Trusts Exploiting Loophole to Carry Forward Deficits, Evading Taxes

Key Takeaways:

- Charitable trusts were allowed to set off deficits from earlier years against their current year's income, leading to potential tax evasion.

- The Income Tax Act did not have a specific provision to prevent this practice, resulting in a legal loophole.

- The Ministry has addressed this issue by introducing an amendment (Explanation 5 to Section 11(1) (of Income Tax Act, 1961)) in the Finance Act 2021, effective from April 1, 2022.

- Audit identified five cases involving a tax effect of ₹3.77 crore where trusts were allowed to set off previous years' deficits against their current income.

Detailed Narrative:

The Income Tax Act, 1961 (the Act) provides for exemptions to charitable trusts and institutions, subject to certain conditions. One of the primary conditions is that the income derived from the trust's property should be applied for charitable purposes. If the income cannot be applied during the previous year, it can be accumulated in prescribed modes and applied for such purposes in accordance with various conditions provided in Section 11 (of Income Tax Act, 1961).

However, until recently, the Act did not have a specific provision to disallow charitable trusts from setting off deficits or excess expenditure over income from previous years against their current year's income. This legal loophole enabled some trusts to claim exemptions by carrying forward and adjusting past deficits, resulting in potential revenue loss for the government.

The Audit identified five cases related to the assessment year 2016-17, involving a tax effect of ₹3.77 crore, where trusts were allowed to set off deficits from earlier financial years with their current year's income. Two illustrative cases are discussed below:

1. In West Bengal, a private trust engaged in educational activities filed a return of income for the assessment year 2016-17 at ₹'Nil' income. The case was selected as a 'High Value' case since the trust's gross receipts were ₹52.36 crore. The scrutiny assessment was completed at ₹'Nil' income in December 2018. Audit noticed that the trust was allowed to carry forward and adjust an 'Excess application of income' of ₹7.28 crore made during the assessment year 2014-15 as 'Application of income' for the assessment year 2016-17. This resulted in an assessed income of ₹'Nil' for the assessment year 2016-17, involving a tax effect of ₹2.17 crore.

2. In Maharashtra, a private trust engaged in educational activities filed a return of income for the assessment year 2016-17 at ₹'Nil' income. The scrutiny assessment was completed in December 2018, assessing a loss of ₹3.32 crore. The provisions of Section 11 (of Income Tax Act, 1961) allow exemption for income derived from the trust's property to the extent it is applied towards the trust's objectives. However, there is no provision under Section 11 (of Income Tax Act, 1961) that provides for carrying forward losses. As such, the determination of a loss of ₹3.32 crore was not in order, resulting in an irregular assessment of loss and a potential tax effect of ₹1.13 crore.

The issue of the absence of a provision disallowing the set-off of deficits from earlier years with the current year's income had also been pointed out in the Comptroller and Auditor General's (CAG) earlier Audit Report No. 20 of 2013. In response, the Ministry had submitted to the Public Accounts Committee (PAC) that the provisions of law are based on the utilization of income towards charitable purposes, and therefore, no provision for the treatment of deficits had been provided.

However, Audit observed that the Assessing Officers were allowing the set-off of deficits from earlier years with the current year's income due to the lack of clarity in the Act. To address this issue, the Ministry introduced Explanation 5 to Section 11(1) (of Income Tax Act, 1961) through the Finance Act 2021, effective from April 1, 2022. This amendment clarifies that any excess of expenditure over income, which had been treated as an application of income in any previous year, shall not be allowed as a deduction in the current year.

FAQs:

Q1: Why were charitable trusts able to set off deficits from previous years against their current year's income?

A1: The Income Tax Act did not have a specific provision to disallow this practice, resulting in a legal loophole that some trusts exploited to claim exemptions.

Q2: What was the potential impact of this loophole?

A2: By carrying forward and adjusting past deficits, some trusts were able to show a lower taxable income or even claim a loss, leading to potential revenue loss for the government.

Q3: How did the Ministry address this issue?

A3: The Ministry acknowledged the issue and introduced Explanation 5 to Section 11(1) (of Income Tax Act, 1961) through the Finance Act 2021, effective from April 1, 2022. This amendment specifically disallows the set-off of deficits from previous years against the current year's income for charitable trusts.

Q4: What was the tax effect of the cases identified by Audit?

A4: Audit identified five cases related to the assessment year 2016-17, involving a tax effect of ₹3.77 crore, where trusts were allowed to set off deficits from earlier financial years against their current year's income.

Q5: Why was the Ministry's initial response to the CAG's earlier report inadequate?

A5: While the Ministry had stated that the provisions were based on the utilization of income towards charitable purposes, it did not address the specific issue of allowing the set-off of deficits, which was being exploited by some trusts.

Key Precedents:

1. Section 11 (of Income Tax Act, 1961):

This section provides for exemptions to charitable trusts and institutions, subject to certain conditions, including the application of income towards charitable purposes.

2. Explanation 5 to Section 11(1) (of Income Tax Act, 1961) (introduced by the Finance Act 2021, effective from April 1, 2022):

This explanation specifically disallows the set-off of deficits or excess expenditure over income from previous years against the current year's income for charitable trusts.

3. Audit Report No. 20 of 2013 by the Comptroller and Auditor General of India (CAG):

This report had initially pointed out the absence of a provision disallowing the set-off of deficits from earlier years with the current year's income for charitable trusts.

4. Public Accounts Committee (PAC) Report (104th Report, 16th Lok Sabha):

The PAC had discussed the CAG's observation and the Ministry's response, highlighting the need for a clear provision to address this issue.

The key precedents mentioned above, particularly Section 11 (of Income Tax Act, 1961) and the newly introduced Explanation 5 to Section 11(1) (of Income Tax Act, 1961), establish the legal framework for the treatment of deficits and income for charitable trusts. The CAG's audit report and the PAC's recommendations played a crucial role in bringing this issue to the forefront and prompting the Ministry to take corrective action through the Finance Act 2021.