The inordinate delays in issue of refunds, particularly in the cash-crunch times of COVID-19 crisis, have prompted certain taxpayers to take the custody battle to Courts, latest ruling on the issue being in the case of Vodafone Idea Ltd by the Apex Court.

BS Nagaraj and GL Rinitha, Chartered Accountants, in their article explore on the issue in light of the aforesaid ruling and provisions relating to processing of refunds and the recent legislative changes. The authors discuss the changes in law with amendments in Sec. 143(1D) which stated that processing of a return shall not be necessary, where a notice has been issued to the assessee under sub-section (2) and introduction of Sec. 241A which laid down provisions on withholding of refunds in certain cases. The authors further discuss the implications of the SC ruling in Vodafone and ponder “If the observations of the Hon’ble SC on the interplay between sections 143(1), 143(1D) and 143(2) as they stood prior to AY 2017-18,  are interpreted on a standalone basis to mean that once notice under 143(2) is issued, there is no requirement for 143(1) processing, it may lead to a conclusion that, there is no requirement for any discretion to be exercised by the AO”. The authors sign off stating that “While the law has since changed, the battle for custody of tax refunds is likely to continue before the Courts and the facts of each case would determine which party wins the battle!”

The battle for custody of tax refunds!

The life cycle of a refund claim made in the tax return begins with its processing and should ideally end with the issue of intimation under section 143(1) of the Income-tax Act, 1961 ('the Act'), determining refund and release of the same. However, over the years, due to changes in law and procedure, taxpayers' assessment history, etc. there have been inordinate delays of income-tax refunds in a few cases. The amount of refund claims pending with the tax office and the importance of cash in challenging business circumstances have prompted certain taxpayers to take the custody battle to Courts. The latest ruling on this issue is by the Apex Court in the case of Vodafone Idea Ltd [TS-218-SC-2020]. The implications of the Apex Court's ruling can be better understood by appreciating the provisions relating to processing of refunds and the recent legislative changes.

Requirement to process return

Section 143(1) of the Act provides that every return of income filed under section 139 or 142(1) of the Act shall be processed and the resultant refund shall be granted to the taxpayer. The Finance Act 2012 had introduced section 143(1D) which stated that 'Notwithstanding anything contained in sub-section (1), the processing of a return shall not be necessary, where a notice has been issued to the assessee under sub-section (2)'.

Section 143(1D) was introduced in the Act, to protect the interest of the Revenue in cases where tax refunds claimed in the return could potentially be converted to tax demands upon completion of assessment under section 143(3) of the Act. In order to clarify the applicability of section 143(1D) of the Act, the Central Board of Direct Taxes ('CBDT') had issued Instruction No 1 of 2015 ('CBDT Instruction') dated January 13, 2015 wherein it was stated that processing of return under section 143(1) of the Act cannot be undertaken if such return was selected for scrutiny.

Thus, in cases where a notice was issued under section 143(2), the return filed was not processed under section 143(1). This resulted in refunds being in the custody of the tax office until such time the scrutiny was completed - estimated to be between 25-37 months from the date of filing return of income.

Challenging CBDT Instruction 1 of 2015

Expectedly, the CBDT Instruction was challenged before the Delhi High Court in the case of [TS-5338-HC-2016(Delhi)-O]. The Delhi High Court quashed the CBDT Instruction on the basis that the words "shall not be necessary" as used in section 143(1D) suggest that, where a 143(2) notice is issued, the Assessing Officer ('AO') has discretion to not process a tax return, if grant of such refund adversely affects the Revenue. Such an interpretation was also in consonance with the legislative intent of 143(1D). Relying on this ruling, various High Courts in several instances have reinforced the principle that section 143(1D) does not prohibit the AO from processing the return under section 143(1); rather the AO can exercise his discretion and choose not to process a tax return under exceptional circumstances, if so warranted.

Change in Law

Based on representations received and the report of Justice R.V Easwar's Committee on simplification of Income Tax provisions, Finance Act 2017 amended 143(1D) to make it applicable only to those years prior to AY 2017-18. It also introduced a new section 241 A - 'Withholding of refund in certain cases' applicable from AY 2017-18 and onwards.

Section 241A enables the AO to withhold refund determined under 143(1), in cases where 143(2) notice is issued, if the AO is of the opinion that grant of refund is likely to adversely affect the interest of the Revenue. Further, this section mandates that the AO should record the reasons for withholding in writing and obtain prior approval of CIT / PCIT as the case maybe.

The discretion exercised by AOs to withhold refunds under section 241A has also been put to test before the Courts [TS-5917-HC-2019(DELHI)-O],  [TS-5129-HC-2020(Punjab & Haryana)-O], [TS-5049-HC-2020(DELHI)-O]. The general principle emanating from these decisions is that the AO should form an opinion that grant of refunds is likely to affect Revenue adversely by making an objective assessment of all relevant factors (such as probability of additions, tax effect of additions, past tax demands, financial position of assessee) and pass a speaking order. Various Courts Section 241 is the erstwhile section under the Act which provided the AO, the power to withhold refunds in certain circumstances. This section was omitted by Finance Act 2001 have held that, existence of tax demands or the fact that some orders are under challenge before higher appellate forums does not ipso facto mean that grant of refund would adversely affect the Revenue.

The AO must thus build a prima facie independent case to withhold refunds year on year based on an objective assessment in order to stand the scrutiny of Courts, as res judicata does not apply to tax proceedings. For instance, the decision of an AO to withhold refund of a particular year based on consistent transfer pricing additions in past assessment years in respect of management fees, even though there is no management fee payout in that particular year may be tested by Courts. On the other hand, let us assume a situation where the company's operating margin of 18% - 20% has been revised upwards by AO in past years. In the year in which the company is seeking refund the operating margin (due to general recessionary business environment) is 16% and the company produces data of comparable companies (chosen by the AO is previous assessments) to have similar operating margins. In this case, if the AO still decides to withhold refund based on past assessments, it will be interesting to see whether Courts will intervene, especially considering that assertions made by the company are fact specific and have to be examined in detail during scrutiny proceedings.

Supreme Court ('SC') decision in Vodafone Idea Ltd:

Adverting to the decision of Hon'ble SC, the crux of the issue was whether the AO was correct in refusing to process the returns for AY 2014-15 to AY 2017-18 under 143(1) owing to the likelihood of potential tax demands from pending scrutiny assessments. The assessee made a plea that once the time limit for 143(1) processing expired, the AO ought to have accepted the assessee's requests for refund processing. The assessee contended that since the AO had taken no action and time limit under 143(1) had expired, it automatically meant that the returns were accepted, and refunds became due.

On the other hand, the AO had issued 143(2) notices for all the years under question. The AO also filed letter dated July 23, 2018 describing in detail various reasons as to why issuing refunds under 143(1) would cause prejudice to the Revenue. Some of the reasons accorded were - reference to special audit, huge past tax demands, year on year adjustments viz. capitalization of license fee and 3G Spectrum fee, TP adjustments etc.

In this factual backdrop, the Hon'ble SC decided as follows:

(i) For AY 2014-15 to AY 2016-17: Where scrutiny assessments are pending, 143(1) processing is not required, and the tax refund / demand shall be determined post completion of assessment under section 143(3) of the Act.

(ii) For AY 2017-18: The SC reinforced the principle that refunds could be withheld only if all the conditions in section 241A are satisfied with. It did not comment on whether the AO made a reasonable case to justify the withholding of refunds.

At this juncture it is important to note that the Delhi High Court after a detailed examination of facts concluded that the AO had made a prima facie case for non-issuance of 143(1) and withholding of refunds under section 241A of the Act. The order of the SC did not deliberate much on the facts; rather there are some interesting discussions on the interpretation of section 143(1D) and section 143(2) of the Act which makes an interesting read for an academic discussion, considering the law has since changed.

In paragraph 18, the Hon'ble SC has remarked that once a detailed scrutiny is initiated by way of 143(2) notice, 143(3) proceedings will override processing under 143(1) of the Act. It drew a distinction between the powers of AO under section 143(1) and 143(3) of the Act and held that once a detailed scrutiny is undertaken, summary assessment under 143(1) will no longer have any relevance. Further, the SC opined that while the general rule is that every return of income filed shall be processed under section 143(1) of the Act, in case of an exception - i.e. when a notice under section 143(2) is issued, the requirement to process the return under 143(1) stands overridden. The SC ruling does not contain any discussion on whether 143(1D) grants discretion to the AO to process returns under 143(1). Further, the challenge of the Assessee stating that the letter given by the AO on July 23, 2018 (communicating the reasons for not processing of return) was time barred (on the ground that the same was issued after 143(1) time limit) was overruled by the SC, on the basis that 143(1D) does not mandate the AO to send any communication to the assessee and therefore the question of any such communication being time barred does not arise.

If the observations of the Hon'ble SC on the interplay between sections 143(1), 143(1D) and 143(2) as they stood prior to AY 2017-18, are interpreted on a standalone basis to mean that once notice under 143(2) is issued, there is no requirement for 143(1) processing, it may lead to a conclusion that, there is no requirement for any discretion to be exercised by the AO (which was advocated by the CBDT Instruction). On the contrary, should these observations of the Hon'ble SC be read in light of the complex factual matrix of the case, where the Revenue had built a strong case for not processing the return and withholding refunds and as such had exercised discretion in not processing the return under 143(1)?

While the law has since changed, the battle for custody of tax refunds is likely to continue before the Courts and the facts of each case would determine which party wins the battle!