Supreme Court Clarifies Section 36(1)(viii): ‘Derived From’ Means First-Degree Nexus, Rejects NCDC’s Deduction Claim
Apex Court Narrows Scope of Tax Incentives for Financial Institutions
Ruling Reinforces Strict Interpretation of Income-Tax Act Provisions
By Our Legal Reporter
New Delhi: December 12, 2025:
In a landmark judgment, the Supreme Court of India has ruled that the phrase “derived from” under Section 36(1)(viii) of the Income-tax Act, 1961 requires a first-degree nexus with long-term finance activities. The Court rejected the claim of the National Cooperative Development Corporation (NCDC) for deduction on income streams such as dividends, interest from deposits, and service charges, holding that these do not qualify as profits derived directly from long-term finance.
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This decision, delivered in December 2025, is expected to reshape tax planning strategies for statutory corporations and financial institutions, reinforcing the principle that incentive provisions must be interpreted strictly.
Background of Section 36(1)(viii)
Section 36(1)(viii) was introduced to encourage statutory corporations and financial institutions to provide long-term finance for industrial, agricultural, and infrastructure development. It allows a 40% deduction of profits derived from long-term finance, defined as loans repayable over a period of not less than five years.
Over time, institutions began claiming deductions on other forms of income, such as:
- Interest from bank deposits
- Dividend income from investments
- Service charges and miscellaneous receipts
They argued that these were incidental to their financing activities and therefore eligible for deduction.
Supreme Court’s Observations
The Court, while dismissing NCDC’s appeal, made the following key points:
- “Derived from” requires a direct, first-degree connection. Only income that flows directly from long-term finance qualifies.
- Dividend income is a return on share capital, not lending activity.
- Interest from deposits is not linked to long-term finance. It arises from treasury management, not lending.
- Service charges and other incidental receipts lack the required nexus.
- Section 36(1)(viii) is a specific incentive provision, not a blanket exemption for all income earned by financial corporations.
The Court emphasised that extending deductions to unrelated income streams would distort legislative intent and dilute the purpose of incentivising long-term lending.
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Legal Context and Precedents
The ruling builds on earlier judicial interpretations:
- HDFC Ltd. v. CIT: Clarified that deduction under Section 36(1)(viii) applies only to income directly linked to long-term finance.
- National Cooperative Development Corporation case (2025): Held that interest from bank deposits is not eligible for deduction.
- Bombay High Court in Kanak Impex: Reiterated that incidental income cannot be treated as derived from core financing activities.
By aligning with these precedents, the Supreme Court reinforced a strict interpretation of Section 36(1)(viii).
Implications of the Judgment
For Financial Institutions
- Corporations like NABARD, NCDC, and other development finance institutions must now segregate dividend, deposit interest, and service income from profits derived from long-term finance.
- These income streams will be fully taxable, increasing effective tax liability.
- Institutions must restructure tax planning strategies to avoid litigation.
For Tax Authorities
- The ruling strengthens the Revenue’s position in disallowing deductions claimed on incidental income.
- It reduces scope for disputes by clarifying the boundaries of Section 36(1)(viii).
For Businesses
- Financial institutions must maintain clear documentation to prove that income is derived from long-term finance.
- Tax planning strategies relying on broad interpretations of “derived from” will need to be revised.
Expert Views
Tax experts welcomed the ruling, noting that it restores the original purpose of Section 36(1)(viii). According to practitioners:
- The judgment ensures that the benefit of deduction is preserved for genuine long-term financing activities.
- It prevents misuse of incentive provisions by extending them to unrelated income streams.
- While corporations may face higher tax liabilities, the ruling enhances clarity and reduces litigation.
Broader Impact on Tax Administration
The ruling highlights systemic issues in tax compliance:
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- Over-claiming deductions: Institutions often interpret incentive provisions broadly to reduce tax liability.
- Need for strict interpretation: Courts have consistently emphasised that tax incentives must be construed narrowly.
- Policy clarity: The government may issue clarifications or amend rules to align with judicial directions.
Global Context
Globally, tax administrations also restrict deductions to income directly linked to incentivised activities:
- United States: Tax incentives for financial institutions apply only to specific lending activities.
- United Kingdom: Deductions are limited to income directly derived from targeted financing.
- Singapore: Tax benefits are restricted to core financing activities, not incidental income.
India’s ruling aligns with international best practices, emphasising that “derived from” means direct nexus, not incidental connection.
Conclusion
The Supreme Court’s ruling that “derived from” under Section 36(1)(viii) requires a first-degree nexus with long-term finance marks a significant clarification in tax law. By rejecting NCDC’s claim for deduction on dividend, deposit interest, and service charges, the Court has reinforced the principle that only income directly derived from lending qualifies for tax incentives.
This decision impacts statutory corporations, financial institutions, and businesses relying on such deductions, while strengthening the Revenue’s ability to curb misuse. Going forward, institutions must carefully structure their income streams and ensure compliance with the strict interpretation of Section 36(1)(viii).
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