The charge to Income Tax – Part 1

1. Section 2 is of prime importance to an understanding of the scope of the income tax. Unless a person can be brought within the charge imposed by Section 2, he cannot be taxed, subject to the exception mentioned in paragraph 8 below. The power to tax which is implicit in Section 2, is a manifestation of Parliament’s sovereignty.

2. In Whitney v CIR (1925, 10 TC, p 88 at 110), Lord Dunedin observed: “…Now, there are three stages in the imposition of a tax: there is the declaration of liability, that is the part of the statute which determines what persons in respect of what property are liable. Next, there is the assessment. Liability does not depend on assessment. That, ex hypothesi, has already been fixed. But assessment particularizes the exact sum which a person liable has to pay…”

3. Section 2 provides that income tax shall be charged at the appropriate rates specified in the First, Second, Third, Fourth and Fifth Schedules of the Act, for every year of assessment, on the profits and income (a) wherever arising to a resident person and (b) arising in or derived from Sri Lanka in the case of every other person.  

For the purposes of the Act, the phrase in paragraph 3.3(b) is meant to include all profits and income from services rendered in Sri Lanka, or from property in Sri Lanka or from business transacted in Sri Lanka, whether directly or through an agent.

It is important to stress that the arising or derivation of income must be looked at, tax-wise, from the standpoint of the person to whom the profit or income belongs by law. The use of the phrases “arising in Sri Lanka” or “derived from Sri Lanka” with reference to every person other than a resident has the effect that profits and income are chargeable only if the profits and income are sourced in Sri Lanka.

4. The word arise means: “To spring up, originate, to come into being or notice, to become operative…” (Per Black’s Law Dictionary, 6th Edition, page 108).

It would seem to follow that since a profit or income must come in for the benefit of the taxable person, the implication of the word arise is to fix the charge at the point of time when his entitlement to the profit or income takes legal effect. This is a question of fact and law. A fact or facts is or are what, indisputably, happens or happen in the circumstances of a particular transaction to which the taxpayer is a party or a beneficiary. It then becomes a question of law to determine when the profit or income from the transaction takes effect for the benefit of the taxpayer.

5. The word derive means: “To receive from a specified source or origin… To proceed from property, severed from capital, however invested or employed, and to come in, receive or is drawn by the taxpayer for his separate use, benefit and disposal.” (Per Black’s Law Dictionary, page 444). In Pandian Chemicals Ltd. v CIT (262ITR 278) the SC of India has opined that: “It is clear that the words ‘derived from’ …must be understood as something which has direct or immediate nexus with.”   

6. In Anglo-Persian Oil Co. v CIT, (1935, CTC Vol. I, p 92) the appellant company was incorporated in England and carried on business there. It produced and sold fuel oil. It entered into contracts in England with shipping companies outside Ceylon, to deliver oil to vessels of the shipping companies, which would be calling at ports around the world. In the contracts, the prices were stipulated as also the minimum and maximum quantities that would be required by each customer. The company stocked its fuel oil in various countries, including Ceylon. When a ship owned by a shipper called at the port of Colombo the agent in Ceylon ascertained the ship’s refuelling requirements and then delivered the requisite quantity of oil ex the appellant’s stock of oil kept with the agent. The issue in the case before the SC of Ceylon was whether the appellant’s profits from the supplies of oil in Ceylon arose in Ceylon or were derived from Ceylon. The Court held that (a) the profits arose in England from the contracts entered into in England and (b) the profits were not derived from Ceylon since the oil was not a product of Ceylon. (ibid, p 100)

6.1. Three Landmark Decisions of the Privy Council.

Where an overseas company carrying on business outside a country, carries on business in that country also through a branch in that country, and the branch invests surplus funds in the purchase of securities and shares in overseas exchanges and markets, through the intermediacy of overseas agents and they sell such securities and shares overseas, profitably, from time to time, such profits neither arise in the country where the branch is nor are the profits derived there from, even though such transactions are controlled from the branch or instructions to sell emanate from the branch office or even if the funds for overseas investments come out of funds earned by the branch. Diligent readers are encouraged to read the full reports of the judgments in CIT v Chunilal B Mehta (1938, 6 ITR 521, PC), CIR (HK) v Hang Seng Bank Ltd (1990, STC 733, PC) and CIR (HK) v HK-TVB International Ltd (1992, STC 723, the summaries of which are given below.

6.1.1 Mehta carried on business in Bombay as a speculator and broker in the purchase and sale of commodities. He also entered into transactions in foreign commodities exchanges through his overseas agents. The foreign transactions were no doubt controlled from Bombay but the actual foreign transactions were effected by the foreign agents. The Indian tax authorities assessed the profits from the overseas sales on the footing that such profits accrued or arose in India even though the profits were not remitted to India.

The Privy Council agreed with the High Court in India and held that the profits arose outside India. The control of the foreign transactions from India was not a relevant consideration.

6.1.2 Hang Seng was established in HK and carried on banking business there. Out of the bank’s surplus funds from foreign currency trading in HK, the bank invested in shares and securities in overseas exchanges and markets through the intermediacy of the bank’s agents there. The foreign currency department of the bank monitored regularly the data on the foreign exchanges and gave instructions to the overseas agents, from time to time, to buy and sell the securities and shares. The overseas profits were taxed in HK on the footing that the profits arose in or were derived from HK.

On final appeal, the Privy Council held that the profits neither arose in nor were they derived from HK. Their Lordships did not consider that the degree of control exercised from HK over the overseas transactions or the use of HK funds for the investments were material factors. The Mehta case was relied on. (Under HK tax law, business profits are taxable only if they arise in HK or are derived from HK.)

Note. Thoughtful readers who have developed the salutary habit of reading tax cases assiduously, may benefit from the following extract of Lord Bridge’s incisive judgment: “Thus here the gross profit from the bank’s trading in certificates of deposit on the Singapore and London markets in any period was the difference between the aggregate of purchase prices paid and of resale prices received less all agents’ commission.

 But the gross profit becomes an item of income in the bank’s profit and loss account for the period which, aggregated with all other items of income, only contributes to the net profits when all expenditure has been deducted.

The practical problem to which this distinction between gross and net profits gives rise in the calculation of assessable profits under section 14, which must of course exclude offshore profits, is resolved …under Section 85 of the Ordinance…” (Rules framed in HK under section 85 provide for the exclusion of expenses, ascertained by apportionment where appropriate, incurred in the production of profits not arising in or derived from HK.

Of related interest is the judgment of the SC of Sri Lanka in the case of Deva Rodrigo v CIR (2002, 1 Sri LR 384) in which the court held that in a single indivisible business of which the gross revenue is partly exempt and partly liable to tax, there is no authority in the Act to prorate expenses and disallow that part attributable to exempt gross revenue.  However, the court appears to have acquiesced in the appellant’s practical agreement with the Inland Revenue to forgo deduction of the direct expenses incurred in the earning of exempt gross revenue.

(The writer is a tax consultant and past President of the Sri Lanka Institute of Taxation. He has taught taxation to the professional students of the institute and served as an examiner for the professional examinations. He is a writer on tax topics and his articles have been published locally in some newspapers as well as the Sri Lanka Tax Review journal. His specialised articles have been published internationally in the Reports of the Annual Congresses of the International Fiscal Association based in The Hague, The Netherlands. He is the Immediate Past Chairman of IFA – Sri Lanka Branch. He can be contacted on email at: [email protected].)