The NSEL Scam: A decade later – Lessons Substance over Form and Interpretative Consistency

A decade on, the fallout from the NSEL financial scandal continues. In a recent decision[1], the Mumbai bench of the Income Tax Appellate Tribunal addressed the tax consequences of the transactions at the heart of the controversy – so called "paired contracts".

Under these "paired contracts", investors would simultaneously execute two contracts with the same counterparty: a contract to buy commodities with a T+2 delivery cycle and a corresponding contract to sell commodities with a T+25 or T+36 delivery cycle. The structure was intended to create the appearance of legitimate trading activity and designed to resemble typical futures transactions on commodities exchanges, where traders enter into contracts for the purchase or sale of a commodity at a future date but often square off their positions before delivery by entering into offsetting contracts, aiming to profit from price movements. However, the product was marketed as an alternative to fixed deposits and as offering fixed returns regardless of the underlying commodity or contract duration.

The National Spot Exchange Limited (NSEL) played a key role in the transactions, issuing warehouse receipts to sellers upon depositing commodities, collecting payment, and ensuring the delivery and settlement of the contracts.

However, in the aftermath of NSEL failure to settle trades worth upwards of INR 5,600 crores, several judicial fora, including the Supreme Court, weighed in on the true legal nature of these “paired contracts”. It is now well established that they were really short-term financing arrangements, not genuine commodity trades.

The tribunal’s decision raises important questions about how tax law should characterize income and interact with private law. In essence, the Tribunal was required to address the following questions:

1. Whether the profit earned by an investor in a ‘paired contract’ was interest for purposes of the income tax,

2. If yes, whether the taxpayer had to deduct tax at source on payments made to investors under Section 194A of the Income Tax Act, 1961 (“ITA”). A finding that the taxpayer had to deduct tax at source would require a finding that the taxpayer was a “person responsible for paying …interest” to the investor.

Profit on “paired contract” transactions characterized as ‘interest’

The tribunal—as did courts before it—rightly characterized the “paired contracts” as short-term financing arrangements, not genuine commodity trades. Having examined the contracts in light of the surrounding circumstances, the tribunal came to the conclusion that, for tax purposes also, what occurred was a short-term financing arrangement, and that any profit therefore constituted interest for tax purposes.

The decision to treat the profits earned as interest aligns with a fundamental principle of tax law: the substance of a transaction determines its tax treatment, not the label or structure given to it by the parties.[2] This principle reflects the independence of tax law in characterizing income, drawing on—but not being dictated by—the manner in which transactions are papered.

Is the taxpayer a “person responsible for paying …interest”

According to the tribunal, simply put, no. Yet, this outcome raises questions about the tribunal's interpretative consistency. While the characterization of the paired contracts is commendably substance-focused, the tribunal’s application of Section 194A’s "person responsible for paying" appears heavily reliant on the procedural mechanics outlined in NSEL's bye-laws and other private contracts between investors, the taxpayer, and NSEL.

These documents seemingly guided the conclusion that only NSEL, as the principal or counterparty, could be held responsible for TDS compliance—not brokers like the taxpayer, acting as intermediaries.

But it’s worth asking ourselves why the language of private bye-laws should command greater deference than the very contracts that facilitated the transactions? If the paired contracts were considered contrivances masking the economic reality of the underlying transactions, why are NSEL's bye-laws, a private instrument, treated as authoritative in determining whether the taxpayer was, in fact, merely an intermediary?

In addition, the tribunal’s interpretation of Section 194A’s "person responsible for paying" would imply that Section 194A applies solely to principals or counterparties, excluding intermediaries. Although Section 194A does not explicitly mandate such a narrow reading, and the statutory language arguably supports a broader interpretation that could encompass agents and facilitators involved in the payment flow, the tribunal relies on two non-controlling judgments[3] of the Delhi High Court, rendered in the context of Section 194C, to conclude that the term “person responsible for paying” can apply only to the actual counterparty to the transaction. In complex financial ecosystems, where intermediaries play crucial roles in facilitating cash flow, limiting liability to counterparties could create loopholes and enforcement gaps.

Conclusion

This case highlights a critical policy question: To what extent should tax law defer to private law instruments, like NSEL’s bye-laws? While private law can and should inform tax analysis, the system benefits when such instruments are not controlling. The interests of tax law—ensuring accurate characterization and equitable enforcement—often demand a deeper examination of transactional realities that transcend the plain letter of private agreements. By treating private rules as merely one factor in the analysis rather than dispositive, tax authorities and tribunals can ensure a more robust, fair, and consistent application of tax principles.

The case also highlights a critical legal question – should the term “person responsible for paying” used prolifically throughout the ITAs provisions on tax withholding be solely limited to the contractual counterparties and principals? There isn’t an easy answer, and It’s therefore worth thinking about whether this was what Parliament intended, and why then it would use terms capable of much broader import.

[1] Dep. Comm’r of Income Tax v Anand Rathi Commodities Limited, ITA Nos. 3900/Mum/2023 and 3919/Mum/2023

[2] See: Sundaram Finance Ltd. v State of Kerala, (1966) 2 SCR 828 (per Subba Rao, J): “The true effect of a transaction may be determined from the terms of the agreement considered in the light of the surrounding circumstances. In each case, the Court has, unless prohibited by statute, power to go behind the documents and to determine the nature of the transaction, whatever may be the form of the documents.”

[3] CIT v Hardarshan Singh, 350 ITR 427 (Del); CIT v Cargo Linkers 218 CTR 693 (Del)