Despite a paradigm shift towards liberalization in 1991, the Central and State Governments continue to extend fiscal incentives, particularly to underdeveloped regions, as a mechanism to catalyze investments. Paradoxically, these subsidies designed to stimulate capital formation are increasingly being subjected to taxation. This creates a fiscal dissonance where governmental largesse is partially recouped via statutory levy.
In this context, CA Mohan Aggarwal critically examines the statutory and jurisprudential framework governing the taxability of investment subsidies under the I-T Act, while evaluating whether such taxation is consonant with the legislative intent and economic rationale behind subsidy disbursement. The author concludes by remarking that, “Even if it is assumed for one moment to tax a subsidy in the hands of recipient, then it shall no longer retain the character of subsidy benefit from government where businesses made capital investments on one hand and end up paying taxes on any incentive received from government.”

“Incentivized Yet Taxed: The Paradox of Capital Subsidy Taxation in India”

1. Introduction

India's economic narrative has long been intertwined with the strategic deployment of industrial incentives. In its pursuit of self-reliance, post-independence industrial policies sought to empower foundational sectors. Despite a paradigm shift towards liberalization in 1991, the central and state governments continue to extend fiscal incentives, particularly to underdeveloped regions, as a mechanism to catalyze investments. Paradoxically, these subsidies—designed to stimulate capital formation—are increasingly being subjected to taxation. This creates a fiscal dissonance where governmental largesse is partially recouped via statutory levy. This article critically examines the statutory and jurisprudential framework governing the taxability of investment subsidies under the Income-tax Act, 1961, while evaluating whether such taxation is consonant with the legislative intent and economic rationale behind subsidy disbursement.

2. Taxation of Subsidies

The receipt of subsidy from Indian government is always a litigious issue wherein the Indian revenue authorities contend this receipts as taxable. The income tax law is albeit silent on the taxability of subsidy, however, the matter has been decided based on several judicial verdicts which sets ‘Purpose Test’ as principle to bifurcate the subsidy as capital or revenue in nature. This principle has been followed in numerous judicial pronouncements over multiple years. The following are three differential case laws with varied nature of subsidies, but the court followed the same logics to determine its taxability:

• Case of Sahney Steel & Press Works Limited [TS-8-SC-1997-O] where Hon’ble Apex Court analyzed receipt of post-production subsidy by an industrial undertaking and the object of which is to ease the undertaking in managing its operations instead of setting a new unit. Hence, held as revenue in nature and taxed.
• Case of Ponni Sugar Mills [TS-57-SC-2008-O] where incentives granted to repay the loan amount taken for setting up / expansion of industrial unit. The Court based on purpose test held the subsidy as capital receipt and same was not taxed.
• Case of Chaphalkar Brothers Pune [TS-5241-SC-2017-O] analyzed the Maharashtra State and West Bengal State Entertainment Tax Subsidy scheme for adjudication of nature of entertainment tax exemption granted for encouraging development of multiplexes or theatre in their respective state and held ETS as capital receipt which is not liable for tax.

On bare perusal of the judicial verdicts, it is apparent clear that the intent of subsidy is driven factor to determine the nature, however, its taxability is governed by relying on the basic principle to tax all revenue receipt and leave the capital receipts untaxed.

3. Amendmentvide Finance Act, 2015

The Finance Act, 2015 came up with an amendment to consider the receipt of subsidy as income and inserted clause (xviii) under section 2(24) of the Act. The clause also contains carve out provisions from not considering such receipts as subsidy, if it has been adjusted from the actual cost of assets in accordance with Explanation 10 to clause (1) to section 43 of the Act.

Further, this clause has been amended subsequently to include one more carve out exception, excluding subsidy granted as corpus to any trust or institution. The final version of clause (xviii) under section 2(24) of the Act is as under:

“(xviii) assistance in the form of a subsidy or grant or cash incentive or duty drawback or waiver or concession or reimbursement (by whatever name called) by the Central Government or a State Government or any authority or body or agency in cash or kind to the assessee other than,

a. the subsidy or grant or reimbursement which is taken into account for determination of the actual cost of the asset in accordance with the provisions of Explanation 10 to clause (1) of section 43; or

b. the subsidy or grant by the Central Government for the purpose of the corpus of a trust or institution established by the Central Government or a State Government, as the case may be.”

After this amendment, the prima facie questions logged in to mind of each taxpayer is a) taxability of capital subsidies received after 2015 b) Application of amendment either prospective or retrospective in nature.

The primary moto of writing this article is to answer the question (a). However, for sake of clarity and retaining reader’s interest, let’s respond to question (b) first.

Response to Question (b) - Based on multiple judicial pronouncements, wherein the Hon’ble judicial forums while adjudicating issues related to subsidies held that the amendment is prospective in nature. The prominent judicial forums clarified this are as under:

• Hon’ble Delhi Tribunal in case of LG Electronics India (P) Limited [TS-5481-ITAT-2017(Delhi)-O]
• Hon’ble Kolkata Tribunal in case of Limtex Tea & Industries Limited [TS-5202-ITAT-2016(Kolkata)-O]
• Hon’ble Pune Tribunal in case of Chaitanya Steelshape (P.) Limited
• Hon’ble Pune Tribunal in case of Alkoplus Producers (P.) Limited [TS-6396-ITAT-2019(Pune)-O]

Moreover, the same has also been confirmed by Additional Solicitor General during hearing before Hon’ble Bombay Court in case Serum Institute of India (P) Limited [TS-5912-HC-2023(Bombay)-O]. Referring to para 39 of the decision, ASG accepted that application of provision on retrospective basis would cause state of chaotic disarray. It would not only disrupt the revenue stream but also place an undue burden on the exchequer.

Now coming back to the moot question regarding taxing the capital subsidy by invoking section 2(24)(xviii) of the Act. Whether, it is the intention of law maker to tax subsidy, irrespective of its nature either capital or revenue. Whether government is taking incentives back in form of taxes revenues. Amending section 2(24) is sufficient to make any income liable to tax under this complex income tax machinery.

These all questions created a chaos. Let’s understand the basic structure of taxing any income under income tax law.

4. Relevant sections governing taxation structure under Income tax Act, 1961

The Indian Income Tax Act, 1961 (‘the Act’) is a codified statute that lays down the rules for taxation of income. The below is the structure of income tax Act for taxing the income:

• Section 2(24) of the Act – It defines the term ‘Income’ which is inclusive in nature.
• Section 2(45) of the Act – It defined total income which made cross reference to section 5 of the Act
• Section 4 of the Act – It defined chargeability of income for every person in accordance with the provision of the Act.
• Section 5 of the Act – It defines scope of total income to be included in income of every person based on residential status for the respective year
• Section 6 of the Act – It defines the conditions for residential status of the person in India
• Section 14 of the Act – It prescribes various heads of income under which income is categorized for taxation purpose. The language of section 14 has clarified that all income shall, for charging income-tax and computation of total income, be classified under the head of income. The below is the relevant head of income along with its respective charging sections:

The combined reading of all the above sections has clarified that the term ‘income’ and ‘Total income’ are differently defined under income tax Act and section 14 uses term ‘Total Income’ to charge tax. The significance has been made to classify the income under different heads of income either covered under charging section or as deemed fiction of taxing the income.  

5 Legacy of taxing any new income under Income-tax Act

Indian government always comes up with several amendments through its budget and introduce new income to levy taxes on it. The amendments were not just made to consider such items as income but also to charge taxes under the income tax act. Few instances are enumerated below where amendments have been made in the provisions to charge tax on income for the first time:

The aforementioned tabular presentation made it ample clear that the taxability has been govern based on classification of income under particular head of income or introducing deeming fiction under the machinery of income tax provisions. Any receipt or gain merely defined as Income shall not be suffice to make it liable for tax under income tax machinery. There are multiple judicial pronouncements wherein court proved the significance of charging section and held it utmost important to tax income under specific head only. Hon’ble Calcutta High Court in the case of General Industrial Society Limited [TS-5268-HC-2003(Calcutta)-O] held the significance of charging section for taxing the income which is clear from para 9 of the court order reads as under:

“9. Secondly, that once a particular income is chargeable under one head and if it cannot be computed and charged under that head, it cannot be charged under a different head or as income from other sources. A subject cannot be taxed unless the charging provision clearly imposes the obligation. It cannot be so done even by fiction, unless expressly created by statute. ………………….”

Hence, taxability is interrelated with the classification under particular head of income. The principle of presumption to include any element under wider definition of term ‘Income’ is not sufficient to charge tax on it unless it is classified under any particular head.

6 Interchangeability of head of income is not permissible in garb of no taxation under specified head

Each head of income has its own computational mechanism and income once classified under particular head of income shall be charged to tax under such head only i.e., inter-change of head of income is not permitted.

The tax officers in multiple instances use to re-classify income during the assessment proceedings to tax particular income under another head if not taxed in one head i.e., if this head is not workable then shift it to another head. But this act of re-classification with just to charge tax is not acceptable and held as illogical and unjustified by court of law.

• Hon’ble Supreme Court of India in case of D.P. Sandu Bros. Chembur (P.) Limited [TS-5-SC-2005-O] wherein issue related to premature termination of tenancy rights by lessor was examined. The assessee received consideration from lessor due to premature termination of tenancy rights and has not offered it to tax. The Assessing officer alleged to tax the receipt under capital gain and if not then to be taxable as other sources. Hon’ble Court after analyzing the provision of section 45 of the Act to be read along with section 2(24)(vi) of the Act held such receipts as capital receipt based on classification of tenancy rights as capital assets under Income tax Act. But due to impossibility to determine cost of acquisition of tenancy rights, nothing taxed as capital gain. Hon’ble Court while adjudicating the case has neglected the stand of tax department to tax receipt under income from other sources if not taxed under capital gain.

• Similarly, Hon’ble Calcutta High Court in case of General Industrial Society Limited (supra) has examined case for transfer of license obtained originally for setting up of business. The issue raised for taxing the receipt as business income or capital gain. Hon’ble Court clarified taxability of such receipt as capital gain but owing to practical impossibilities to determine the cost of acquisition, no amount taxed under capital gain. Hence, no amount has been taxed under business head due to nil taxability under capital gain.

Therefore, the aforesaid judicial pronouncements clarified the significance of charging section and based on which it is inferred that income covered under particular charging section should be taxed under such head only.

7 Taxation of income under residuary head i.e., Income from other source

The definition of income under section 2(24) is wider and inclusive term which covers several receipts within its wings, but the ultimate taxability of any receipt is dependent upon its coverage under the charging section of the different heads of income. As per charging section 56(1) of the Act, income not classified under any other head of income shall be taxable as income from other sources. The relevant extract of this subsection is as under:

“56. (1) Income of every kind which is not to be excluded from the total income under this Act shall be chargeable to income-tax under the head "Income from other sources", if it is not chargeable to income-tax under any of the heads specified in section 14, items A to E.”

On perusal of aforesaid section 56(1) of the Act, the following are the primary conditions to be complied with:

a. There should be an ‘Income’

b. There should be no chargeability under any other head of income

Moreover, this residuary head of income prescribes various deductions and exemptions, which would be available for specifically categorized incomes under this head and merely by including any receipt under wider terminology of ‘Income’ does not make available such beneficial provisions for it. The combined reading of provision of section 2(24), 4, 5, and 14, infer that income will be charged to tax if it covered under the scope of particular head of income. The below judicial pronouncements made this understanding clearer:

• Hon’ble Calcutta High Court in case of Justice R.M. Datta [TS-5542-HC-1989(Calcutta)-O] has adjudicated issue related to taxability of income received after discontinuance of legal profession by the assessee under section 176(4) of the Act. The court after analyzing the provision of section 176(4) held that the amount received is in nature of income but the same is not chargeable to tax under the head ‘business or profession’ due to absence of deeming fiction to co-relate both provisions i.e., section 176(4) and section 28 of the Act. Section 176(4) is applicable on income received after discontinuation of business whereas section 28 applies on income received in respect of existing business. Therefore, income u/s 176(4) is not taxed as business income and moreover, the court also held that the receipts should not be taxed as other sources and proved the residuary machinery of section 56 of the Act failed. Hence the receipt of income had not taxed at all.

• Hon’ble Mumbai ITAT in case of DP World (P) Limited [TS-767-ITAT-2012(Mum)-O] adjudicated issue related to receipt of gift of three flats from its sister concern. While adjudicating this issue, Hon’ble Tribunal has analyzed taxability of Gift under the provision of Income-tax Act and held that the same in nature of capital receipt. The amount has not been taxed as business income by virtue of no deeming classification u/s 28(iv) of the Act and not as income from other sources u/s 56 of the Act based on capital nature of receipt not to be taxed as income.

• Hon’ble Mumbai Tribunal in case of Direct Media Distribution Ventures (P) Limited [TS-5401-ITAT-2023(Mumbai)-O] while dealing with the taxability of receipt of shares at Nil consideration has analyzed the taxability of receipts under the head business income and income from other sources. Hon’ble Tribunal in its decision held that the shares are not received as part of its business dealing making it out of taxability as business income and also not covered under sub-section 1 of section 56 due to capital in nature.

Therefore, on perusal of the aforementioned precedents, it is inferred that income in each of the case has not been taxed under Other Sources. Thus, failing the residuary machinery to cover all income if not taken shelter under any head of income.

After going through all the above-mentioned judicial precedents, legal matrix, income taxation structure, it is clear that the receipt of subsidies merely classified as Income is not enough to offer it to tax. The understanding can be made for taxing revenue nature subsidies, but the capital receipts shall not be taxable. Instead, the revenue subsidies received in the course of business has been included under the head business or profession. Without making any corresponding change in section 28(iv), no subsidy shall be liable to tax as ‘Business or profession income’ or ‘Other source income’.

8 Conclusion

a. After analyzing all the relevant provisions, facts of case and ratio decidendi in the judicial precedents, amendment made over years to tax income for first time, it seems that by covering the subsidy under the definition of term ‘Income’ without any subsequent classification to respective head of income, cannot make the income liable to tax under the Act at least for taxing receipt of subsidies of capital nature.

b. Even if it is assumed for one moment to tax subsidy in hands of recipient, then it shall no more retain character of subsidy benefit from government where businesses made capital investments on one hand and end up paying taxes on any incentive received from government.

c. Moreover, taxes will be levied on total income as defined under section 2(45) of the Act instead on inclusive term defined under section 2(24) of the Act. The provision of section 2(45) of the Act made subsequent reference to the computational mechanism for deriving such total taxable income i.e., income computed under different heads of income after adjustment of deductions, set of exemptions etc. It implies that income under respective head form base for taxation of income.

d. The amendment made to tax subsidies irrespective of nature of receipt as capital receipt or revenue receipt is beyond the intent of legislature. After going through several instances like taxing receipt of forfeited advance money, it can be inferred that new income can be taxed if changes were made either via separate section or making change to the respective head of income.

e. The subsidies from government are received by the assessee in the due course of running the business and have to be suitably categorized as business income and not under any other income head, even not as other sources. Without any corresponding change to section 28(iv) of the Act, it cannot be taxed as Business income and due to mere no taxability as business income, it shall not be re-classified to tax under residuary provision of section 56 of the Act.

f. However, the action of the government to double cross the entities by granting benefit on one hand and levying tax on other hand has been challenged before Hon’ble Bombay High Court in case of Serum Institute of India (P) Limited [TS-5912-HC-2023(Bombay)-O]. The assessee was represented by counsel Sh. Arvind Datar, but all the efforts to quash the amendment or to obtain relief in respect of capital receipts went in vain as the writ petition filed by the assessee challenging constitutional validity of amendment has been rejected and decided in favour of tax department.

g. The appellant has filed an SLP before Hon’ble Supreme Court of India vide. diary number 10541 of 2024 on 5 March 2024. The matter is currently pending for hearings and disposal.

h. At last, the act of gifting and then taking it back is not appreciable and that too without making any valid legislative provision in this regard.