The Perils of Taxing a Legal Fiction: Re-Visiting the Bombay HC’s Judgement in All India Central Bank Officers

Tejasvi Kochar*

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The Bombay High Court (‘BHC’) declared its judgement in All India Central Bank Officers vs. Union of India and Ors. (‘All India Officers case’) on 20th January 2025. This case has disposed of the petition questioning the amendments brought to Section 17(2)(ii) of the Income Tax Act, 1961 (‘Act’ or ‘Parent Act’) by the Finance Act, 2007 (‘2007 Amendment’). This blog analyses the said judgement. 

Section 17(2)(ii) of the Act taxes concessional accommodation provided by the employer, as a perquisite (commonly known as a ‘perk’). Before 2001, only actual concessions on rent were taxed, and any assessee paying rent without concession could argue before the Assessing Officer (‘AO’) that their rent matched the Fair Market Value (‘FMV’) and need not be taxed. However, this created challenges, as AOs had to determine concessions across various locations. The Income Tax (Twenty-Second) Amendment Rules, 2001 (‘2001 Amendment’) by adding Rule 3 of the Income Tax Rules, 1962 (‘Rule 3’), amended this process and gave a straight-jacket formula for calculation of the perquisite value for concessional accommodation provided by the employer. The straight-jacket formula devised under Rule 3 mandated taxation if fixed salary percentage (based on city population) exceeded rent paid. Tax would be paid on the difference amount. This created a legal fiction of concessional accommodation notwithstanding any actual concession provided.

The validity of this rule was challenged before the Supreme Court (‘SC’) in Arun Kumar v. Union of India (‘Arun Kumar’). The core issue was whether Rule 3, imposing tax liability on employees regardless of any actual concessions, contradicts Section 17. The appellants argued that Section 17 only intended to tax employer-provided concessional accommodation, not create a legal fiction of concession. This is apparent from the wording of Section 17- “the value of any accommodation…at a concessional rate”. The court harmonised Rule 3’s fictional concession with Section 17(2)(ii)’s tax on concessional accommodation. Paragraph 74 of the judgement held that AOs must first establish the existence of concession as a jurisdictional fact before applying the straight-jacket formula for calculating concession under Rule 3. This preserved the statute’s intent of taxing just concessional accommodation.  

However, the 2007 Amendment overruled this interpretation by inserting an explanation under Section 17(2)(ii), deeming a concession to exist whenever the computed accommodation value under Rule 3 exceeds the rent paid. This legal fiction creates a perquisite where none exists, contradicting Arun Kumar. The Amendment was later challenged in the All-India Officers case. The court, while upholding the amendment, primarily relies on 2 arguments: first, that the 2007 Amendment does not override the Arun Kumar case, and second, that the creation of legal fiction is valid since the legislature has the authority to do so. This blog critically examines both these arguments through the lens of taxation principles and constitutional law. Following this, the author highlights a crucial aspect overlooked by the BHC judgment—the significance of an employer-employee relationship in taxing perquisites. The analysis culminates in a conclusion demonstrating that the BHC erred in upholding the constitutionality of the 2007 Amendment. 

I. REASONING 1: 2007 AMENDMENT DOES NOT OVERRIDE ARUN KUMAR

The BHC notes that Arun Kumar permitted assessees to argue that Rule 3 applies only when a concession exists under Section 17(2)(ii), as Rule 3’s language left room for this interpretation. This interpretation was made impossible when the 2007 Amendment added an explanation to Section 17, deeming any excess of computed salary over the rent payable as an existence of concession. The appellants argued this as overruling Arun Kumar as a prior existence of concession is no more required to tax the deemed concession under Rule 3. However, BHC held that this is only a minor clarification under the ‘small repairs doctrine’—required to achieve the legislature’s aim. The court further observed that this explanation does not impermissibly override but clarifies a gap identified in the Arun Kumar case.

It is submitted that the BHC was wrong on two grounds when it held that the Amendment does not constitute an impermissible judicial override.

First, this Amendment, contrary to what BHC says, in essence, overrules Arun Kumar. The SC, in that case, held that a real concession must exist before Rule 3 can apply, affirming that taxation must be based on real economic benefits, not artificial legal constructs. The 2007 Amendment disregards this principle, introducing a deeming fiction that can classify any rent as a perquisite, even when the employee pays FMV. The 2007 Amendment thus taxes a fiction, which was not allowed in the Arun Kumar case, essentially overruling it.  

Second, this Amendment is not just a clarification but a fundamental distortion of the Parent Act's intent. Section 17’s purpose is clear: to define and tax an individual’s salary by breaking it into three heads—salary, perquisites, and profits in lieu of salary. This ensures that any financial advantage derived from employment is taxed under one of the three heads. Perquisites are specifically taxed to address non-monetary benefits arising from employment. Initially, only actual rent concessions received as non-monetary benefits from employment were taxed. However, by introducing the explanation under Section 17(2), a tax is imposed on amounts that may not even be a financial benefit. Therefore, this contradicts the principles of Section 17, which just taxed financial advantages received from the employment. Had the Amendment genuinely addressed a statutory gap, it would have remained consistent with Section 17’s core principles.  

In this light, the 2007 Amendment does not simply override Arun Kumar; it distorts the intent of the Parent Act under the guise of a clarification. By upholding this explanation, the BHC ignores Arun Kumar's reasoning and expands tax liability beyond the statute’s intended scope, creating an unfair and excessive tax burden on employees and undermining the core principle that taxation must be based on real economic transactions.

II. REASONING 2: THE CREATION OF LEGAL FICTION IS VALID

The 2007 amendment stipulates that the computation made under Rule 3 will be considered a concession under Section 17(2)(ii) irrespective of any real concession. The appellants challenge legal fiction's creation as unnecessary and contrary to legal principles. The court rejected the appellant’s argument that the legal fiction was unnecessary, affirming that the legislature holds the power to create legal fiction as long as it serves a legitimate purpose and aligns with constitutional requirements. BHC followed a deferential approach, focusing solely on the power to create legal fiction without considering whether creation of this particular fiction is justified.

The stated goal of this legal fiction was to standardise tax computation and reduce the AO's discretion in determining these concessions. This goal could have been achieved by using the existing framework under the Income Tax Act while keeping in line with the Parent Act’s principles of taxing financial advantages. But the Amendment does not consider this way. This raises doubts about the real objective, as it strays from the existing framework as well as principles of the Parent Act.

To reduce AO’s additional burden of calculation of concession, the legislature could have simply used the existing calculation of rent within the Parent Act for calculation of concession. The existing framework which the legislature could have used was the taxation on income from house property. Section 22 taxes the annual value of a house property, including those house properties which are let out. The method of calculation of annual value of house property which is let out is given under Section 23 of the Act. The annual value will be higher of the expected rent or the actual rent of the house property. The expected rent is higher of the FMV rent or the municipal rent. Municipal rent is calculated on the municipal value of the property, which is determined by a periodic survey held by municipal authorities of all the buildings in their jurisdiction.  FMV rent is the reasonable expected rent which the property can fetch. It can be determined based on rent fetched by a similar property in the same or similar locality. Thereby, the municipal rent and the FMV rent are always calculated for calculating the tax on the annual value of a property that is let out.

This system could then be simply be imported here for the calculation of concession by comparing the FMV rent or the municipal rent with the actual rent paid by the employee. Using this existing framework would have avoided the requirement of creating new legal fiction while not adding extra compliance burdens for the AO. The legislature has taken an unnecessary step by ignoring this existing framework and introducing a legal fiction instead. While there may be some perceived benefit by standardising the process under Rule 3, this approach ultimately creates an unfair system for assessees, who may be taxed over and above the actual perquisites received. As a result, the legal fiction's intended purpose of ensuring consistency loses its legitimacy compared to more effective solutions addressing the problem with AO’s discretion.

Moreover, the legal fiction must also pass the test of constitutional scrutiny, particularly the Article 14 challenge. The appellants argued that the amendment arbitrarily taxes employees who receive no concession. The court dismissed this claim, stating that classification based on city population satisfies the reasonable classification test, yet failed to explain why employees with and without concessions are taxed identically. The reasonable classification test is a two-stage test to determine an Article 14 violation- where first, there needs to be an intelligible differentia between two groups of people who are being differentiated or not differentiated, and second, the differentia should have a rational nexus with the aim that is to achieve from creating such a differentia.

This test applies not only when there is a difference but also when the failure to recognize a difference itself violates Article 14. The present case is an example of the latter. Two groups of individuals—one receiving no concession and the other receiving a concession—are taxed for concessional accommodation on the same basis. A person receiving a concession is not taxed unless a certain percentage of their salary exceeds their rent. In contrast, someone who receives no concession is taxed if that percentage exceeds their rent, even though no actual concession has been granted. This results in both groups being taxed for concessional accommodation without distinguishing between those actually receiving a concession and those who are not. Therefore, the legislature has enacted a discriminatory provision that violates Article 14 by prioritising uniformity over fairness.

BHC’s dismissal of the Article 14 challenge rests on an overly deferential approach to economic legislation, overlooking the fundamental requirement of a rational nexus in classification. It simply notes that “individual hardships are not very relevant in such matters”, and defers to “economic policy”. The court’s broad reliance on legislative discretion sidesteps the fact that uniformity in taxation when it results in differential treatment of unequals, is itself a violation of equality under Article 14. The court’s justification for this provision—linking taxability to salary structure is neither arbitrary nor discriminatory—ignores that an employee receiving no concession is still taxed under a provision meant for concessional accommodation. This failure to recognize a crucial difference undermines the constitutional validity of the amendment.

Therefore, the creation of a legal fiction of a concession to tax concessional accommodation under Section 17(2)(ii) fails the tests of a valid legal fiction as it violates constitutional provisions and does not serve a valid purpose.

III. OVERLOOKED ARGUMENT: EMPLOYER-EMPLOYEE RELATIONSHIP IN TAXING PERKS

A key argument overlooked by the BHC is that an employer-employee relationship must exist for any benefit to qualify as 'salary' under Section 17. To fall within the broad definition of salary, the benefit must meet one crucial requirement: it must stem from the employer-employee relationship between the payer and the payee. It is not enough for there to be a mere existence of this relationship; the payment must also be derived from it. In ITC v. CIT, the court did not recognize an employer-employee relationship between the hotels and its waiters when paying them tips received from customers. Even though the payment was linked to their employment, it did not originate from the employer-employee relationship and thus did not fall under Section 17.

Similarly, in the case of FMV-rent accommodation provided by the employer, the employee is not receiving any benefit arising from an employer-employee relationship. This transaction is more akin to a standard landlord-tenant agreement than an employer-provided benefit. A perquisite arises only when an employee receives an advantage exclusive to the employment relationship, which is not the case here. When an employee pays the same rent as any third party, no economic benefit is derived from the employer-employee relationship, meaning the transaction should not be classified as a perquisite for tax purposes under Section 17. In such cases, the employer is acting as a property owner, not as an employer providing a benefit. The absence of any preferential advantage means this should be treated as a landlord-tenant lease, not an employer-given perquisite. Thus, if the payment does not arise from an employer-employee relationship but from a landlord-tenant relationship, it should not be taxed as a perquisite under Section 17(2)(ii).  

IV. CONCLUSION

The 2007 Amendment's explanation under Section 17(2)(ii) is not merely a clarificatory addition but a fundamental distortion of the Parent Act’s intent. By deeming a concession to exist where none may actually arise, it overrides Arun Kumar and imposes taxation based on a legal fiction that was never required. The very foundation of Section 17 is to tax economic benefits, yet this amendment ignores that prerequisite, instead imposing tax liability based on a deemed fiction.

The judiciary's role is to interpret statutes in alignment with legislative intent, yet, the BHC’s judgment fails to recognize that the amendment does not merely fill a gap but creates a new liability untethered from actual economic transactions. Legal fictions should only be employed where necessary to resolve genuine legislative ambiguities—not to override statutory safeguards and constitutional principles. Here, the fiction serves no essential purpose, as existing frameworks for FMV-calculations under the Parent Act already provide a practical alternative.

By upholding this amendment, the BHC has sanctioned an interpretation that undermines core taxation principles, allowing the state to tax hypothetical advantages instead of actual benefits. This sets a dangerous precedent, expanding the scope of perquisites beyond what Section 17 originally intended and eroding taxpayer protections against arbitrary impositions. In prioritising administrative convenience over substantive fairness, the ruling legitimises an unconstitutional expansion of perquisites that ignores fundamental principles of tax law. This raises a critical question: if legal fictions can be used to impose tax liabilities untethered from actual economic benefits, where will the line be drawn in future expansions of taxation?

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*Tejasvi Kochar is a third-year law student pursuing a B.A., LL.B (Hons.) from NALSAR University of Law, Hyderabad.