Background and Context of the Case
The decision in CIT v. Sterling Foods (1999) is one of the most influential judgments on the meaning of the expression “derived from” in the Income Tax Act, 1961. The phrase is used in several deduction provisions—especially Section 80HH, Section 80-I, Section 80J (older regime), and later Sections like 80-IB and 80-IC. The case deals with whether profits earned from the sale of import entitlements can be considered as profits “derived from” an industrial undertaking engaged in exporting processed marine products.
The assessee, Sterling Foods, was an exporter of processed sea foods. Under the Export Promotion Scheme, when they exported goods, they became entitled to import replenishment licenses (REP licences). These licences had an independent market value and could be sold to third parties. Sterling Foods sold these import entitlements and claimed deduction on such profits under Section 80HH, arguing that these earnings were “derived from” their industrial undertaking engaged in manufacturing and exporting sea products.
The Revenue rejected this claim, arguing that import entitlements do not arise directly from manufacturing activity but from a Government Scheme. Thus, the central issue was whether such profits have a direct nexus to the industrial activity, or whether they are only incidental or consequential.
Statutory Framework Involved
The dispute concerns the interpretation of Section 80HH, which provided deduction on profits “derived from” industrial undertakings located in backward areas. Courts have consistently held that the phrase “derived from” indicates a narrow and immediate connection, unlike the broader phrase “attributable to”. The distinction has far-reaching implications for what constitutes eligible income for deductions.
Previous judgments like Cambay Electric Supply Co. v. CIT (1978) dealt with the expression “attributable to,” which was held to be broader. The Supreme Court in Sterling Foods had to determine whether import licence profits were directly derived from manufacturing, or merely connected indirectly.
Issues Before the Supreme Court
1. Whether the sale of import entitlements constitutes profits “derived from” the industrial undertaking?
The key question was whether manufacturing activity had a direct nexus with the income arising from import entitlements.
2. Whether export activity can be treated as part of the same business nexus for deduction purposes?
The assessee argued that because import entitlements arise automatically when exports are made, such profits should be considered as derived from the industrial undertaking.
3. Whether government incentives can be considered as income derived from industrial activity?
This issue is central to multiple tax deductions under Chapter VI-A.
Arguments of the Assessee
Sterling Foods argued that:
- The export of manufactured goods was inseparable from industrial activity.
- Import entitlements arose only because the products were manufactured and exported.
- Therefore, the profits generated from the sale of such import entitlements must be seen as directly linked.
- They stressed that the incentive was not independent but an integral part of the export business.
The assessee relied on earlier decisions that broadly construed the term “derived from” but none addressed government incentives specifically.
Arguments of the Revenue (Tax Department)
The Revenue maintained that:
- Import entitlements arise only due to the Export Promotion Scheme, not manufacturing.
- Even if exports are linked to manufacturing, import licences arise only after a further step, i.e., recognition by the state policy.
- Thus, the nexus is indirect, mediated through government action.
- Income that is not immediately and directly derived from the industrial activity falls outside Section 80HH.
They relied heavily on the distinction between “derived from” and “attributable to.”
Judgment of the Supreme Court
The Supreme Court ruled in favor of the Revenue, holding that profits from import entitlements are not derived from the industrial undertaking.
Key Reasoning of the Court
The Court clarified the meaning of “derived from”:
- It requires a direct and immediate nexus with the industrial undertaking.
- There must be a first-degree connection, not something that arises because of an external intervention.
- Import entitlements are not generated by the manufacturing process; they arise solely due to the Government Scheme.
The Court emphasized:
“The source of the import entitlement cannot be said to be the industrial undertaking. Its source is the Export Promotion Scheme of the Central Government.”
This was a decisive analytical step. Even though the industrial undertaking must export goods to qualify for import entitlements, the entitlement itself is not the product of the undertaking. Instead, it is the product of government policy.
Therefore, profits from the sale of import entitlements cannot be treated as profits “derived from” the industrial undertaking.
Also Read: CIT v. Shoorji Vallabhdas & Co. (1962) – Detailed Case Analysis
Significance of the Judgment
1. Narrow Interpretation of “Derived From”
This case became the cornerstone for restricting deduction-based incentives. It set a precedent that unless income flows directly from the industrial activity, no deduction is allowable.
2. Impact on Export-Linked Incentives
Schemes like DEPB, REP Licences, Duty Drawback, etc., became the subject of similar litigation. Many were ultimately held not eligible under narrow deduction provisions.
3. Reinforcement of Nexus Principle
The “proximate nexus” principle became a binding rule. Later cases like Pandian Chemicals v. CIT (2003) and Liberty India v. CIT (2009) relied heavily on Sterling Foods.
4. Clear Demarcation Between Business Income and Deduction-Eligible Income
While incentives may be part of business income under Section 28, they may not qualify as “derived from” industrial activity for Chapter VI-A deductions.
Practical Relevance for Students and Practitioners
Even today, Sterling Foods remains a foundational case when determining whether subsidies, incentives, duty benefits, insurance claims, or ancillary receipts qualify for deductions.
The distinction is especially crucial under provisions like:
- Section 80-IA
- Section 80-IB
- Section 80-IC
- Section 80JJA
- Section 10AA
It is also significant for understanding modern incentive schemes under foreign trade policy.
“Tip: Always remember that ‘derived from’ = direct nexus, not indirect or policy-mediated benefits.”
Conclusion
CIT v. Sterling Foods (1999) stands as a landmark judgment defining the boundaries of deduction-eligible income under the Income Tax Act. By holding that import entitlement profits are not “derived from” an industrial undertaking, the Supreme Court created a strict and precise test for determining eligibility. This judgment ensures uniformity and prevents over-expansion of deduction claims based on indirect government incentives. For students and professionals, Sterling Foods is a vital authority in tax jurisprudence, shaping decades of legal reasoning on the nature of income and the scope of tax incentives.
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