The Hon’ble Supreme Court of India (“SC”) delivered two landmark decisions dealing with the conditions and entitlement of charitable institutions to claim exemption under the Income Tax Act, 1961 (“IT Act”), recently. While Ahmedabad Urban Development Authority,[1] (“AUDA”) dealt with the provisions and conditions of a charitable institution engaged in the activity of advancing an object of general public utility (“GPU”), New Noble Educational Society,[2] (“New Noble”) dealt with the issue of whether educational institutions can be engaged in other activities.
In the case of AUDA, the SC held that a charitable organisation cannot be engaged in any trade, commerce or business, or provide services in relation thereto for any consideration unless such commercial activity is incidental to the main object of GPU and is also within the monetary threshold of up to 20% of its total receipts, as prescribed under section 2(15) of the IT Act. To ascertain whether an activity would constitute “trade, commerce or business”, the SC clarified that it would depend on the cost at which the services are availed and the price at which they are provided by the institution to its clients. In this case, the SC dealt with a batch of appeals ranging from certain statutory authorities, trade promotional bodies, the ICAI, a few cricket associations and many private trusts to interpret the proviso to section 2(15), and to identify activities that would qualify as “trade, commerce or business” under the provision.
Section 2(15) of the IT Act defines charitable purpose to include, inter alia, the advancement of any other object of GPU. The proviso to section 2(15) of the IT Act provides that such advancement of object of GPU would not be considered charitable, if an institution is engaged in trade, commerce or business, or provides any service relating to trade, commerce or business for which a cess or fee or any other consideration is received. However, if such activity is undertaken in the course of carrying out such advancement of any other object of GPU, and the aggregate receipts from such activity during the previous year does not exceed 20 per cent of the total receipts of the institution for the relevant period, such activity would be considered as charitable activity.
The charitable institutions submitted that even if their proposed activity is not the predominant object of the GPU, any incidental involvement in such activities should be considered favourably. However, the Indian Revenue Authorities (“IRA”) claimed that the reference to the phrase “trade, commerce or business” in the provision reiterates that there shouldn’t be any profit motive and the GPU should not be engaged in any commercial activity. The exception to this principle would be such activities undertaken in the course of achieving the objects of the charitable institution.
However, the SC was not impressed with these arguments and held that instead of looking at the predominant object, an analysis of the nature of activities undertaken by the charitable organisation must be made to ascertain whether or not they were intrinsically linked to GPU and in order to qualify as a charitable organisation engaged in GPU, such activities should be conducted in the course of achieving the GPU.
Further, where charges for the said services merely covers costs or consists of nominal mark-up, such activities must not be considered to be in the nature of “trade, commerce or business” and may remain permissible. However, in case the entity charges a substantial amount, significantly higher than the costs incurred by it, such activities could get categorised as “trade, commerce or business”; and assuming the consideration is significantly higher than the costs, the income will attract the mischief of the proviso to section 2(15), and be considered to be commercial in nature if the threshold limit of 20% is crossed.
This criterion was uniformly applied by the SC to different categories of institutions, including, inter alia, statutory corporations, trade promotional bodies, private trusts, and non-statutory bodies. For example, in case of statutory corporations, the SC observed that it must have been set up to provide essential public functions by the government, such as the supply of water or food grain management and thus, their objects and activities would qualify as charity. Any amount charged for such purposes shall, prima facie, be excluded from the mischief of business or commercial receipts. However, the IRA must analyse the records to determine the amounts charged as compared to the costs to ensure adherence to section 2(15) of the IT Act. If the statutory corporation has received consideration significantly higher than its costs, such activities may get categorised as “trade, commerce or business” and accordingly, must remain within the 20% quantified limit.
The SC has held that such analysis of income and expenditure of GPU charitable institutions must be done on an annual basis to determine the nature of their activities. This would indicate whether the amounts charged are nominal or significantly higher and accordingly determine if such activity amounts to “trade, commerce or business”.
In the case of New Noble, the SC dealt with another batch of appeals, concerning the interpretation of the expression ‘solely’ appearing in section 10(23C)(vi) of the IT Act, and the requirement to register with state laws as a prerequisite for approval under the IT Act.
Section 10(23C)(vi) of the IT Act provides that income from any university or other educational institution, existing solely for educational purposes and not for the purposes of profit, is not included while computing total taxable income of a person.
The institutions relied on the earlier decisions of the SC in the case of American Hotel[3] and Queens Education Society[4] to claim that the expression ‘solely’ has been interpreted to mean dominant, main or principal object of the institution. Accordingly, the existence of more than one object does not mean that the institution ceases to exist ‘solely’ for educational purposes, as long as it ‘mainly’ carries education and education-related activities. The word ‘solely’ must be interpreted for the institution’s motive to not operate for profit and not in the context of its objectives.
However, the IRA contended that the statute expressly stipulates that the institution must exist ‘solely’ for the purpose of education. The IRA submitted that the predominant object test employed in the case of American Hotel and Queens Education Society was enunciated in the Surat Art Case[5], which was decided in the context of charities engaged in advancing objects of GPU and not in a case dealing with educational institutions. Hence, the reasoning of the two cases relied upon is incorrect and accordingly, the application of the predominant object test cannot be used in the case involving educational institutions.
The SC observed that none of the previous decisions, including the American Hotel and Queens Education Society, have explored the true meaning of the expression ‘solely’. The SC noted that the plain meaning of the expression ‘solely’ is ‘only’ or ‘exclusively’ and not ‘primarily’. Further, it observed that the approach and reasoning applicable to charitable organisations set up for the advancement of objects of GPU are entirely different from charities established for the object of imparting education. Hence, the application of the ‘predominant object’ test, developed in the context of an institution set up to advance objects of GPU in a case dealing with educational institutions, is incorrect and educational institutions should have all its objects aimed at imparting or facilitating education. Accordingly, the interpretation of the expression ‘solely’, adopted by the decisions of the American Hotel and Queens Education Society was held to be incorrect, and the judgments have accordingly been overruled.
The SC also analysed the seventh proviso to section 10(23C)(vi) of the IT Act, which permits the educational institution to record profits and gains of business, which is incidental to the attainment of its objectives. Since the educational institution solely exists for the purpose of education, the business must be interpreted as related to education and educational activities. The SC observed that activities incidental to providing education could include providing textbooks, hostel or bus facilities for students, or organising educational camps. However, activities like renting out the premises for external events would not qualify as activities incidental to education.
In the context of registration with state laws, the SC observed that compliance with the applicable local state laws is a relevant consideration for the IRA to grant registration to charitable institutions under section 10(23C) of the IT Act. The SC held that compliance with such local and state laws assists relevant authorities in ascertaining the genuineness of the charitable institution. Hence, compliance with the local laws is mandatory and is a condition precedent for the grant of approval under the IT Act.
Significant takeaways
The landmark judgments are expected to have significant repercussions on charitable institutions claiming exemptions under the IT Act. The novel test whereby charitable institutions claim exemption under the GPU category to render charitable services only on cost plus nominal mark-ups can open another line of litigation as it can be seen that a number of entities are operating in the market place and earning huge amount of income and profit like the Board of Control for Cricket in India, many clubs and societies, business chambers, etc., and still contend themselves to be charitable organisations. Charitable institutions also offer different mark-ups and claim them as marginal or nominal mark-ups. This confusion on what would qualify as nominal mark-up, along with the annual scrutiny of financial statement to determine if the mark-ups are nominal, could be a ground for significant disagreement between the assessee and the IRA and thus, could become a hotbed for future litigations.
These decisions also require charitable institutions to review their objectives and activities undertaken thereto. By discarding the predominant object test, the SC has called for educational institutions to ensure that their activities are totally focussed on imparting and facilitating education and any activity directly connected with the objective of education. Additionally, for a GPU charity, the activities undertaken must be intrinsically linked to the object of the GPU charity, to fall outside the purview of “trade, commerce or business”.
Another important consideration emanating from the New Noble case is that the SC has very categorically stated that complying with the conditions under other laws that are mandatorily required to be followed by a charitable organisation is a precondition for claiming exemption under the IT Act. It is relevant to note that the provision has been inserted recently, and this decision has made their applicability even stronger. In cases where the charitable organisations have been questioned for frivolous reasons or technical/ procedural violations, which are not directly connected with the task of undertaking charitable activity, this provision may make the claim of exemption subject to radar and complications. This could result in a lot of unproductive and baseless investigations and certain high-handed assessments. The IRA is likely to become very aggressive! One hopes that the IRA would not become vindictive and apply the rationale of these decisions carefully so that unnecessary and unavoidable litigations can be avoided.
[1] Assistant Commissioner of Income Tax (Exemptions) v. Ahmedabad Urban Development Authority [Civil Appeal No. 21762 of 2017].
[2] M/s New Noble Educational Society Vs. The Chief Commissioner of Income Tax and Anr [Civil Appeal No. 3795 of 2014].
[3] American Hotel and Lodging Association v. CBDT (2008) 10 SCC 509.
[4] Queens’s Educational Society v. CIT 2015 (8) SCC 47.
[5] Assistant Commissioner v. Surat Art Silk Cloth Manufacturers’ Association (1980) 2 SCC 31.