I-T dept says Oil India cannot claim subsidy given to retailers as a deductible expense.

After sharing the losses of state-owned fuel oil retailers, upstream producers may also have to pay income tax on the burden they take on their books.

The income tax department, which is facing a drop in tax collections because of the economic slowdown, has issued a tax demand of Rs 750 crore (Rs 7.5 billion) to Oil India, India's second-largest oil producer after Oil & Natural Gas Corporation, for claiming deductions, said a senior government official.

Retail prices of diesel and petrol in the country are fixed by the government. As crude oil prices went up in the global market, state-owned oil marketing companies - Indian Oil Corporation [Get Quote], BPCL [Get Quote] and HPCL [Get Quote] -- incurred huge losses (called under-recoveries) on their retail operations because they were not allowed to raise prices.

These losses were to be shared equally by these companies, the government and upstream oil producers Oil India and ONGC [Get Quote].

The under recoveries in 2007-08 were estimated at Rs 77,123 crore (Rs 771.23 billion), and oil producers had to cough out Rs 25,708 crore (Rs 257.08 billion).

In 2008-09, the under recovery is expected to cross Rs 100,000 crore (Rs 1,000 billion).

Oil India, officials of the income tax department said, had shown the subsidy given to the oil retailers as an expenditure and has claimed deduction while paying income tax.

The department has contended that the subsidy is in the nature of 'trade discounts' given to oil marketing companies and is 'application of income', which results only in a reduction in income and is not a deductible business expenditure.

By showing subsidy provided to its customers as expenditure, Oil India was able to reduce to its tax liabilities. The Rs 750 crore (Rs 7.5 billion) tax demand for assessment year 2007-08 also includes the I-T department disallowing Oil India from treating each oil well within a single block as a separate company to claim seven-year tax holidays.

"We have disputed the order and we will move to CIT (Appeal) by March first week," said an Oil India executive.

The demand could open a whole new can of worms for Oil India as well as ONGC. "The case has implication on other oil producing companies and a new area, which is evolving as a potential source of tax for the department" said a direct tax expert.

Official sources said Oil India has tried to argue that the licence fee paid by Mahanagar Telephone Nigam Ltd [Get Quote] to the department of telecommunications is allowed as deductible expenditure. Similarly, it should be allowed to show the subsidy to downstream retailers as a deductible expenditure.

On its turn, the department has countered that the licence fee paid by MTNL is a statutory liability under the Telegraph Act, whereas no such statutory liability is there for the oil producer.