Case Law Details
Tax authorities can determine true character of a transaction. Further, the tax authorities should evaluate a transaction from the point of view of prudent businessman
Recently, the High Court of Punjab and Haryana (the High Court) in the case of CIT Vs. Rock man Cycle Industries Private Limited [201 1-TIOL-88-HC-P&H-IT-LB] held that if the taxpayers used certain devices to conceal true nature of the transaction, it was the duty of the taxing authority to unravel the device and determine its true character.
Further, the tax authorities should look at the matter from the point of view of prudent businessman.
However, the High Court held that the legal effect of the transaction cannot be displaced by probing into the substance of the transaction.
Facts of the case
• The taxpayer borrowed money from a sister concern and paid interest therein @ 18 percent per annum. The sums borrowed were invested in preference shares of another sister concern which carried dividend @ 4 percent.
• The Assessing Officer (AO) held that there was no justification to borrow funds at the rate of 18 percent interest for making investment in shares, which would give a fixed dividend of 4 percent. Accordingly, the AO disallowed the interest expenditure beyond 4 percent.
• The AO held that the taxpayer’s conduct of paying higher interest to the sister concern of the same group by taking a loan for the purchase of preference shares with a fixed low yield was a colourable device to reduce the tax liability. Such device is not permissible in view of the Supreme Court’s decision in the case of McDowell and Company Limited v. Commercial Tax Officer, [1985] 154 ITR 148 (SC).
• The division bench of the High court referred the matter to a larger bench.
Issue before the High Court
Where a transaction taxes place which is patently imprudent, the taxing authority should examine the question of business expediency and not go merely by the fact that the taxpayer had taken a decision in its wisdom?
Taxpayer’s contentions
• Reference was made to the finding recorded by the Income-tax Appellate Tribunal (the Tribunal) that the transactions entered into by the taxpayer with its sister concern were bonafide. This finding of the Tribunal has not been challenged by the tax department and hence, the issue of business expediency is not required to be gone into.
• Cost incurred could not be disallowed merely on the fact that in a particular assessment year when the expense was incurred there was no profit earned.
• The tax department has no authority to question the prudence of a businessman since he is the best judge for running his business.
• Investment made in a venture may or may not result in profit immediately, but the investments were made from long term prospects.
• The manner in which the transaction has been entered into by the taxpayer can be termed as tax planning and not tax evasion. Placing reliance on the Supreme Court’s decision in the cases of McDowell and Union of India v.Azadi Bachao Andolan, [2003] 263 ITR 706 (SC), the taxpayer contended that tax planning is permissible.
• The Supreme Court in the case of SA Builders Limited v. CIT [2007] 288 ITR 1 (SC) held that the expression ‘commercial expediency’ is an expression of wide import and includes such expenditure which a prudent businessman incurs for the purpose of business. Accordingly, expenditure incurred on the grounds of commercial expediency is allowable.
Tax department’s contentions
• There was no justification to borrow funds carrying interest @ 18 percent per annum for the purpose of making investment in shares which would have given dividend of only 4 percent p.a. Therefore, expenditure incurred by the taxpayer in raising loans for the purpose of investment in shares was not for the purpose of business and accordingly, expenditure to that extent was disallowed.
• In terms of the provisions of Section 57(iii) of the Income-tax Act, 1961 (the Act) only that expenditure can be allowed, which was made to earn income. In the present case, expenditure on interest made by the taxpayer was not for the purpose of earning income since it was known that the investment would result in income less than the expenditure being made to earn it.
• In the present case, the actions of the taxpayer are not that of a reasonable person and therefore imprudent.
High Court’s ruling
• Reliance was placed on the Supreme Court decision in the case of Commissioner of Income Tax v. Rajendra Prasad Moody [1978] 115 ITR 519 (SC)wherein it was held that as the language of Section 57(iii) does not provide that expenditure shall be deductible only if any income is made or earned.
• However, the High Court relying on the Allahabad High Court’s decision in the case of Commissioner of Income Tax v. Smt. Swapna Roy [2010] 233 CTR 10 (All) held that if the dominant purpose for making an investment was not to earn income, deduction under Section 57 of the Act may not be available.
• The High Court relying on the Supreme Court decision in the case of CIT v. B. M. Kharwar, [1969] 72 ITR 603 (SC) held that the taxing authority is entitled and is indeed bound to determine the true legal relation resulting from a transaction. If the parties have chosen to conceal the legal relation by a device, it is open to the taxing authorities to unravel the device and to determine the true character of the relationship.
• The High Court further relied on the Supreme Court’s decision in the case of SA Builders Limited wherein it was held that the tax authorities must not look at the matter from their own view point but that of a prudent businessman.
• The High Court however held that the legal effect of the transaction cannot be displaced by probing into the ‘substance of the transaction’. The High Court also cautioned that the exercise of jurisdiction cannot be stretched to hold a roving inquiry or deep probe.
• Accordingly, the Larger Bench directed the Division Bench to provide a decision on merits.
Our Comments
This is a very important ruling by the Punjab & Haryana High Court wherein it has reiterated several important principles laid down by various courts.
The High Court held that the AO or the appellate authorities and even the courts can determine the true legal relation resulting from a transaction. If some device has been used by the taxpayer to conceal true nature of the transaction, it is the duty of the taxing authority to unravel the device and determine its true character.
However, the High Court has clearly cautioned that the legal effect of the transaction cannot be displaced by probing into the substance of the transaction. Further, the High Court also opined that each case will depend on its own facts.
It is pertinent to note that the larger bench on the high court has referred the matter back to the Division Bench to provide a decision on merits based on the principles laid down.
In the given situation the A.O. should apply one more test what is the net profit percentage of the business carried on by the assessee. If it is more than 4% say 10%then A.O. can take the view that it is a colourable device.However if it is say 3% or loss then it could be considered as colourable device. From the assessee’s point of view investment in preference shares is not just for earning dividend income for a particular assessement year only. There can be some other commercial purpose say possibility of making inroads in the company. Secondly the department should not ignore the fact that the interest earned by the sister concern would be charged to tax it is not tax free. If it is colourable device the assessee would have opted for rate of interest less than 18 %.