Over subsequent decades, taxation laws were codified and centralised, leading to the enactment of the Income Tax Act, 1961, which remains the foundation of India’s direct taxation system today. However, despite ongoing amendments, gaps and ambiguities persist. The case of Mukesh Rasiklal Shah vs. ACIT [TS-7117-ITAT-2024(Ahmedabad)-O] decided by Ahmedabad ITAT discusses one such legal ambiguity with respect to taxing fraudulent income, highlighting the need for further legislative refinement.

Mr. K. Ravi (Advocate) and Ms. Mridula Venkatesh (2nd year Student, O. P. Jindal Global Law School) present an in-depth analysis of the aforesaid ITAT ruling and outline the consequences of the stance taken by ITAT. In this regard, they inter alia highlight that, by failing to distinguish between temporary control and legitimate ownership, the judgment erroneously equates mere possession with a rightful claim to income. While concluding, the Authors remark that “…the decision’s rigid application of taxation laws, without due regard for the unique circumstances of the case, risks establishing a troubling precedent wherein individuals engaged in fraudulent activities are taxed on amounts that were never lawfully theirs. Such an approach effectively extends punitive measures beyond their intended scope, conflating tax liability with criminal sanction.”

“The Absurdity of Taxing Recovered Ill-Gained Proceeds”

INTRODUCTION

Around the world, the need for established laws has emerged as a consequence of humanity’s evolution from primal instincts and the genesis of morality and justice through religious lens as seen in the Code of Ur-Nammu, the oldest surviving legal code. In the Indian subcontinent, the Dharmashastras played a pivotal role in codifying legal principles, intertwining law with moral and religious duties. These ancient texts laid the foundation for governance, emphasising justice, and social order.

Over time, legal frameworks evolved alongside shifts in political authority. With the rise of kingdoms and later colonial rule, taxation became a structured mechanism. Modern income tax was first introduced in India in 1860 to address the financial strain caused by the Revolt of 1857. Over subsequent decades, taxation laws were codified and centralised, leading to the enactment of the Income Tax Act, 1961 (hereinafter “the Act”), which remains the foundation of India’s direct taxation system today[1]. However, despite ongoing amendments, gaps and ambiguities persist. The case of Mukesh Rasiklal Shah vs. ACIT[2] examines one such legal ambiguity with respect to taxing fraudulent income, highlighting the need for further legislative refinement.

FACTS OF THE CASE

The brief facts of the case are as follows, a Chartered Accountant was found to have fraudulently obtained income tax refunds by submitting forged challans for the assessment years 1992-93 and 1993-94. Following a search and seizure operation, incriminating documents were discovered, leading to the recovery of the encashed funds.

The Income Tax Appellate Tribunal (hereinafter “ITAT”) ruled that the fraudulent income, despite being illegal, was taxable under the Act, as the assessee exercised control and dominion over the funds, which were invested and leveraged for economic gain. It cited Supreme Court precedents establishing that illegality of income does not exempt it from taxation. The doctrine of real income dictates that taxation occurs at the time of accrual, irrespective of subsequent restitution or repayment. The ITAT also disallowed deductions claimed for the return of fraudulently obtained income, holding that restitution does not qualify as an allowable expense under Section 57.

Additionally, while the Income Tax Department initiated prosecution under Section 277, the charges were later dropped due to lack of substantiation. However, the ITAT highlighted that fraudulent activities undermine government efficiency and tax administration, urging the Revenue Authorities to take appropriate legal action beyond the tax proceedings. Ultimately, the appeal was dismissed as devoid of merit.

CONSEQUENCES OF THE ITAT’S STANCE

The judgement’s failure to acknowledge the unique nature of this case, particularly the question of whether recovering appropriated funds absolves the assessee from being taxed on the income earned, is a significant oversight with potentially harmful consequences. It sets a concerning precedent by suggesting that criminals should not only face penalties from civil and criminal courts but also from income tax tribunals. It also risks broadening the scope of punitive measures beyond their proper jurisdiction and punishes the assessee beyond the scope of law.

The Court’s failure to provide a clear and extensive ratio decidendi for why the assessee should be taxed beyond the simple legality of taxing income is concerning. As established by the Apex Court in Career Institute Educational Society vs. Om Shree Thakurji Educational Society[3], it is not the judge's statements of fact or conclusions that constitute binding precedent, but rather the legal principles upon which the case is decided. By failing to clearly articulate the legal rationale in this instance, the ruling not only lacks the necessary clarity to establish a firm precedent but also risks undermining the consistency and credibility of judicial decisions. This oversight suggests that the courts prioritise enriching the nation's treasury over protecting the interests of the common people, which could ultimately erode public trust in the legal system and diminish faith in its impartiality.

UNDERSTANDING INCOME

As Ralph Waldo Emerson eloquently stated, “criticism should not be querulous and wasting, all knife and root-puller, but guiding, instructive, inspiring, a south wind, not an east wind”. Echoing this sentiment, this paper shall put forth an argument based on legal precedents that the ITAT could have used to approach the case in Mukesh Rasiklal Shah vs. ACIT[4] by redirecting the scope of inquiry from the legality regarding the taxability of income earned by fraudulent means to questioning whether the income earned by the assessee can be considered as income in the assessee’s name. The straightforward way of proving this hypothesis would be to place reliance on the facts of the case and the Supreme Court’s ruling in D.N. Singh vs Commissioner of Income Tax & Anr.[5], where it was observed that an assessee must be found to be the owner before anything in his possession can be deemed to be his income. The facts of the case in Mukesh Rasiklal Shah vs. ACIT[6] are quite simple as described above. The assessee had forged challans to seek refunds from the government from the assessment year 1992-93 to 1993-94. Following a search and seizure operation, incriminating documents were discovered, leading to the “recovery” of the refunds. In Late Nawab Sir Mir Osman Ali Khan v. Commissioner of Wealth Tax, Hyderabad[7], ownership is defined as follows:

“Salmond On Jurisprudence, 12th edn., discusses the different ingredients of ‘ownership’ from pages 246 to 264. ‘Ownership’, according to Salmond, denotes the relation between a person and an object forming the subject-matter of his ownership. It consists of a complex of rights, all of which are rights in rem, being good against all the world and not merely against specific persons. Firstly, Salmond says, the owner will have a right to possess the thing which he owns. He may not necessarily have possession. Secondly, the owner normally has the right to use and enjoy the thing owned: the right to manage it, i.e., the right to decide how it shall be used; and the right to the income from it. Thirdly, the owner has the right to consume, destroy or alienate the thing. Fourthly, ownership has the characteristic of being indeterminate in duration. The position of an owner differs from that of a non-owner in possession in that the latter’s interest is subject to be determined at some future time. Fifthly, ownership has a residuary character. Salmond also notes the distinction between legal and equitable ownership. Legal ownership is that which has its origin in the rules of the common law, while equitable ownership is that which proceeds from rules of equity different from the common law. The courts of common law in England refused to recognise equitable ownership and denied the equitable owner as an owner at all”.

A “right to receive the income” as per E. D. Sasoon vs CIT[8] if the assessee must have “acquired a right to receive the income” which is acquired only when there is a “debt owed to him by somebody”. This reinforces the notion that the assessee has no right over the funds encashed by virtue of no debt being created. Therefore, per the Supreme Court Judgement in D.N. Singh vs Commissioner of Income Tax & Anr.[9], the income cannot be assessed in the name of the assessee.

A perusal of the following excerpt from the landmark judgement of CIT v. Sitaldas Tirathdas[10] illustrates that where income is legally diverted to a third party by virtue of an overriding title, the original recipient is not subject to taxation on that diverted income. The mere transit of funds through their hands does not establish the right to tax. Rather, the liability to tax attaches to the ultimate beneficiary of the income, i.e., the individual who receives the benefit under the overriding title.

“Obligations, no doubt, there are in every case, but it is the nature of the obligation which is the decisive fact. There is a difference between an amount which a person is obliged to apply out of his income and an amount which by the nature of the obligation cannot be said to be a part of the income of the assessee. Where by the obligation income is diverted before it reaches the assessee, it is deductible; but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence, in law, does not follow. It is the first kind of payment which can truly be excused and not the second. The second payment is merely an obligation to pay another a portion of one's own income, which has been received and is since applied. The first is a case in which the income never reaches the assessee, who even if he were to collect it, does so, not as part of his income, but for and on behalf of the person to whom it is payable”.

The last sentence may appear to be contradictory to the assessee’s position in Mukesh Rasiklal Shah vs. ACIT[11], however, the phrase “for and on behalf of the person to whom it is payable” does not presuppose consent of the third-party. The phrase simply put means that a third-party’s payment was taken by the assessee, however, the assessee is not the intended party and therefore the assessee simply “collects” the funds on behalf of the intended party, albeit be that it may be by deceit.

A question that may reasonably arise is with regards to the dominion and control over the income that the assessee enjoyed. It is not particularly asinine to be apprehensive of allowing the assessee to be discharged of his liability to pay taxes when he had dominion and control of the encashed funds, solely based on the technicality of ownership. The factum of recovery alludes to the illusory nature of the assessee’s dominion and control over the funds. The term dominion is a terminology used by the courts to describe a property right[12]. If no right exists, how can dominion be established? A temporary right extended by the owner to a third-party is contingent and never supersedes the owner’s right. Following the same principle, temporary dominion cannot be equated to the dominion expressed by the rightful owner. The Government, under the assumption that the assessee is the rightful owner granted the assessee the right to dominion and control over the funds. When the assessee’s fraud had been brought to light, the right to dominion was snatched from the assessee and went back to its rightful owner. Therefore, the dominion expressed by the assessee was legal at the time. Regardless of the assessee’s dominion over the funds, true dominion always lies with the rightful owner. In this case, the Government’s act of recovering reaffirms its right or dominion over the encashed funds.

CONCLUSION

The ruling of the ITAT in this case, whilst adhering to the principle that even illegally acquired income is subject to taxation, raises significant concerns regarding the broader implications of such an approach. By failing to distinguish between temporary control and legitimate ownership, the judgment erroneously equates mere possession with a rightful claim to income. This misinterpretation contradicts established legal doctrines, including the principle of overriding title and the requirement that an individual must have a legally enforceable right to receive income for tax liability to arise.

Furthermore, the decision’s rigid application of taxation laws, without due regard for the unique circumstances of the case, risks establishing a troubling precedent wherein individuals engaged in fraudulent activities are taxed on amounts that were never lawfully theirs. Such an approach effectively extends punitive measures beyond their intended scope, conflating tax liability with criminal sanction. This not only undermines the fairness of the tax system but also risks eroding public confidence in the judiciary, should the perception arise that taxation is being employed as an additional means of punishment rather than a neutral mechanism of revenue collection