Facts of the Case

The petitioners were shareholders of Escorts Heart Institute & Research Centre Ltd. and had entered into a Share Purchase Agreement dated 25.09.2005 with Fortis Healthcare Ltd. for sale of their shares. As part of the transaction, a portion of the sale consideration amounting to approximately ₹64.99 crores was retained in an escrow arrangement. The retained amount was intended to secure potential tax liabilities arising from disputed income tax demands against the assessee company.

The Income Tax Department had raised a substantial tax demand against the assessee company after denying exemption under Section 35(1)(ii) of the Income Tax Act. To safeguard the purchaser against adverse financial consequences arising from such disputed liabilities, a portion of the sale consideration payable to the selling shareholders was retained in escrow.

Subsequently, the Assessing Officer issued notices under Section 226(3) directing the escrow bank to remit funds lying in the escrow account toward recovery of tax dues of the assessee company. The bank submitted an affidavit specifically stating that the amounts held in escrow neither belonged to nor were held on account of the assessee company. Despite such objection, the Assessing Officer proceeded with recovery and appropriated the amount. The petitioners challenged this action before the Delhi High Court.

Issues Involved

  1. Whether amounts held by an escrow agent pursuant to a Share Purchase Agreement could be regarded as money due to or held on behalf of the assessee company.
  2. Whether proceedings under Section 226(3) of the Income Tax Act could continue after a third party objected on oath and denied holding any money on behalf of the assessee.
  3. Whether the Assessing Officer had jurisdiction to adjudicate disputes concerning liability between the assessee and a third party.
  4. Whether escrow funds retained as security in a share transaction could be attached for recovery of tax dues of the assessee company.

Petitioners’ Arguments

The petitioners argued:

  • Proceedings under Section 226(3) are in the nature of garnishee proceedings and permit recovery only where money is due to the assessee or held on behalf of the assessee.
  • The escrow account did not contain money belonging to the assessee company but represented a portion of the sale consideration payable to the selling shareholders.
  • The escrow bank had categorically affirmed through an affidavit that no money was owed to or held for the assessee company.
  • Once such objection was raised on oath, the Assessing Officer lacked jurisdiction to continue proceedings.
  • The Assessing Officer could not assume the role of adjudicating disputes regarding indebtedness between third parties and the assessee.

Respondent’s Arguments

The Revenue contended:

  • The escrow arrangement had been created for addressing possible income tax liabilities of the assessee company.
  • Since the retained funds were specifically linked to disputed tax demands, they effectively existed for meeting tax obligations.
  • Therefore, the Department argued that the funds could be appropriated through recovery proceedings under Section 226(3).
  • The Revenue further asserted that its action was consistent with the terms of the escrow agreement and the Income Tax Act.

Court Findings / Court Order

The Delhi High Court allowed the writ petition and held:

  • Proceedings under Section 226(3) are in the nature of garnishee proceedings where the Assessing Officer merely steps into the shoes of the assessee and cannot acquire greater rights than those available to the assessee.
  • Section 226(3) does not provide machinery for adjudicating disputed questions concerning whether a third party owes money to an assessee.
  • Once the escrow bank filed an affidavit stating that it neither held nor owed any amount to the assessee company, the Assessing Officer lacked jurisdiction to proceed further.
  • The Share Purchase Agreement and Escrow Agreement clearly demonstrated that the escrow funds formed part of the sale consideration payable between shareholders and purchaser and did not belong to the assessee company.
  • The assessee company was not even a party to the Share Purchase Agreement or Escrow Agreement.
  • Under no circumstance could the escrow funds become payable to the assessee company or directly to the Income Tax Department.

Accordingly:

  • The order dated 01.02.2013 and notice dated 04.02.2013 were set aside.
  • The Department was directed to immediately refund the amount recovered from the escrow bank.
  • Parties were directed to bear their own costs.

Important Clarification

The Court clarified an important legal principle:

An Assessing Officer exercising powers under Section 226(3) cannot adjudicate disputed claims regarding indebtedness between a third party and the assessee. Where a third party objects on oath and states that no money is due to the assessee or held on its behalf, recovery proceedings cannot continue unless the Revenue establishes that such statement is materially false.

The Court further clarified that sale consideration arising from transfer of shares belongs to shareholders and not to the company whose shares are being sold. Therefore, escrow funds created from such sale consideration cannot automatically be treated as assets of the company merely because they relate to potential liabilities affecting share value.

Sections Involved

Income Tax Act, 1961

  • Section 226(3) – Recovery of tax through garnishee proceedings
  • Section 35(1)(ii) – Deduction/exemption provision relating to approved institutions

Code of Civil Procedure, 1908

  • Order XXI Rule 46
  • Order XXI Rule 46C
  • Order XII Rule 6

Link to download the order –https://delhihighcourt.nic.in/app/case_number_pdf/2013:DHC:3584-DB/VIB24072013CW12722013.pdf

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