In a vastly populated developing nation, the parallel role of NGOs in public welfare is indispensable. The Income-tax Act, 1961 has recognized the importance of the very concept of charity in the Indian society. The income derived by charitable institutions is exempt under section 10 or section 11. This article discusses certain issues arising out of section 11, which provides exemption to income derived from property held under trust for charitable or religious purposes. The author opines that the law relating to taxation of charitable institutions ought to be simple looking at the noble cause behind the existence of such institutions. He hopes that with the new Income-tax Code likely to be put in place, we will find a simple and non-controversial taxation system for charitable institutions.
1. In a vastly populated developing nation, the parallel role of NGOs in public welfare is indispensable. Public charity has reached numerous areas which were untouched by the Government due to bureaucracy or otherwise. In fact, the theory of dan or charity is found even in our mythology where we find instances of Karna or Raja Harishchandra.
The Income-tax Act, 1961, has recognized the importance of the very concept of charity in indian society and, hence, it finds place in sections 10(23AA), 10(23AAA), 10(23B), 10(23BBA), 10(23C), section 11, section 35, section 35AC, 35CCA, 35CCB, sections 80G, 80GGA, etc. The income derived by charitable institutes is exempt under section 10 or section 11 and the donors get deduction under section 35, 35AC, 35CCA, 35CCB, 80G or 80GGA.
2. Certain issues arising out of section 11 which provides exemption to income derived from property held under trust for charitable or religious purposes are :
(i)- Section 11(1)(a) provides exemption to income derived by charitable or religious institutions/trusts (the trust) to the extent it is applied for charitable or religious purposes, i.e., for the objects of the trust. Further, 15 per cent of the income can be set apart for future application. In other words, at least 85 per cent of the income is to be applied on the objects of the trust to claim 100 per cent exemption. It is well-settled by various judicial pronouncements that the words income derived should be interpreted as income in commercial sense and not the total income as per the Income-tax Act. Further, the words applied to such purposes are to be interpreted in a wide sense so as to include all outlays on the objects of the institution – be they capital or revenue in nature. Thus, for instance, purchase or construction of a school building by an educational institution is an application of income. [CIT v. Kannika Devasthanam & Charities  133 ITR 779 (Mad.); S.RM.M.Ct.M. Tiruppani Trust v. CIT  230 ITR 636/96 Taxman 635 (SC)]
(ii)- Barring the dogmatic approach of certain departmental authorities in not considering administration expenses as application of income but as an expense against earning the income; the law under section 11(1)(a) is well-settled that all spendings or outlays by such institutions are application of income. In fact, judiciary has even upheld that expenses incurred for maintaining the establishments like legal expenses, audit fees, etc., are to be considered as application of income. However, there is another issue which is often less discussed about and that is section 11(1A).
(iii)- As per section 11(1A), where a charitable or religious institute/trust transfers a capital asset, the capital gains shall be deemed to have been applied towards charitable or religious purposes to the following extent:
(a)- Where entire net consideration is utilized for acquiring a new asset, the whole of the capital gain;
(b)- where only a part of the net consideration is utilized in acquiring a new asset, the excess of the cost of the new asset over the cost of the old asset.
An example may clarify the above position.
A capital asset was acquired by a trust during 1985-86 for Rs. 10 lakhs and it is transferred during 2007-08 for Rs. 25 lakhs resulting into a surplus of Rs. 15 lakhs.
Situation 1 : Cost of the new asset is Rs. 25 lakhs or more.
In such a case, the entire surplus of Rs. 15 lakhs shall be deemed to have been applied towards charitable purpose.
Situation 2 : Cost of the new asset is Rs. 22 lakhs.
In such a case, Rs. 12 lakhs (22 lakhs-10 lakhs) shall be deemed to have been applied towards charitable purpose. The balance surplus of
Rs. 3,00,000 (15,00,000 – 12,00,000) shall be taxable subject to application under section 11(1)(a) and 11(2).
2.1 Some controversies – The following controversies arise in the above scenerios:
(i)- Section 11(1A) uses the words capital assets, transfer and capital gains arising from the transfer. Though the words capital assets and transfer are defined in section 2(14) and 2(47), yet the expression capital gains is nowhere defined in the Act. A controversy therefore arises as to whether capital gains should be interpreted as profits arising on transfer in commercial sense or capital gains calculated under section 48, i.e., after indexation. The Amritsar Tribunal has held that the capital gains need to be calculated as per sections 45 to 55. It implies that the benefit of indexation can be claimed by charitable trusts also. [Akhara Ghamanda Dass v. CIT  68 TTJ (Asr.) 244/ 114 Taxman 27 (Asr.)(Mag.)] Whereas there are a series of judgments favouring the commercial income theory. [CIT v. Rao Bahadur Calwala Cunnas Chetty Charities  135 ITR 485 (Mad.) & CIT v. Trustees of H.E.H. Nizams Supplemental Religious Endowment Trust  127 ITR 378 (A.P.)]
(ii)- Section 11(1A) starts with the expression For the purpose of sub-section (1). It implies that sub-section (1A) is merely an enabling provision quantifying the application of income. The main provision granting exemption is sub-section (1), which uses the expression income and not total income. It can, thus, be inferred that a trust has to apply 85 per cent of its income (in commercial sense). If that is the case, the benefit of indexation which is a special mechanism for the purpose of the Income-tax Act may not apply and entire profit on sale of capital asset may be regarded as capital gain. Another remote view could also be possible that the surplus on transfer of capital assets is not at all an income (being a capital receipt) and, hence, outside the purview of 85 per cent application.