditure for updating to

cope with the demand of high efficiency. The maintenance of computer and internet

connection were indispensable fbr canying out their jobs. The academicians were of

the view that students need access to intemet and teachers should be resourceful to

guide them. But most of the institutions do not offer sufficient facilities in this

respect and so they are compelled to spend for these facilities.

The study indicated that the employees were incurring expenditure for the

purposes of their jobs and most of them were not receiving any allowance or

reimbursement in that regard.

The data from the study show that the opinions of the two committees were

fonned without any mature consideration of realities."'

"' Report of the Advisory Group on Fax Policy ond Tax Administration for the Tenth Plan. (2001), p. 96. The Committee observed thus: "Experience and anecdotal information tell us that the expenditure on such items is generally less than five percent. It is also well known that most employers provide for extensive library facilities and reimbursement to senior employees for expenditure on books and periodicals. In fact in the government the expenditure by the senior

Kelkar committee was relying on intemational practice. The present writer

has compared the issue at the intemational level. The study indicates that all these

countries permit deduction of expenditure incurred in connection with

empl~yment."~

The denial of standard deduction exposes the salaried class to more

progressive rates. For example, in a case where a salaried and a professional earning

Rs.2,70,000/- each and incurring expenditure at the rate of Rs.300001- per year; the

salaried would be liable to pay tax at rate of 30 % whereas the liability of self

employed after deduction of expenses is limited to 20 % rate. The tax liability of the

salaried would be Rs.340001- and that of self-employed would be Rs.250001-.

Taxing salaried people on gross income and taxing non-salaried sources on

net income is discriminatory. Denying a legitimate deduction to a segment of

taxpayers who are best known for tax compliance cannot be justified legally or

otherwise. Thus the vertical equity is violated between salaried and non-salaried

taxpayers. Hence in the interest of justice and to promote equity among taxpayers

the provision for standard deduction has to be restored to all employees.

officers on newspapers is reimbursed. In the case of the corporate sector the expenditure on newspapers and periodicals is an allowable business deduction without being treated as a perquisite in the hands of the employees."

For detail, see Chapter V11.