Regulatory Gaps Enabling Tax Evasion in Legal Fee Structures: An Analysis of Indian Tax Law

~ by Ms. Shriya Maini, an Advocate-on-Record at the Supreme Court of India, practising at her father’s chambers (Advocate Rajive Maini). She is a designated Professor of Practice at Lloyd Law College, Noida.

A gold medalist from Gujarat National Law University and BCL (Oxford) graduate, she specialises in commercial litigation, regularly appearing in complex cross - border matters before the Supreme Court of India and High Courts.

She has been assisted by two interns at her chambers -- Ms. Natasha Mittal and Ms. Arsheya who are currently pursuing their legal studies.

Overview 

This article aims to explore the critical gaps within Income Tax Act, 1961, particularly within the Goods and Services Tax (GST) framework trying to demonstrate how provisions intended to simplify compliance often become avenues for evasion, particularly unreported cash receipts. Advocates must charge reasonable fees but currently fees are often arbitrary, opaque and grossly inflated due to the lack of transparency under Section – 44ADA, strict enforcement mechanisms to keep a check on the fees charged by advocates. Even if there does exist some framework to keep a check on the fees of advocates, there exists loophole or judicial relaxation under section 44ADA, 194J, 37, 68–69A, 115BBE which allows the advocate to evade tax. This article argues that structural gaps in India's Income Tax Act and GST framework combined with weak enforcement and judicial leniency enable systematic tax evasion within the legal profession.

Gaps in Taxation of Lawyers’ Fees under the Income Tax Act, 1961

Section 44ADA: The Evasion Gateway for High-Earners

Section 44ADA of the Income Tax Act, 1961 provides for a presumptive taxation scheme for professionals which was introduced by the Finance Act 2016 w.e.f 01-04-2017. Under this presumptive scheme, resident professionals whose gross receipts do not exceed fifty lakh rupees in a financial year qualify for special treatment. They pay tax on only 50% of their total receipts, as the law presumes this represents their actual profit. If for example, the assessee has earned higher sum than 50% then that higher sum is taxable. However, there was an Amendment by Finance Act, 2023 which added two provisos which raised the upper limit to 75 lakh rupees if the amount or aggregate received during the previous year in cash does not exceed five percent of the total gross receipts.

The definition of 'receipt in cash' is expanded by the second proviso to include payments received via a cheque or bank draft, provided the instrument is not an account payee instrument. The law encloses a loophole that allowed professionals to accept untraceable payments by treating bearer cheques and non-account payee instruments as cash and claiming they were legitimate banking transactions.

On declaration of the statutory 50% as presumptive income by a professional, all expenses of business like Sections 30 to 38 including depreciation are deemed to have been claimed and no detailed bookkeeping or audit is required. But there are three triggers for full accounting compliance: declaring net income below 50%, receipt exceeding the ₹75 lakh threshold or accepting more than 5% in cash (including non-account payee instruments). This sets up a paradoxical compliance regime. The scheme appears to reward simplicity, but the 5% cash threshold acts as a de facto enforcement mechanism and professionals need to actively monitor their payment methods or face the requirement of an audit.

Compounding on these problems, the provision allows Chapter VI-A deductions (investments under Section 80C, health insurance, etc.) over and above the 50% presumptive deduction, leading to a compounding tax benefit. When a lawyer receives ₹50 lakhs, they pay tax on only ₹25 lakhs (50% presumption), then further cut this down by ₹1.5-2 lakh in 80C deductions, so in effect they are taxed on barely 46% of actual receipts. This dual benefit of presumptive expenses + statutory deductions makes the scheme attractive not only for compliance reduction but for massive tax minimization, encouraging income suppression to stay under the eligibility limits. The main purpose rather the object of section 44ADA was to introduce a smaller more efficient method of taxation for small professionals reducing their compliance burden and encouraging easier tax filing. 

In Shri.Vinod Raghavenra Deshpande,Bagalkot v The Income Tax Officer, in this decision, the Tribunal firmly maintained that the applicability of Section 44ADA is threshold-based and absolute; the presumptive scheme was specifically declared inapplicable because the advocate's gross professional receipts, as found during a survey, exceeded the statutory limit of Rupees 50 Lakh. This demonstrates that the 50% presumptive rate cannot be legally used by a high-earning advocate whose actual receipts are significantly higher than the cap. However, the tribunal adopted a very lackadaisical  and practical approach rather than strictly enforcing the law. Rather than taxing the entire amount of unreported income discovered during the survey as 100% profit, the tribunal allowed a substantial expenditure deduction of 40% of the undisclosed professional income.

Section 194J of the Income Tax Act: Tax Deducted At Source. 

Under section 194J of the Income Tax Act, the tax is deducted at source by any person other than an Individual or HUF, paying the sum to a resident person. It mandates 10% TDS on professional fees exceeding rupees 30,000 per annum. However it does provide an exception, it says that an Individual or HUF will be liable to deduct tax under section 194J if their turnover or gross receipts exceed rupees 1 crore if it is a business and rupees 50 lakhs in case of a profession. This section acts like the government’s primary mechanism to create an audit trail for professional fees (including legal fees). However the liability is payer-centric, as it is their responsibility to deduct TDS and even though there is a provision mandating HUF and Individuals to deduct TDS it comes with exceptions. 

As mentioned earlier, an individual and HUF is mandated to deduct TDS only if their business turnover or gross receipts exceeds rupees 1 crore or rupees 50 lakhs for professionals. However, creating this exception gives the business owners and professionals enough space to evade tax by underreporting their income under the section 44ADA of the Income tax act. This exception given to individuals which includes lawyers removes the automatic cross-verification that the Income Tax Department relies upon under section 194J and provides space to high earning advocates to under-report their income.

Section 37: General Deductions on taxable income

Section 37 acts as a residuary deduction, it says that any deduction which is not in the nature described in sections 30-36 and not being in the nature of capital expenditure or personal expenses of the assessee will come under this section. However, the bare act wording is quite ambigious which is “any expenses Wholly and Exclusively for the purpose of business or profession” shall be allowed in computing the income chargeable under the head of “profit and gains of business or profession”.

This section gives impetus towards violating the condition of “wholly and exclusively”, professionals and in our case advocates claim personal expenses as professional deductions to reduce their taxable income. Most commonly what is done is that if an advocate is using a residence as their office, then they claim that the rent paid, electricity bill, maintenance will come under the ambit of wholly and exclusively. 

The court via various judicial precedents laid down tests to explain what comes under the ambit of “wholly and exclusively”, the burden of proof lies on the assessee to show that all 3 conditions laid under section 37(1) has been fulfilled. It is mandatory to provide documentary evidence to establish and show that there is a nexus between the expense and the profession. Further it is important to note that lawyers normally use methods like opaque billing to avail the protection given under section 37(1), specifically the phrase “wholly and exclusively”. Courts have established that the burden of proof lies with the assessee to demonstrate the business nexus through documentary evidence, yet this standard proves toothless when faced with deliberately obscure billing practices.

GST On Legal Services u/s 19(3) of Central Goods and Services Tax Act, 2017 

The main idea behind indirect taxation is that the tax is paid by the supplier of the goods and services. Under the GST Act, there are few exceptions where the recipient pays the tax; this is known as the Reverse Charge Mechanism (RCM).

The RCM mechanism for legal services under GST shifts the liability from service providers (advocates) to a business entity, it won't apply if the legal services are being provided to a non-business entity. Legal service provided by a senior advocate enjoys the same kind of GST exemption except there is one notable exception, though: a Senior Advocate's provision of legal services to another Advocate or a Partnership Firm of Advocates is not exempt. Rather, under the Forward Charge Mechanism (FCM), it is a taxable supply. This means that the Senior Advocate is an exception to the general RCM rule that is common in the legal sector because they must obtain GST registration (if their turnover exceeds the threshold) and collect the 18% GST from the recipient advocate/firm and remit it to the government. The notification relating to RCM on advocates was examined in the case of J.K.Mittal and Co. v Union of India by the Delhi High Court. In this case the court passed interim order saying that all legal services provided by advocates, law firms and LLP’s will come under the RCM mechanism. 

Supreme Court Rules On Charging Fees

Rule 20 of the Bar Council of India states “An Advocate shall not stipulate for a fee contingent on the results of litigation or agree to share the proceeds thereof”. This rule was laid down so that the Advocate does not charge arbitrary fees from the clients and is unfair to them. Its main objective is to ensure fairness and justice and so that the advocate acts objectively and in a detached manner as an officer of the court, if there is a financial interest in the result of the case it may create perverse incentives for lawyers. However this ethical prohibition is often not seen in practice. The advocates in India don't have to follow a specified fee structure, the lawyer holds the undisturbed right to demand fees as they please. This kind of opaque fee structure inevitably encourages tax evasion as a lot of advocates choose to use cash transactions as a way to get their fees. Section 68-69A of the Income Tax Act exists in order to tax unexplained cash, investment or money at an exorbitant rate, around 83% currently under section 115BBE.

A very common defence used by advocates when asked to prove the source or genuineness of such payments they tend to invoke client-attorney privilege. One might ask that the attorney-client privilege only protects confidential communications related to legal advice however the advocate when asked to provide the source of money denies to provide the client’s name, addresses and PANs stating that this comes under the ambit of attorney-client privilege. Even though the tax authorities have the right to investigate an advocate’s records overriding the attorney-client privilege, this power is very limited and subject to strict judicial safeguards. Such actions are permissible only if the authorities prima facie believe that the advocate is involved in an illegal activity. In the case of Puneet Batra v Union of India & Ors  the Delhi High Court ruled that searches and seizures at an advocate’s office require prima facie evidence of the advocate’s personal involvement, they cannot unnecessarily harass the advocate. This strict judicial protection makes it difficult to investigate and verify payments or invoices. 

Regulatory Recommendations

Mandatory written engagement letters for fees which exceeds a modest threshold, these letters need to include a mandatory fee disclosure with a clear breakdown of charges. This leaves an audit trail and leaves behind a clear document which can be used in a subsequent fee dispute or tax inquiry. There can be a digital payment trail for all fees above rupees 10,000 so that no payment remains unaccounted, it can be traced if there is a need for inquiry. Indicative fee slabs can be introduced based on the type of matter, court level and lawyer’s experience like the way it happens in Canada. This will provide a check on arbitrarily high fee charging while also ensuring consumer protection. Hence, there can be Reporting mechanism or Database which can be created which links Bar Council’s Advocate registration number to their PAN-based tax returns. This will close the gap of enforcement that the Income Tax department currently faces. 

Hence, Section 37(1) of the Income Tax Act, 1961 acts as a residuary provision which eventually permits deduction of business expenditures incurred wholly and solely for the purpose of carrying on a business or profession. There shall not be rigid or arbitrary subjugation by tax authorities but determined by standards like commercial expediency and business necessity. As highlighted in the aforementioned judicial precedents that an expenditure need not be compulsory or legally enforceable to qualify for deduction, provided it bears a direct nexus with the legitimate interests of the business. Hence, the current framework shall strive towards balancing tax avoidance with commercial realism and with the recognition of genuine business decisions.