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WHEN IS A PRIVATE COMPANY’S DIRECTOR PERSONALLY LIABLE FOR THE INCOME-TAX DUES
OF THE COMPANY?

Khaitan Legal Associates
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India July 13 2023

Section 179(1) of the Income-tax Act, 1961 (“the Act”) makes directors of a
private company jointly or severally liable for the non-recoverable tax dues of
the company, unless they can prove that the non-recovery of such dues is not due
to gross neglect, misfeasance, or breach of duty on their part.

For directors with minority shareholding, independent directors and nominee
directors of institutional investors, it can be challenging task to demonstrate
their limited control and lack of involvement in the company's affairs,
especially when decisions are predominantly made or overturned by majority
shareholders or other executive directors. This situation creates a potential
burden on these directors, as they may be held personally liable for
non-recoverable tax liabilities of the company, despite having little influence
over the company's operations and decisions.

The High Court of Bombay, in the case of Prakash B. Kamat vs. Principal
Commissioner of Income Tax (Writ Petition No. 3129 of 2019), recently examined
the liability imposed on directors under Section 179(1) of the Act. The judgment
explains the exceptions and circumstances under which directors were able to
successfully demonstrate that the prescribed liability provisions were not
applicable to them.

To elaborate, the petitioner, a mechanical engineer, developed a smart
card-based ticketing solution for public transport in Mumbai. For this purpose,
a private company (‘PCo.’) was incorporated on 30th March 2006. After a
successful trial run, a joint venture agreement was signed with Khaleej Finance
and Investment (KFI) for investment and management control of PCo. Thereafter, a
Joint Venture Agreement was executed in June 2006 and the Managing Director
Agreement was executed in February 2007. The clauses of these agreements
provided that the management and real control of PCo. was in the hands of 6
Directors appointed by KFI (out of total 8 directors including petitioner and
his wife). KFI had 74% voting rights whereas the balance 26% voting rights were
with the petitioner and his wife. Further, the decision in respect of PCo.’s
accounts and/or audits were solely in the control of the directors appointed by
KFI.

However, disagreements arose, leading to the petitioner's removal as the
managing director and termination of directorship in September 2009. Eight years
later, the petitioner received a show cause notice under section 179 of the Act,
regarding outstanding tax demands against the company to the extent of ~ INR
140million. The petitioner and his wife contended that they were namesake
directors without having any control over any decision of PCo. Further, during
the time when the petitioner was a director of PCo., there were no outstanding
demands of tax from the income-tax department. However, the tax authorities did
not agree with the contentions of the petitioner and froze the bank accounts of
the petitioner and his wife. Hence, the petitioner filed a writ petition before
the Bombay High Court under articles 226 and 227 of the Constitution of India.

After considering various judicial precedents, the Bombay High Court ruled in
the favour of the petitioner. The High Court held that:

 * It is settled position of law that in absence of any specific provisions in
   the statute, duty or penalty liability of the company cannot be recovered
   from its director, who is not personally liable towards liability of the
   company.
 * Where a director proves that non-recovery of tax dues cannot be attributed to
   any gross neglect, misfeasance or breach of duty on his part in relation to
   the affairs of the Company, he shall not be liable for payment of tax dues.
   The primary responsibility of establishing such fact is upon the director.
   However, once the director places before the authority his material and
   reasons why the non-recovery cannot be attributed to any of the three factors
   on his part, the authority is bound to examine such grounds and come to a
   reasoned conclusion in this respect.
 * The legislature in its wisdom has used the words “gross neglect” and not mere
   neglect on the part of the director. Further, gross negligence etc. is to be
   viewed in the context of non- recovery of tax dues of the company and not
   with respect to general functioning of the company.
 * Having brought on record material to show lack of financial control, lack of
   decision- making power and having very limited role in PCo. even as a
   director and entire decision- making process being with the directors
   appointed by KFI, the petitioner had sufficiently discharged the burden cast
   under section 179(1) of the Act to absolve him from the liability thereunder.
 * Action was initiated after a long period of about 8 years and such delay in
   adjudication defeats the very purpose of the legal process. Such delayed
   action is in contravention of procedural fairness and is violative of
   principles of natural justice.

Our comments

In our view, this is a welcome judgment that would give peace of mind to
directors who possess limited control over the company's affairs. Having said
that, the statutory burden cast on such directors to furnish evidence of their
bona-fide intentions and actions cannot be overlooked. Such directors may
consider keeping documentation on record such as shareholder agreements, board
resolutions, and other records (e.g. financial statements, director’s reports,
etc.) that establish their lack of control or limited control over the company's
affairs (financial or otherwise), to be able to mitigate any potential personal
ramifications under section 179. The possibility of obtaining suitable Directors
and Officers (‘D&O’) insurance may also be considered which can protect / assist
the directors from claims under section 179 of the Act. Further, if a D&O
insurance is already obtained, then the wording of the existing policy may be
carefully reviewed to check if they cover costs / liabilities pertaining to
section 179 of the Act.

Khaitan Legal Associates - Sakate Khaitan, Abbas Jaorawala and Isha Wadhwa

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