State Government security exemption survives transfer to a trust; interest remains tax-free under section 8

A State Government loan security issued on an express tax-free footing was treated as a security of the State Government under section 8 of the Income-tax Act, and the earlier binding decision on the same loan governed the reference. The court held that the interest retained its exempt character under the third proviso to section 8, and that transfer of the security to a trust did not destroy the exemption. Correspondence and surrounding circumstances confirmed the original intention that the interest would remain free of income-tax, so the assessee succeeded on both questions.

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Issues: (i) Whether the loan of Rs. 4.5 crores was a security of the State Government within the meaning of section 8 of the Income-tax Act; (ii) Whether the interest on the loan was exempt from tax in the hands of the assessee under the third proviso to section 8.

Issue (i): Whether the loan of Rs. 4.5 crores was a security of the State Government within the meaning of section 8 of the Income-tax Act.

Analysis: The same loan, the same rate of interest, and the same trust had already been considered in earlier litigation. The prior decision had held that the Hyderabad Government was a State Government for the purpose of section 8 and that the loan was issued by that Government as a State Government security. The correspondence and surrounding circumstances also showed that the loan was advanced on the footing that the interest would be free from income-tax.

Conclusion: The loan was a State Government security, in favour of the assessee.

Issue (ii): Whether the interest on the loan was exempt from tax in the hands of the assessee under the third proviso to section 8.

Analysis: The earlier decision of the Supreme Court had already concluded that the interest on this very security retained its tax-free character and that the transfer to the trust did not destroy the exemption. The court also treated the contemporaneous correspondence as confirming that the loan was intended to remain free of income-tax, and rejected the attempt to confine the exemption only to the Hyderabad Income-tax Act.

Conclusion: The interest was exempt from tax in the hands of the assessee, in favour of the assessee.

Final Conclusion: The reference was answered for the assessee on both questions, and the departmental challenge to taxability failed.

Ratio Decidendi: Where a security was issued by a State Government on an express tax-free footing, the exemption attaches to the interest and is not lost by transfer of the security to a trust; a prior binding decision on the same security and exemption governs the subsequent reference.

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