India: Credits And Creditors In Focus: How To Effectively Resolve Tax Investigations?

The last few years have witnessed increased scrutiny by the tax department of credits in the books of accounts of the taxpayers and the source of such credits. All this relates back to the department's agenda and clear mandate of the Government to unearth black money. A common practice, amongst shell companies, has been to reflect amounts as 'share capital' received from shareholders and thus trying to escape the tax net. However, the tax department has over the years (specifically starting from 2014) has started identifying companies receiving a high premium and targeting them to examine the genuineness of such transactions. The investigation wing of the department, which is separate from the wing which assesses tax liability of payers, had identified a multitude of such companies. Goes without saying, not all transactions are sham and geared towards avoiding taxes. Lets look at the relevant provision and also some practical aspects which may be used for avoiding unnecessary additions and tax outgo in genuine cases.

The relevant provisions in this regard are contained in section 68 of the Income-tax Act, 1961 ("IT Act"). Section 68 provides that a sum credited to the books of a taxpayer may be charged to income-tax as 'income' of such taxpayer of that relevant year where the taxpayer does not offer any explanation about the nature and source of such sums or the explanation offered by him is not satisfactory in the opinion of the tax officer. The section also provides that in case of the credit being in the nature of share capital, the resident shareholder who infused such amounts would also be required to demonstrate the source of such funds. Therefore, the section, in effect, requires proof regarding the 'source of source' in cases where the shareholder is a resident of India. It is important to note, there are three key aspects which need to be proved in a section 68 investigation, i.e. (i) identity of the creditor, (ii) creditworthiness of the creditor and (iii) genuineness of the transaction.

In this context, and may be indicating that these investigations would only increase, the Central Board of Direct Taxes has recently issued a 'Standard Procedure for applying provisions of section 68' ("SOP") to its officers. As per this SOP, tax officers should adhere to the following sequence when applying provisions of section 68:

Step 1: Whether there is credit of a sum during the year in the books of accounts maintained by the taxpayer.

Step 2: If yes, the taxpayer should be asked to explain the nature and source of such credit appearing in its books of accounts.

Step 3: If the taxpayer offers no explanation, the sum so credited may be charged to income-tax as the income of the taxpayer in the relevant previous year.

Step 4: If the taxpayer furnishes an explanation, the tax officer should examine whether the explanation so offered establishes the three ingredients i.e. identity of the creditor, creditworthiness of the creditor and genuineness of the transactions.

Step 5: Whether explanation of the taxpayer is reliable or acceptable? If yes, no further action is required and the sum so credited may not be charged to income tax.

Step 6: If the explanation so offered by the taxpayer is not acceptable or reliable, the tax officer should give a detailed reasoning in the assessment order for not accepting the same.

Step 7: The reasons for not accepting the explanation of the taxpayer should be communicated to the taxpayer.

Step 8: The order passed by the tax officer should be speaking one bringing on record all the facts, explanation furnished by the taxpayer in respect of nature and source of the credit in its books of accounts and reasons for not accepting the explanation of the taxpayer. Relevant case laws should be relied upon wherever possible.

Of course it goes without saying and, this is also noted in the SOP, that the above questions are only illustrative and the questions and sequence may vary depending upon facts of each case.

It is important to understand that issues relating to section 68 are largely facts driven and proper documentary evidence needs to be presented to the tax authorities. Like all transactions, planning should begin at the stage of acceptance of credits (including share capital) from creditors. It is at this stage that a lot of litigation can be pre-empted and avoided. We have dealt with some strategies which could come in handy at the time of tax assessment. While the article specifically focuses on handling tax disputes in the context of section 68 related issues, these will be helpful even in other cases.

The importance of in depth tax counselling and effective legal strategy cannot be overemphasized to mitigate or resolve tax disputes. As is commonly known, unless handled properly, litigation can be a long drawn and expensive affair especially in tax matters. Tax department may require payment of disputed tax demands (along with interest, etc) in the absence of an order staying such demands.

As mentioned above, there are three key aspects which need to be established in a section 68 investigation, i.e. (i) identity of the shareholder, (ii) creditworthiness of the shareholder and (iii) genuineness of the transaction. These aspects can only be proved if appropriate and adequate documents are maintained in this regard. Some of the key factors that could help avoid or reduce tax litigation when share capital is questioned under section 68 are set out below:

  1. Permanent Account Number of the shareholder
  2. Certificate of incorporation of the shareholder (if a company) or other similar registration documents (for other entities)
  3. Audited financial statements of the shareholder
  4. Indian tax returns filed by the shareholder for the relevant year as well for previous years to show history of the shareholder as well as the fact that such person is a taxpayer
  5. Bank account statement reflecting the debit / credit of relevant amounts in the books of the taxpayer under investigation as well as the shareholder
  6. Tax residency certificate issued by the tax authorities of the country of residence of the shareholder if shareholder is a non-resident
  7. Filings undertaken with regulatory authorities under the Companies Act and the Foreign Exchange Management Act
  8. Relevant agreements under which payments were made by shareholder to the taxpayer
  9. Valuation report determining value of shares of the target company (ie taxpayer under investigation)

If, on receipt of relevant documents assessing officer is satisfied with the genuineness of the case, then the credits in question would not be treated as unexplained cash credits / income of the taxpayer. However, in case the assessing officer is not satisfied then the risk continues. Keeping in touch with the assessing officer is often found to be advantageous strategy which enables one to get a sense of the thinking of the assessing officer and whether he has appreciated the case of the tax payer. Being in touch affords a timely opportunity to make additional submissions to satisfy the assessing officer and clear his doubts. Further, it also puts one on notice to approach seniors in deserving cases to seek their intervention if one is reasonably sure that the assessing officer has not appreciated merits of the case and is likely to pass an adverse assessment order. It has been found at times that seeking a timely intervention of the seniors helps in a meritorious assessment based on evidence brought on record thereby saving potential trouble and costs if an adverse order was to be otherwise passed.

In extreme cases, taxpayers also have the option of approaching the High Pitch Assessment committees which are formed with a view to address grievances of taxpayers.

All in all, bringing relevant documentary evidence on record at the very first opportunity and a vigilant and diligent approach is helpful in making right representation before the assessing officer and in all likelihood a proper assessment order based on facts and merits of the case.

This article was first published in Taxsutra.

The content of this document do not necessarily reflect the views/position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at legalalerts@khaitanco.com

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