It is a well settled principle in the Indian context that income-tax of a taxpayer is a not an allowable expenditure / deduction from taxable profits / income. This is also formally incorporated in terms of business profits / income by section 40(a)(ii) of the Income-tax Act, 1961 ('the Act') which states as under:

"40. Notwithstanding anything to the contrary in sections 30 to 38, the following amounts shall not be deducted in computing the income chargeable under the head "Profits and gains of business or profession",-

(a)(ii) any sum paid on account of any rate or tax levied on the profits or gains of any business or profession or assessed at a proportion of, or otherwise on the basis of, any such profits or gains.

….."

As a result, taxpayers with business income have been disallowing the income-tax (including the surcharge and education cess computed on such income-tax) debited to the profit and loss account while computing taxable income.

Judgement of Honorable Rajasthan High Court (HC) in case of Chambal Fertilisers and Chemicals  [TS-6741-HC-2018(Rajasthan)-O]

In this recent judgment, the honorable Rajasthan HC has held that 'education cess' computed on income-tax is not to be disallowed under section 40(a)(ii) of the Act. While coming to this conclusion, the Honorable HC has mainly relied on the following:

- Circular F. No. 91/58/66-ITJ(19) issued by the Central Board of Direct Taxes (CBDT) on 18 May 1967 wherein it was clarified that the legislators had consciously decided to omit the word 'cess' from section 40(a)(ii) of the Act. The intention was to only disallow taxes under the said section. Accordingly, the CBDT had advised tax officers to not disallow 'cess' and avoid litigation on this account.

- Honorable Supreme Court (SC) judgment in case of Jaipuria Samla Amalgamated Collieries Ltd. [TS-5086-SC-1971-O] where, in the context of the Bengal Cess Act of 1889 and Bengal (Rural) Primary Education Act, 1930, it was held that cess should not be disallowed under section 10(4) of the Income-tax Act, 1922 [corresponding to section 40(a)(ii) of the current Act] if the assessment of cess is not made on basis of profits.

Accordingly, the principle emanating from this judgment is that 'education cess' is not a 'tax' as envisaged under section 40(a)(ii) of the Act and hence, should not be disallowed from taxable business profits / income.

Alternative arguments against the judgement of the Honorable Rajasthan HC

It is noteworthy that while accepting the proposition of the SC ruling on the erstwhile 1922 Act based on cess acts of Bengal, the reliance placed by the income-tax authorities on the SC ruling in the case of Smith Kline & French [India] [TS-5058-SC-1996-O] in the context of disallowance of surtax under section 40(a)(ii) of the Act has not been accepted by the Honorable HC.

In this judgment, it was held by the SC that surtax was not allowable under section 40(a)(ii) of the Act since the same was in principle computed on business profits, going by the contextual meaning of provisions rather than literal reading of the same. This SC judgment has also affirmed the Honorable Bombay HC judgment in the case of Lubrizol India Ltd. [TS-5450-HC-1990(Bombay)-O] where the broad and wide scope of the word 'tax' used in section 40(a)(ii) of the Act has been explained in detail. The Honorable Bombay HC has held that:

- The word 'tax' is used in conjunction with the words 'any rate or tax'. The word 'any' goes both with the rate and tax.

- If the word 'tax' is considered only as per section 2(43) of the Act, the word 'any' used before it will be otiose and the further qualification as to the nature of levy will also become meaningless.

- The word 'tax' under section 2(43) of the Act is subject to "unless the context otherwise requires".

- Accordingly, the word 'any' tax under section 40(a)(ii) of the Act refers to any kind of tax on the business profits or assessed at a proportion of or on basis of, any such business profits.

Interestingly, the decision of the Honorable Goa ITAT in the case of Sesa Goa Ltd. [TS-5366-ITAT-2013(Panaji)-O] which is on this very same issue and in the favor of the income-tax authorities, has not been discussed in the HC judgement. In this decision the Honorable Goa ITAT held that education cess is not a fee but is a tax which is disallowable under section 40(a)(ii) of the Act.

Lastly, although section 115JB of the Act (Minimum Alternate Tax) is a complete code by itself, the persuasive argument that the term 'income-tax' under Explanation 2 to Section 115JB(2) includes 'education cess' and thus explains the intention of the Act, does not seem to have been taken before the Honorable Rajasthan HC.

In my humble view, considering:

- the rationale of the above SC judgment in case of Smith Kline, Bombay HC judgement in case of Lubrizol and Goa ITAT decision in case of Sesa Goa; and

- the fact that the SC judgment in case of Jaipuria and CBDT Circular of 1967 pertain to a period much before education cess was introduced,

the income-tax authorities may consider filing an appeal before the SC against the rationale of the Honorable Rajasthan HC to obtain absolute clarity on this issue.

Impact of the judgment on taxpayers

In the meantime, assuming that the Rajasthan HC judgement was to be applied by taxpayers (either under its jurisdiction or otherwise, based on due professional analysis and advice), the following points merit attention:

1. At the outset, can 'education cess' be treated as an expenditure incurred wholly and exclusively for the purpose of the business and hence be allowable in the first place?

2. Since the Finance Act states that 'education cess' is in the nature of an additional surcharge, can an argument be made that even the first 'surcharge' on income-tax should not be disallowed under section 40(a)(ii) of the Act?

3. Would the deduction, if permissible, for 'education cess' then not be governed on 'payment basis' under section 43B of the Act?

4. Very interestingly, the income-tax computation will become a loop or a reiterative calculation - education cess is computed on income-tax and when claimed as a deduction will change the base income-tax amount on which education cess is to be computed. See the illustration below:

5. Hopefully, the now settled position that the term 'tax' in India's tax treaties includes 'education cess' will not be impacted by this judgment. This is because generally the term 'tax' in India's tax treaties is defined to include surcharge and education cess is in fact a surcharge as per the Finance Act. Accordingly, this should neither impact the flat withholding tax rates provided under the tax treaty or availability of tax credit for education cess in foreign countries (where tax rate under Act is applied) subject to other conditions.

Parting note