To attract investment, industrial activities and improve economic development ,in certain states such as Himachal Pradesh, Uttaranchal, Sikkim and the states in the North-East, the Central Government has introduced a time-bound tax holiday, deducting 100% profit for the first five years and 25% of profits in subsequent five years under section 80-IC of the Income-tax Act, 1961 (IT Act).

This tax holiday is available to enterprises that have set up new units or carried out substantial expansion of existing units within a specified period (different dates apply for different states and regions). The conditions for availing the holiday are that the unit should operate or commence production, or manufacture specified articles, in these special category states.

The benefit was made available not only for setting up a new unit but also if the enterprise undertook ‘substantial expansion’ of the units. The intention was that if the enterprise made significant investment in the unit within the specified time limit, then the benefit of 100% deduction could restart from the day such substantial expansion became operative.

This means that the legislature intended the benefit to be available for ten-year period in such a manner that it became possible for an enterprise to claim 100% deduction throughout those ten years and not limit the deduction to 25% in the second half of the ten-year period, provided the enterprise made substantial expansion of the unit in the 5^th year. Substantial expansion for this purpose is also defined in the law.

In the case of Aarham Softronics [1](comprising several entities), the question before the Supreme Court (SC) was whether the taxpayers, after having claimed a deduction of 100% from their profits for the first five years from commencement of their eligible activities, could again claim 100% deduction for a further five years on the grounds that they had carried out ‘substantial expansion’ of the units?

The interesting point for the SC was whether they should follow their earlier decision in the case of Classic Binding Industries[2], where it had concluded that the 100% exemption to the taxpayer for the second term of five years could not be allowed. However, while dealing with the facts at hand in the present case of Aarham Softronics, the SC recognised that there was a flaw in the earlier decision and, acknowledging this, did not hesitate in accepting the error and rectifying it by granting the 100% deduction to the taxpayers for the second term of five years.

Facts

The taxpayers had established industrial undertakings in Himachal Pradesh and having satisfied the conditions under section 80-IC, had claimed a 100% deduction from their profits and gains for the first five years. During the five-year period – while they were claiming the deduction – but before the end of the five year period, the taxpayers carried out enough expansion activities to satisfy the definition of substantial expansion as given in law. Thereupon, they claimed that they should be allowed 100% deduction from profits and gains for another five years, beginning the time they completed the substantial expansion.

The lower tax authorities decided against the taxpayers and denied the availability of 100% deduction for another five years, but the High Court of Himachal Pradesh (High Court) upheld the claims of the taxpayers. On appeal before the SC, the division bench of the SC also denied this benefit, in its earlier decision in the Classic Binding Industries case, thereby it overturned the decision of the High Court.

However, in this case, some taxpayers had not been issued the notice of the appeal filed by the tax department before the SC against the High Court order. Hence, on an application filed by the taxpayers, the SC recalled its order in respect of such taxpayers and granted a fresh hearing– as they had challenged the same question of law and clubbed the petitions.

Decision

The SC firstly dealt with its earlier ruling in the case of Classic Binding Industries where it had reasoned that if further 100% deduction was to be granted after the first five years on account of any substantial expansion, then that would be tantamount to a presumption of a second ‘initial assessment year’ within the period of ten years from the commencement of a specified undertaking, which would be contrary to the spirit of the provisions of section 80-IC.

In reaching this decision, the SC had relied on and referred to the definition of ‘initial years’ under section 80-IB and not under section 80-IC. This difference was brought to the notice of the SC by the taxpayers in the present case and the SC was quick to recognise the error in its previous judgment and expounded that in the Classic Binding Industries case, it had failed to give consideration to the definition of ‘initial assessment year’ under section 80-IC.

The SC accepted the submission of the taxpayer that an ‘initial assessment year’ for the purpose of section 80-IC is specifically defined to mean an assessment year that is relevant to the previous year in which the undertaking: (i) begins production; (ii) commences operations; or (iii) undertakes substantial expansion, i.e. there is increase in investment in plant and machinery by 50% of the book value of the existing plant and machinery.

The SC held that it is evident from the said definition that the entire section is applicable to new units as well as to existing units undertaking ‘substantial expansion’. Therefore, interpreting section 80-IC to state that there cannot be two initial assessment years would be contrary to the scheme of the said provision as it equally applies to existing units that undertake ‘substantial expansion’.

The SC further clarified that the 25% deduction post claiming 100% deduction for five years out of the ten-year period, would only be applicable in cases where the existing unit is stagnant and no ‘substantial expansion’ is carried out. It was also noted that such an interpretation would also be in consonance with the legislative intention of introducing section 80-IC, which is to encourage industrial development in the special category states.

Takeaways

This decision puts to rest the controversial issue of whether substantial expansion within a new unit becomes entitled to a fresh five-year 100% deduction under section 80-IC. This will also be a relief to taxpayers who have claimed 100% deduction beyond the fifth year of commencement of business or activities due to carrying out substantial expansion or who are facing litigation in this regard, especially post the decision in the Classic Binding Industries.

Importantly, the SC clarified that though the substantial expansion may initiate a second initial assessment year, it would not have the effect of initiating a new ten-year period of tax holiday and the deduction would be limited to a maximum of ten years.

While section 80-IC having a sunset clause may no longer be available to new units set up after 1 April 2012 (in certain states), if any of those units undertook substantial expansion towards the end of their first five years of exemption, they could benefit from this decision. The decision does seem to uphold the legislative intention of the provision.

[1] PCIT v Aarham Softronics 2019-TIOL-73SC-IT-LB

[2]CIT v Classic Binding Industries TS -474-SC-2018 (SC)