Under the Income-tax Act, 1961 (‘IT Act’) educational and medical institutes have the option of availing the benefit of two exemption regimes, namely under Section 10(23C) and Section 11 of the IT Act. Prior to 1 July 2020, these institutes had the option of availing the benefit of both the exemption regimes simultaneously which was exercised by numerous such institutes. Thus, the income of such institutes could be exempt if they satisfied the associated conditions laid down in either of the regimes.

The changing landscape of exemption regimes – Finance Act, 2014 to Finance Act, 2023

The Legislature sought to change the aforesaid position by inserting a proviso to Section 11(7) of the IT Act vide the Finance Act, 2020. In order to understand the background for the same it is important to refer to the legislative history of Section 11(7).

Section 11(7) of the IT Act, which was inserted into the IT Act vide the Finance Act, 2014, provides that a charitable institution availing an exemption under Section 11 could not simultaneously claim exemption under Section 10 of the IT Act with the exception of clauses (1) and (23C) thereto. The said provision was inserted in the IT Act to address the problem of educational and medical institutes being registered to claim the benefit of Section 11 but claiming exemption under the general provisions of Section 10 without having to comply with the conditions relating to application of income laid down in Section 11.

The Legislature also noted that a similar situation also existed with respect to institutes approved under Section 10(23C), and in order to remedy the same, inserted the erstwhile eighteenth proviso to Section 10(23C). Therefore, educational and medical institutes registered under Section 10(23C) which did not apply their income in accordance with the said provision could not fall back on other clauses of Section 10 to claim income-tax exemption.

Subsequently, in 2020 the Legislature took note of the fact that in certain cases educational and medical institutes were registered in both Section 12AA and Section 10(23C) and were claiming exemption interchangeably in either of the provisions. Noting that since the provisions relating to such charitable institutes constitute a complete code, it was felt that once an institute had voluntarily opted for one of the aforesaid exemption regimes, the option of switching between the two regimes at convenience should not be available.

Consequently, Section 11(7) of the IT Act was amended vide the Finance Act, 2020 by way of insertion of two provisos. The first of the said provisos provides that the registration of a charitable entity claiming exemption under Section 11 would become inoperative from the date on which it is approved under Section 10(23C) or in case of institutes which were already availing the benefit of both the exemption regimes, on the date on which the first proviso come into effect i.e., 1 June 2020. Thus, educational and medical institutes claiming exemption under Section 11 and Section 10(23C) were shifted to exemption regime under Section 10(23C) alone by virtue of this proviso.

However, by way of the second proviso, a one-time opportunity to switch back to the exemption regime under Section 11 was also provided to these institutes. The second proviso lays down that charitable entity whose registration becomes inoperative because of the first proviso may apply for re-registration, in which case the approval received by such charitable entity under Section 10(23C) would stand cancelled and the charitable entity would not be entitled to exemption under Section 10(23C).

In addition to the above changes, the Finance Act, 2020 also introduced a new set of provisions for grant of approval under Section 10(23C) and registration for claiming exemption under Section 11. As per the said amendments, all charitable entities had to make an application for fresh approval or registration in order to continue to enjoy the benefit of either Section 10(23C) or Section 11 respectively.

Therefore, with effect from 1 June 2020, a charitable entity which was availing the benefit of the exemption regimes under Sections 10(23C) and 11 of the IT Act, was forced to choose between one of the said regimes. Firstly, due to the operation of the first proviso to Section 11(7), the charitable entity’s registration for availing exemption under Section 11 would become inoperative and it would have had the option to either apply for approval under clause (i) of the first proviso to Section 10(23C) or for registration under clause (iv) of Section 12A(1)(ac). Thereafter, the one of following sequence of events could take place:

• If it were to apply under clause (i) of the first proviso to Section 10(23C), it could only switch back to the exemption regime under Section 11 by making an application for registration under clause (iv) of Section 12A(1)(ac). If the option to switch back to Section 11 was taken up, then the charitable entity would be prevented from ever being able to claim exemption under Section 10(23C) in the future.
• If it were to apply under clause (iv) of Section 12A(1)(ac), it would become ineligible to switch back to the exemption regime under Section 10(23C) and would thereafter have to continue under Section 11.

Further amendments were made by the Finance Act, 2022 to align both the aforesaid exemption regimes and insert certain additional compliances and conditions. One of these amendments was in relation to the cancellation of registration/approval under the two exemption regimes which provided that the relevant authority could cancel the registration/approval of a charitable entity in case of a ‘specified violation’, i.e., the happening of certain specified events.

Now vide the Finance Act, 2023, even more amendments have been made to the exemption regimes under Sections 10(23C) and 11 of the IT Act. For the purposes of the present discussion, three amendments must be considered.

The first pertains to the expansion of the meaning of ‘specified violation’ as used in Sections 10(23C) and 12AB, the occurrence of which would result in the cancellation of approval under Section 10(23C) or registration for availing exemption under Section 11. The Memorandum states that one of the issues which was being faced under the new system of registration/approval was that charitable institutes were being granted provisional registration/approval or re-registration/re-approval automatically without any scrutiny because of which even defective applications containing incorrect or incomplete information were being passed. Thus, in order to curb such practice, an amendment has been made to expand the scope of the expression ‘specified violation’ to include the filing of an incomplete application or an application containing false or incorrect information.

The second amendment relates to Section 115TTD of the IT Act which deals with the taxation of accreted income of charitable entities in case they are inter-alia converted to a form which is ineligible for grant of registration for availing exemption under Section 11 or approval under Section 10(23C). As per the amendment to Section 115TD, a charitable entity is considered to ineligible for registration/approval if it fails to make an application within the time specified either under the first proviso to Section 10(23C) or under Section 12(1)(ac). The said amendment has been made to address the situation whereby a charitable entity would seek to opt out of the exemption regimes without having to pay tax on accreted income under Section 115TD.

The third amendment is with respect to the registration/approval process under the two exemption regimes. The residual clause for application under both Section 12A(1)(ac) and Section 10(23C) has been amended so that registration/approval would only be given to those trusts who have already commenced activities if they have not previously claimed exemption under either Section 11 or Section 10(23C).

Therefore, the provisions relating to the exemption regimes under Sections 10(23C) and 11 of the IT Act have undergone a multitude of wide-ranging changes having an impact on nearly every aspect associated with the operation of educational and medical institutes. As will be discussed in this write-up, this has resulted in a situation where a mere procedural lapse can have far reaching consequences.

Procedural lapse or a fatal mistake?

A problem which has arisen on account of the complex nature of these provisions is with respect to educational and medical institutes which were availing the benefit of both the exemption regimes. As has been discussed above, due to the first proviso to Section 11(7), the registration for availing exemption under Section 11 became inoperative with effect from 1 June 2020. However, since no order was required to be passed by any statutory authority to give effect to the said provision, numerous such institutes continued to operate under the assumption that they were still covered under the purview of Section 11 and therefore, applied under clause (i) to section 12A(1)(ac) for automatic re-registration.

Thus, this has resulted in certain procedural irregularities. Firstly, such educational and medical institutes have applied for re-registration for exemption under Section 11 under the incorrect provision of law. Secondly, they have also failed to make the application for re-approval under Section 10(23C) within the time stipulated under the said section.

The consequence of the first of the two irregularities is that following the amendment to expand the definition of the expression ‘specified violation’, the application made by the charitable entity may be considered to be one containing false or incorrect information. Thus, it may result in the cancellation of registration for availing exemption under Section 11. In addition to the above, the consequence of the second irregularity would be that the charitable entity would be considered to have been converted to a form which is ineligible to seek approval under Section 10(23C) of the IT Act.

The ultimate consequence, therefore, would be that the charitable entity would then become liable to pay tax on its accreted income under Section 115TD of the IT Act. Moreover, such a charitable entity would no longer be eligible to apply for exemption under either Section 10(23C) or Section 11 since neither does the first proviso to Section 10(23C) nor does Section 12A(1)(ac) contain any clause which would allow application by a charitable entity which has commenced operations and also previously claimed exemption under Section 10(23C).

Hence, any charitable entity which has even inadvertently committed the afore-mentioned procedural lapses would potentially face a heavy tax burden. Not only would such a charitable entity have to pay tax on its accreted income, but it would also be barred from making a fresh application in the future for claiming exemption under either Section 10(23C) or Section 11 of the IT Act.

While it is a settled position of law that the benefit of a substantive provision of law cannot be denied due to a mere procedural lapse, considering the express intention of the Legislature behind the amendments introduced vide the Finance Act, 2023 as well as the host of other amendments to both the exemption regimes, it would be interesting to see how the income-tax department deals with the situation discussed above.

[The author is a Principal Associate in Direct Tax Team at Lakshmikumaran and Sridharan Attorneys, New Delhi]