Corporate Tax Responsibility of Directors

BY Mohit Singhvi.

The world is moving from acknowledged risks to unacknowledged or almost unknown risks. Some absolutely unforeseen and unprecedented events have recently occurred leading to totally ironic concern as to how the directors of a private company can be made personally liable for the losses. In contrast to the well-established rule of limited liability of companies as respected by the Companies Act 1956 (“Companies Act”), where a director is not personally liable for the company’s debts and the Income Tax Act, 1961 (“ITA”) seeks to make directors personally liable for the tax arrears of the company. This article highlights the liability for the payment of taxes and some illustrations of it.

A company is a separate legal entity, which is independent of its directors and shareholders. Directors are bound to use fair and reasonable diligence in discharging their duties and to act honestly, and act with such care as is reasonably expected from him, having regard to his knowledge and experience. In R.K. Dalmia and others v. The Delhi Administration it was held that “A director will be personally liable on a company when he has accepted either expressly or impliedly to be liable… Directors are the agents or the trustees of a Company”. The practice of ‘piercing the corporate veil’ by which the shareholders of a company can be held personally liable for the debts of the company is not in India as the courts are normally reluctant to rebut the presumption of limited liability and pierce the veil. The principal grounds on which such a course of action can be adopted are typically where “the corporate personality is being blatantly used as a cloak for fraud or improper conduct.”

Under company law, a director of a company is not personally liable for the debts unless a court of competent jurisdiction finds him guilty of misfeasance. Company Law proceeds on the basic principle of jurisprudence that a director is presumed to be innocent unless he is proved to be otherwise. In general practice, a director’s financial liability is limited only to the extent of his capital contribution in the company and he is not individually liable for the company’s debts unless found guilty of misfeasance or other wrong by a court of competent jurisdiction. In the case of Peter J R Prabhu v. Asst Commissioner of Commercial Taxes, the court stated that apart from any provisions of the taxing statute, arrears of the tax amount are not to be recovered from the directors personally.

Section 543 of the Companies Act is the relevant section on the subject which provides for the assessment of the loss or damage suffered by the company consequent on acts of misfeasance or breach of trust committed by directors and officers of the company and for the making of a compulsive order against the delinquent for repayment. The said section authorizes the Court to pass an order making him liable to pay a sum of money to the company by way of compensation. Further, at the conclusion of the proceedings under Section 543 of the Act, an order is made. Such an order contributes to the character of a decree in a suit. When once the order is declared it is open to the Official Liquidator to realize the amount due by resorting to Section 634 of the Act to enforce the declaration made under Section 543.

These salient principles of company law and jurisprudence are given the go-by under the income-tax law. Section 179 of the Income-Tax Act, 1961 imposes a vicarious liability on a director and liability can be imposed by the assessing officer (AO) without adjudication by a court. The Income Tax Act fixes a personal liability on the directors of a private company in respect of the tax payable by the company. Under section 179 of the Income Tax Act, any tax arrears due from the private company can be recovered from the directors in charge of the company during the relevant tax year. It is only in the event a director can prove that the non-recovery of arrears of tax cannot be attributed to any gross neglect, misfeasance or breach of duty on his part in relation to the affairs of the company, that the tax cannot be recovered from such a director.

Section 179 brings in its sweep all private companies and also those which are transformed into public companies in respect of the period when such company was a private company. Section 179 thus imposes a vicarious liability upon the directors in respect of the tax arrears of the companies, although the companies themselves are entities independent of the directors. As a result, this section foisting a tax liability on the directors of a private limited company could be regarded as a deviation from well accepted principles of company law, where a director is otherwise not individually accountable for the company’s debts except under certain circumstances.

In Arvind Kumar Gupta v. Tax Recovery Officer, the High Court held “Section 179 is a departure from the provisions of the Companies Act, where a director is not individually liable for the company’s debts unless the Company Court finds him guilty of misfeasance or other wrong. Section 179 imposes a vicarious liability on the directors of private limited companies, even though a private company is a separate legal entity…”.

It is interesting to note that the concept of making directors of a private company liable in respect of tax arrears of the company was initially applicable only with respect to directors of companies that were in liquidation. Subsequently, in 1975 the Legislature decided to extend the net to bring in its sweep directors of all private companies irrespective of whether such companies were in liquidation or not and also those companies which were converted into public companies in respect of the period when such company was a private company. Thus section 179, prior to its amendment on October 1, 1975, operated only in cases of private companies in liquidation. The 1975 amendment is retrospective in operation and applies in respect of assessment years commencing on or after April 01, 1962.

It would thus be appropriate to refer to the background in which section 179 (1) and (2) was substituted for the old section 179 with effect from October 1, 1975. The Taxation Laws (Amendment) Bill, 1973, that is, Bill No. 34 of 1973, was introduced in the Lok Sabha on May 9, 1973, and section 50 of this Bill provides for amendment of section 179. As per the Statement of Objects and Reasons, section 179 was amended so as to extend the liability for taxes due from a private company to the directors even though such company may not be in liquidation. The Bill was forwarded to the Select Committee for its report and the report was presented on March 20, 1975. As regards the amendment of section 179, the Select Committee recommended that the provisions of the clauses also applied to a director of a private company which has been converted into a public company but in respect of which tax was due on the income of such private company. The Select Committee recommended that the liability should be restricted to tax due in respect of the assessment years commencing on or after April 1, 1962. The report of the Select Committee was accepted and instead of the proposed amendment of section 179, sub-sections (1) and (2) were the amendments made in 1975 as discussed above.

Despite the amendment in 1975, it is interesting to note that the marginal heading of section 179 still reads ‘Liability of Directors of Private Company in Liquidation’. The provisions of Section 179 of the Income-tax Act of 1961 would apply only to companies in liquidation but not to the companies which were struck off the register under Section 560(5) of the Companies Act. Since the company was not wound up, the provisions of Section 179 of the Income-tax Act, 1961, are inapplicable.

In the case of Gurudas Hazra v. B.K. Chowdhury, the High Court held that the marginal note or heading of Section 179 is misleading, because the body of the section applies to all private companies, whether those are in liquidation or not. In Smt. Bidya Devi v. Commissioner of Income Tax and Ors., the High Court of Calcutta held “Prior to the amendment in 1975, the director was liable under Section 179 jointly and severally for the payment of his company’s tax arrears only if the company had been wound up, but after the amendment in Section 179 in the year 1975, Section 179 provides that where any tax was due from a private company which could not be recovered from the company, every person who was a director of the company is jointly and severally liable for the payment of such tax unless he proves that the non-recovery cannot be attributed to any gross neglect, misfeasance or breach of duty on his part in relation to the affairs of the company… meaning if the company has gone into liquidation or not the ex-director is also liable to pay the tax arrears due against the company.”

Subsection (1) of section 179 is a statutory presumption of the tax liability of a director of a private company casting a burden on the director to prove that the non-recovery cannot be attributed to any gross neglect, misfeasance or breach of duty on his part. This section introduces a dangerous innovation in fiscal laws as it cuts at the root of the doctrine of limited liability of companies. Whereas under company law, a director is not personally liable for the company’s debts unless a court of competent jurisdiction finds him guilty of misfeasance or other wrong, the vicarious liability under this section can be imposed on a director by the Income-tax Officer without adjudication by a court. Secondly, whereas company law proceeds on the basic principle of jurisprudence that a director is presumed to be innocent till he is proved to be a wrongdoer, this section is an instance of the disquieting drift in modern Indian jurisprudence towards presuming a citizen to be guilty until he is proved to be innocent. A director is liable under this section unless he proves the absence of gross neglect or breach of duty on his part. However, this liability of the director arises only provided the tax authorities are unable to recover the arrears of tax from the assets of the company.

From the above discussion, it can be concluded that, while directors of private limited companies may be made jointly and severally liable for payment of tax due from the company, they should be made so liable in line with the principles laid down by the Companies Act. In that, such a provision must operate only on the liquidation of the company concerned and the burden of proof in respect of establishing the director’s gross neglect, misfeasance or breach of duty must be shifted to the tax department. Further, the recovery mechanism in respect of taxes due under Section 179 may also be modified by way of providing for the issuance of a demand notice to the directors once an order has been passed under the section against the concerned directors.

Section 179 cuts at the root of the doctrine of limited liability of companies. Even resignation of directorship of the company will not absolve him from the liability incurred during the period he was a director of the company. It is to be remembered that Section 179 has been introduced to create a liability which did not exist under the 1922 Act; and, further, that section creates a liability which is contrary to the provisions of the Companies Act. It is very clear from the section itself as it starts with “notwithstanding anything contained in the Companies Act”. As the section creates a new liability and is a taxing statute, it has to be strictly construed, unless a liberal interpretation has to be given by way of necessary intendment.

On an examination of Section 179 of the 1961 Act, it is found that not only the expression “wound up” has been used in the said section but also while determining the taxes which can be recovered it has been specifically stated that those taxes may have been assessed on the company before or in the course of or after its liquidation. The material date, therefore, is the date of the company’s liquidation. If the expression “wound up” and the word “liquidation” found in Section 179 are read together, the only meaning that can be attributed to the expression “wound up” is the meaning which is given to that expression in the Indian Companies Act. The provisions of Section 179 are, therefore, limited only to those private companies against which proceedings for winding-up have been taken and have been wound up after the commencement of the 1961 Act. The expression “wound up” cannot be interpreted so liberally as to include also defunct companies as having become defunct without being wound up. It cannot be said that Parliament, when it enacted Section 179, was not aware of the meaning to be given to the expression “wound up”. A reading of the whole of Section 179 clearly shows that it is applicable only to cases where proceedings for winding-up are taken under the Indian Companies Act and the company is wound up under the said Act after the commencement of the Income-tax Act, 1961.

A Director is required to act honestly and diligently applying his mind and discharging his duties as a man of prudence of his ability and knowledge would do.