Case Law Details

Case Name : State Bank of Mauritius Ltd. Vs Deputy Director of Income-tax, (International Taxation) - 2(1) (ITAT Mumbai)
Appeal Number : IT Appeal No. 2254 & 3005 (MUM.) OF 2005
Date of Judgement/Order : 03/10/2012
Related Assessment Year : 1999-2000
Courts : All ITAT (4534) ITAT Mumbai (1485)

IN THE ITAT MUMBAI BENCH ‘L’

State Bank of Mauritius Ltd.

versus

Deputy Director of Income-tax, (International Taxation) – 2(1)

IT APPEAL NOS. 2254 & 3005 (MUM.) OF 2005

[ASSESSMENT YEAR 1999-2000]

OCTOBER 3, 2012

ORDER

R.S. Syal, Accountant Member 

These two cross appeals – one by the assessee and the other by the Revenue – arise out of the order passed by the Commissioner of Income-tax (Appeals) on 17.01.2005 in relation to the assessment year 1999-2000.

2. First ground of the assessee’s appeal is against the direction of the ld. CIT(A) to levy tax at the rate of 48% applicable to normal non-resident companies. At the very outset the learned Counsel for the assessee conceded that similar issue was there in assessee’s appeal for assessment year 1997-98 and the Tribunal was pleased to decide it against the assessee. In view of the fact that the circumstances and the legal position continue to remain same in the year under consideration, respectfully following the order passed by the Tribunal in ITA No.525/Mum/2001 for assessment year 1997-98, we uphold the impugned order on this issue. This ground is not allowed.

3. Ground no.2 is against the confirmation of disallowance of expenditure on purchase of fixed assets at Rs. 3,43,28,114. On this issue also the learned AR was fair enough to admit that the Tribunal decided similar issue against the assessee in its order for assessment year 1997-98. Respectfully following the precedent, we uphold the impugned order on this score. This ground is not allowed.

4.1 Ground no. 3 is against the sustenance of disallowance out of bonus expense. The facts apropos this ground are that the assessee claimed deduction of Rs. 66,500 as bonus. The Assessing Officer found that only a sum of Rs. 24,000 was paid before the due date of filing the return of income. As per the tax audit report in Form no.3CD, the auditor had reported that the remaining amount of Rs. 42,500 was not paid on or before the due date. Invoking the provisions of section 43B, the Assessing Officer made disallowance for Rs. 42,500. The learned CIT(A) upheld the disallowance. The assessee is aggrieved against the sustenance of this disallowance.

4.2 We have heard the rival submissions and perused the relevant material on record. There is no dispute about the fact that the assessee is a banking company incorporated in Mauritius. The fact that the assessee is entitled to the benefit of Double Taxation Avoidance Agreement between India and Mauritius (hereinafter called “the DTA”), is not in dispute. The authorities below have made and sustained the said disallowance by testing the facts of the case on the touchstone of prescription of section 43B and also the provisions of Article 7 of the DTA.

4.3 The claim of the Revenue is that the provisions of section 43B should be applied for the purpose of confirming disallowance amounting to Rs. 42,500. Any amount of bonus debited to the Profit and loss account which is not paid on or before the due date of filing of the return, is not deductible as per the provisions of section 43B. There is no quarrel on the fact that the assessee failed to pay the aforesaid amount on or before the due date of filing the return of income as per section 139(1) of the Act. Thus, when we compute the income of the assessee as per the provisions of the Act, no deduction can be allowed to this extent and the view canvassed by the authorities below becomes acceptable.

4.4 Section 90 deals with the rationale and consequences of Agreement with foreign countries or specified territories. Sub-section (1) provides that the Central Government may enter into an agreement with the Government of any country outside India or specified territory outside India, inter alia, for granting of relief in respect of income on which tax is payable both in India and the other country. Sub-section (2) of section 90 provides that where the Central Government has entered into an agreement with the Government of any country outside India or a specified territory outside India, as the case may be, under sub-section (1) for granting relief of tax, or as the case may be, avoidance of double taxation, then, in relation to the assessee to whom such agreement applies, the provisions of this Act shall apply to the extent they are more beneficial to that assessee. In other words, if a particular item of income is taxable under the Income-tax Act, 1961 (hereinafter called “the Act”), then it shall cease to be taxable in India if the DTA provides exemption in respect of such income. In the like manner, if any expenditure incurred by the assessee is not deductible as per the provisions of the Act, the same shall still be allowed as deduction if the DTA provides for such deduction. The crux of the matter is that the DTA overrides the regular provisions of the Act, in so far as it is more beneficial to the assessee. If the DTA provides for a more liberal mode of computation of income, then it is this mode of computation, which needs to be followed notwithstanding any contrary provision contained in the Act. However, if there is no specific provision in the DTA concerning a particular aspect, then it is the basic law, that is, the Act, which applies.

4.5 Having seen that the disallowance u/s 43B is called for in the determination of income under the Act, let us see the position under the DTA. The assessee is admittedly a tax resident of Mauritius. The authorities below have not disputed the entitlement of the assessee to avail the benefit, if any, available to it as per the terms of DTA. Rather, the ld. CIT(A) has considered the claim of the assessee as per the DTA and thereafter rejected it as having been not maintainable.

4.6 Article 7 of the DTA provides for the computation of ‘Business Profits’. It provides that the profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as are attributable to that permanent establishment. The assessee is admittedly having an Indian branch, which constitutes its permanent establishment as per Article5 of the DTA. As the issue rotates around the computation of business profits, let us have a look at the relevant paras of Article 7 of the DTA, as under : –

Article 7

BUSINESS PROFITS

“1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprises may be taxed in the other State but only so much of them as is attributable to that permanent establishment.

2. Subject to the provisions of paragraph 3 of this Article, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. Where the correct amount of profits attributable to a permanent establishment cannot be readily determined or the determination thereof presents exceptional difficulties, the profits attributable to the permanent establishment may be estimated on a reasonable basis.

3. In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the business of the permanent establishment including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.

4. No profits shall be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods or merchandise for the enterprise.

5 & 6** ** **”

4.7 A bare perusal of para 1 of Article 7 reveals that when the enterprise of one Contracting State (say, Mauritius) carries on business in the other Contracting State (say, India), the profits of the enterprise may be taxed in India but only so much of them as are attributable to the permanent establishment (hereinafter also called ‘the PE’), through which the Mauritius enterprise carries on business in India. Para 2 of Article 7 talks of attribution of profits to such PE by considering it as distinct and separate enterprise de hors the general enterprise for the limited purpose of the computation of business profits. The provisions of para 2 are “subject to the provisions of paragraph 3 of this Article”. When we turn to para 3 of Article 7, it transpires that in determining the profits of the permanent establishment, deduction is allowed for all expenses which are incurred for the purpose of the business of the permanent establishment including executive and general administrative expenses which are incurred in the State in which the permanent establishment is situated or elsewhere. The crux of para 3 of Article 7 of the DTA is that for the purposes of determining the profits of the permanent establishment in India, all the expenses incurred for the purpose of business of the permanent establishment are to be allowed as deduction. In other words, the deductibility of all the expenses for the purpose of computing the ‘business profits’ of the permanent establishment, has been sanctioned by para 3 of Article 7.

4.8 It was contended by the ld. AR that since there is no reference to any disallowance as per section 43B in para 3 of Article 7 of the DTA, there can be no question of making any disallowance by considering section 43B. On the other hand, the ld. DR argued that the application of section 43B is implicit in para 3 of Article 7 directly and also by virtue of the provisions of Article 3(2) and Article 23(1) of the DTA.

4.9 From para 3 of Article 7 as extracted above, it is apparent that the business profits imbibe the question of grant of deduction of all expenses which are incurred for the purpose of business of the permanent establishment. There is no restriction on the allowability of such expenses subject to the limitations of the taxation laws of the respective State. Thus it is discernible that the restrictions, if any, on the deductibility of expenses as per the domestic law are not enshrined in this part of the DTA.

4.10 At this juncture, it is relevant to note that there are several treaties containing the restrictive clause in so far as the deductibility of expenses is concerned. For example, Article 7(3) of Indo-US DTAA provides that the deduction of expenses is to be allowed in accordance with the provisions of and subject to the limitations of the taxation laws of that State. We can usefully refer to para 3 of Article 7 of Indo-US DTAA, as under :-

“In the determination of the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the business of the permanent establishment, including a reasonable allocation of executive and general administrative expenses, research and development expenses, interest, and other expenses incurred for the purposes of the enterprise as a whole (or the part thereof which includes the permanent establishment), whether incurred in the State in which the permanent establishment is situated or elsewhere, in accordance with the provisions of and subject to the limitations of the taxation laws of that State. ……”

(emphasis supplied by us)

4.11 Para 3 of Article 7 of Indo-US DTAA can be split into two parts, viz, the first part granting deduction for the expenses incurred for the purposes of the business of the permanent establishment and the second part, towards the end of the para, restricting such deduction ‘in accordance with the provisions of and subject to the limitations of the taxation laws’ (hereinafter referred to as ‘the restrictive clause’) of the State. On a careful reading of para 3 of Article 7 in entirety, it emerges that the deductibility of any expenditure has to necessarily pass the restrictive clause, if any, contained in the Act. Suppose there is any provision restricting the deductibility of any expenditure or such deduction has been made dependent on the satisfaction of any condition, then unless such condition is fulfilled, the deduction cannot be allowed and that too, to the extent as provided in such provision.

4.12 This position can be viewed from the stand point of section 44C of the Act. This section puts a ceiling on deduction of head office expenditure, as defined in clause (iv) of Explanation, in the case of non-residents. If any expenditure in the nature of “head office expenditure” is incurred and suppose there is a provision in the treaty that the deductibility of expenses as per Article 7(3) is subject to ‘the restrictive clause’ of the taxation laws of the concerned State, then such limit as provided u/s 44C to restrict the deduction to 5% of the adjusted total income, shall be presumed as bodily incorporated in the treaty also. In such a case, it will be understood as if section 44C is inbuilt in the treaty also for the purposes of limiting the deductibility of head office expenditure.

4.13 It is manifest that difference between the full or partial deductibility of any expenditure is due to the absence or presence of the restrictive clause in the treaty. But for such restrictive clause, any expenditure incurred by the assessee for the purposes of the business of the permanent establishment becomes deductible in full as per the first part of para 3 of Article 7. It is only due to the occurrence of such restrictive clause that the otherwise full allowability of deduction as per earlier part of the para 3 of Article 7, gets restricted to the extent of deductibility as per the provisions of the Act. The nutshell is that if there is no restrictive clause in the treaty, then the expenditure incurred for the purposes of the business of permanent establishment has to be allowed in full. If, however, there is a restrictive clause in the treaty, then the otherwise full deductibility gets reduced in accordance with the provision of the Act.

4.14 It is pertinent to note that we are dealing with the Indo- Mauritius DTA. As can be seen from the phraseology of para 3 of Article 7 of the DTA, reproduced above, that there is no restrictive clause therein. It indicates that both the countries have decided to allow expenses incurred for the purpose of business of the permanent establishment in full, without any limit as may be set out in sections of the Act. So long as an expense is incurred for the purpose of the business of the permanent establishment, the same has to be allowed as deduction in full as per the prescription of Article 7(3). The absence of the restrictive clause in para 3 of Article 7 makes it abundantly clear that any expenditure incurred for the purpose of business of the permanent establishment deserves to be allowed as deduction in entirety. As we are presently computing the business profits of the assessee from the operations carried out in India through its permanent establishment, all the expenses so incurred including the bonus qualify for deduction in entirety. It is noticed that but for section 43B, the entire amount of bonus would have been allowed as deduction. Section 43B has placed a limit on the otherwise full deductibility of bonus expenditure to the amount actually paid on or before the due date of filing the return. Prior to the insertion of section 43B, the entire amount of bonus was allowed as deduction under the mercantile system of accounting on the principle of incurring liability in respect of such bonus irrespective of its payment. It is not the case of the Department that the assessee did not incur liability in respect of such bonus expenditure. The assessee has incurred this expenditure and it is only the payment part which is delayed for the time being. The otherwise incurring of such expenditure and the consequent allowability of deduction is not in dispute. As we are dealing with the Indo-Mauritius DTA, which does not expressly contain any restrictive clause in this regard, contrary to the presence of such clause in certain Conventions including Indo-US DTAA, it becomes perceptible that ex facie restrictive provisions of the Act including section 43B cannot be read into Article 7.

4.15 Now we will espouse the contention of the learned DR that the presence of section 43B of the Act should be inferred by virtue of the Article 3(2) and Article 23(1) of the DTA. It is observed that Article 3 is a definition Article which incorporates definitions of various terms used in the DTA. Para 1 of Article 3 deals with certain specific terms which have been expressly defined for the purpose of DTA. Para 2 of Article 3 provides that : “In the application of the provisions of this Convention by the Contracting State, any term not defined therein shall, unless the context otherwise requires, have the meaning which it has under the laws in force of that Contracting State relating to the areas which are the subject of this Convention”. A cursory look at para 2 of Article 3 in juxtaposition to para 1 of the same Article divulges that the terms which have been defined in para 1 of Article 3 of the DTA shall have the meaning which has been specifically given and any other term, which has not been specifically defined in para 1 shall, unless the context otherwise refers, will have the same meaning as is there under the domestic law. It is trite that a definition provision is ordinarily different from a substantive or machinery provision. Whereas, Article 3 is only a definition clause, para 1 of Article 7 is a substantive clause and para 3 of Article 7 is a machinery clause. We are unable to appreciate as to how Article 3(2) helps the Revenue in importing the mandate of section 43B in Article 7(3). Section 43B is a section providing that the deduction in respect of expenses, mentioned in clauses (a) to (f), shall be allowed only in computing the income referred to section 28 of the previous year in which such sum is actually paid or is paid before the due date of filing return as per section 139(1) of the Act. It is palpable that this section does not define any term, the meaning of which, in the absence of any specific provision in para 1 of Article 3, can be lifted in the DTA through Article 3(2). Clearly the disallowance of bonus as per section 43B, cannot be characterized as “any term not defined” as per Article 3(2). In our considered opinion the contention raised on behalf of the Revenue that section 43B should be read into Article 7 by means of Article 3(2), deserves the fate of rejection.

4.16 The learned Departmental Representative then focused his attention on para 1 of Article 23 to bolster his submission that the restriction u/s 43B should be read in to Article 7(3). Para 1 of Article 23 provides that : “The laws in force in either of the Contracting States shall continue to govern the taxation of income in the respective Contracting States except where provisions to the contrary are made in this Convention”. The first part of para 1 of Article 23 makes out a general rule that if income of the permanent establishment is to be computed in India, then the provisions of the Act shall govern the taxation of income in India. However, the second part of para 1 of Article 23 contains a rider, which makes the operation of the first part of para 1 of Article 23 subject to the fulfillment of such stipulation. The word “except” is the dividing point between the main provision and the qualification part. The portion starting thereafter enumerates the qualification, which is : ‘where provisions to the contrary are made in this Convention.’ When we read full text of para 1 of Article 23, it is amply borne out that if there is some provision in the DTA contrary to the domestic law, then it is the provision of the DTA which shall prevail. Thus the general rule contained in the first part of para 1 of Article 23, being the applicability of the domestic law, has been eclipsed by any provision to the contrary in the DTA. In case there is no contrary provision in the treaty, then it is the domestic law which shall apply. If however, there is some provision in the DTA contrary to the domestic law then it is such contrary provision of the DTA which shall override the provision in the domestic law in the computation of income as per the DTA.

4.17 With this understanding we will proceed to vet the contention raised by the learned Departmental Representative that since there is a precise provision of section 43B under the Act, which limits the deductibility of the specified expenses, this provision will apply because there is no such contrary provision in the DTA.

4.18 In order to appreciate this contention of the ld. DR in right perspective, it is of paramount importance to note the scheme of Article 7. First para, in so far as we are concerned, provides for taxing the income of the PE of a foreign bank having branch in India, which constitutes its PE. Second para mandates the attribution of profits to the Indian PE by considering such Indian branch as independent of its General enterprise. It means that for the purposes of determining the profit attributable to PE, all its transactions even with the Head Office or its other branches are to be considered as done with outsiders unless otherwise expressly provided. Para 3 of Article 7 provides for the deductibility of expenses incurred for the purpose of business of permanent establishment. Thus the mandate of Article 7(3) is to allow deduction for expenses. It does not exclusively deal with non-deductibility of expenses independent of any separate provision dealing with the allowability of expenses. Consequently it follows that para 3 of Article 7 is basically an enabling provision for granting deduction of expenses and not a disabling provision for restricting the otherwise allowable deductions. Thus para 3 of Article 7 is a specific provision governing the deductibility of expenses as per the DTA.

4.19 Section 29 of the Act provides that the income referred to in section 28 shall be computed in accordance with the provisions contained in sections 30 to 43D. There are various sections under Chapter IV-D which grant deductions for expenses and allowances, such as sections 30, 31, 32 and 36. In the like manner, there are certain sections, which restrict the otherwise allowability of deductions, such as sections 40, 43B, 44C. Thus, while computing income under the head ‘Profits and gains of business or profession’, what is required to be done is to allow deduction for expenses under the relevant sections only to the extent it is not barred by the operation of the later sections such as 30, 43B and 44C. Resultantly, section 43B needs to be read in conjunction with the other relevant sections providing for the deduction of expenses as enumerated in clauses (a) to (f) of section 43B. For example, section 36(1)(iii) provides deduction of interest on capital borrowed for the purpose of business. Section 43B(d) provides a restriction on the otherwise deductibility of interest u/s 36(1)(iii), if such interest is on any loan or borrowing made from the public financial institutions etc. and such interest is not paid before the due date applicable for filing the return of income u/s 139(1). When we read both these provisions in unison what follows is that it is the question of allowing deduction for interest on borrowings but to the extent it is paid before the due date of filing the return of income. Reverting to our issue, it is found that the deductions of expenses are to be regulated as per the restrictions contained in relevant sections. Thus, if one has to view these sections on a wholesome basis at macro level, what emerges is that these are meant for granting deduction for expenses to the permissible extent.

4.20 The natural corollary which follows from the above discussion is that the Act envisages deductions for expenses with some restrictions. On the other hand, para 3 of Article 7 the DTA is a specific provision governing the deductibility of expenses without any restriction. In both the cases, that is, under the Act as well as the DTA, the subject matter under consideration is same, being, the granting of deductions in the computation of business profits of the permanent establishment of a foreign enterprise. When there is a specific provision as per Article 7(3) of the DTA providing for the deductibility of all expenses incurred for the purpose of permanent establishment, we fail to comprehend as to how Article 23(1) can be applied to invoke disallowance u/s 43B. This contention of the ld. DR, being devoid of any merit, is thus jettisoned.

4.21 We can support our above conclusion from one more angle. If, for a moment, we accept the contention of the ld. DR that Article 23(1) is an authority for importing the provisions containing disallowances under the Act, in the DTA, then absurd results will follow. We have noticed supra that many treaties including Indo-US DTAA contain a restrictive clause in para 3 of Article 7 to limit the deductibility of expenses in accordance with and subject to the provisions of tax laws of that State. It is only in such cases that the restrictions provided on the deductibility of expenses as per the provisions of the domestic law, apply even while computing the business profits as per the DTA. In the otherwise situation, that is, in the case of a treaty not containing such restrictive clause, the deductibility of expenses is governed by the first part of para 3 of Article 7, which sanctions the grant of deduction of expenses to the full extent in so far as these are incurred for the purposes of the business of the PE. The acceptance of this contention of the ld. DR will obliterate the difference in the language of treaties containing and not containing such restrictive clause, thereby rendering the restrictive clause in para 3 of Article 7 in some of the treaties, as redundant. Obviously, it can not be the case. As such, we turn down the contention of the learned Departmental Representative that para 1 of Article 23 impliedly sanctions the invoking of section 43B, as in our considered opinion there is an express contrary provision in Article 7(3) providing for deduction of all expenses incurred for the purpose of business of permanent establishment. Before disassociating with this issue, we consider it our duty to record that both the sides have relied on tribunal orders supporting their respective stands. In fact, these orders, do fortify the viewpoint of the rival parties. We have desisted from dealing with such contradictory orders but decided the extant issue on what we perceive as the simple and plain interpretation of the relevant Articles.

4.22 In view of the foregoing discussion, we hold that no disallowance u/s 43B can be made in respect of the bonus unpaid before the due date of filing of return u/s 139(1) because Article 7(3) expressly provides for the deduction of all expenses incurred for the purpose of the business of permanent establishment. Further Article 3(2) and Article 23(1) do not impliedly sanction the invoking of section 43B in Article 7(3) of the DTA. Ex consequenti, the ground raised by the assessee in this regard is allowed.

5.1 The only ground in the Revenue’s appeal is against the deletion of disallowance u/s 14A. Factual matrix of this ground is that the assessee invested Rs. 10 crore in tax free bonds and claimed exemption in respect of interest from the same. From the copy of bank account with the Reserve Bank of India, it was observed by the AO that the assessee borrowed funds to the tune of Rs. 15 crore on 12.11.1998 and made investment in tax free bonds from such borrowed amount. As the assessee had not offered any disallowance in respect of such exempt income, the AO called upon it to explain as to why disallowance u/s 14A be not made towards proportionate interest expenditure. The assessee replied that there were daily borrowings/deposits from/to other banks to maintain the necessary cash reserves with the RBI and hence the payment for investment in tax free bonds was not liable be co-related with the borrowings from the RBI. It was also stated that the funds borrowed on 12.11.1998 were utilized for making investment in tax free bonds on the same date but were repaid on the next day i.e. 13.11.1998. Without prejudice to its main claim of no disallowance u/s 14A, the assessee stated that if any interest was to be disallowed, the same should be restricted to one day alone. Not convinced with the assessee’s submissions, the Assessing Officer made disallowance u/s 14A to the tune of Rs. 34,76,712 by applying rate of 9% as interest on the borrowed funds to the extent of investment in tax free bonds. The assessee filed before the learned CIT(A), its funds flow statement as at the year end, to demonstrate that it had sufficient interest free funds available with it and hence no disallowance of interest was called for. The ld. CIT(A) concurred with the submissions advanced on behalf of the assessee and deleted the disallowance made by the A.O. u/s 14A.

5.2 We have heard the rival submissions and perused the relevant material on record. It is not disputed that the assessee invested Rs. 10 crore in tax free bonds from the borrowing made by it from the RBI on 12.11.1998. It is equally not disputed that the assessee has paid interest on such borrowings made from the RBI. In such circumstances, the question arises as to whether any disallowance of interest can be made when there is a direct nexus between the borrowed funds and investment in tax free bonds.

5.3 The learned AR vehemently argued that the decision of the learned CIT(A) in deleting the disallowance u/s 14A should be upheld for the reason that Article 7(3) does not provide for limiting the deductibility of expenses as per the provisions of the Act. In that view of the matter, it was contended that the provisions of section 14A also limiting the deductibility of expenses, cannot be applied.

5.4 It is clear from the language of section 14A that it provides for disallowance of expenses incurred by the assessee in relation to income which does not form part of the total income under the Act. Obviously, if investment is made in tax free securities, interest thereon will be exempt from tax. The provisions of section 14A will squarely apply to make disallowance in respect of expenses incurred in relation to such exempt income as has been held by the Hon’ble jurisdictional High Court in the case of Godrej & Boyce Mfg. Co. Ltd. v. DCIT [2010] 328 ITR 81 (Bom)]. This is the position under the Act.

5.5 The learned AR has made out a case for no disallowance u/s 14A in the light of the Aricle 7(3) of the DTA. We have noticed above that section 90(2) of the Act provides that where a DTA has been signed for granting relief of tax then “in relation to the assessee to whom such agreement applies, the provisions of this Act shall apply to the extent they are more beneficial to that assessee”. In other words, if the Act charges a particular item of income to tax and the DTAA provides exemption to such item of income, it is the DTAA which shall prevail. To put it in simple words, the DTAA can provide relief only if the Act favours taxability of an item of income or disfavours the deductibility of any expenditure. Unless an item of income is taxable under the Act, there can be no question of pressing into service the provisions of the DTAA because the DTAA can intervene only for providing relief. It cannot be the other way. If an item of income is exempt under the provisions of the Act, the DTAA cannot expose it to tax. Operation of the DTAA ceases if an item of income is otherwise exempt under the provisions of the Act. It is self evident that when an item of income is not chargeable under the Act that cannot become the subject matter of consideration under the DTAA as well. Only such items of income can come within the purview of the DTAA which are otherwise chargeable to tax as per the Act.

5.6 It is axiomatic that if an item of income is exempt and gets excluded at the very outset from entering into computation of total income, any expenditure incurred in relation to such income shall also meet with the same fate. Such expense will also not come within the ambit of consideration zone as to its deductibility or otherwise. Business expenses go hand in hand with the business income as legal spouse. Both are to be viewed together and not divorced from each other. Business income can be determined after deducting business expenses. If we compartmentalize business income and expenses into taxable and exempt parts, it is but natural that only that much of the business expenditure can be allowed as deduction from the taxable income as has been incurred in relation to such taxable income. Business expenditure incurred for earning the exempt business income shall call for deduction only against the exempt business income. It is quite elementary that, unless expressly provided otherwise, exemption is always in respect of income and not the gross receipt. It is the excess of gross receipt over the expenditure for earning such income, which qualifies for exemption. The crux is that if any business income is exempt from taxation under the Act, the expenditure incurred in relation to such income shall also stand qualify for reduction against the exempt income and not any taxable income. Neither such exempt income nor any expenditure incurred in relation to such exempt income shall enter into the computation of taxable income.

5.7 We have noticed above that a DTAA can only cure the rigor of the Act and not convert an exempt income under the Act into a taxable one. If a particular amount of income is exempt under the Act, it will cease to form part of ‘Business profits’ of the enterprise under Article 7. Once a particular item of income does not itself constitute business profit as per Article 7 because of its exemption under the Act, there can be no question of allowing any deduction for an expenditure incurred in relation to such income against the other taxable business income. To put it in simple words, when the exempt income does not enter into the process of determination of ‘business profits’ of the permanent establishment, the expenses incurred for earning such income also do not equally qualify for deduction. If such expenses have been included in the total business expenses claimed as deduction under Article 7(3), then these are required to be reduced accordingly, as incurred in relation to the income which does not form part of the ‘business profits’.

5.8 The ld. AR projected his stand point by contending that it is because of the language of Article 7(3) of the DTA not containing any restrictive clause, that no disallowance can be made u/s 14A as is the case in respect of disallowances under sections 43B and 44C of the Act. In a way, he tried to drive home analogy from section 43B for putting section 14A on the same platform.

5.9 It is important to highlight the fundamental distinction between disallowance under section 14A on one hand and other sections providing for disallowances, such as section 37, 40, 43B and 44C on the other. Certain sub-sections of section 37, prior to their omission, provided for disallowance of expenses to some extent. For example, the limit on the allowability of entertainment expenses was provided in sub-section (2) of section 37. Section 40(a)(i)provides for disallowance of any expenditure on which tax is deductible but the assessee failed to deduct or deposit such tax after deduction. Section 43B provides for disallowance of certain expenses which are deductible on payment basis only. Section 44C refers to restricting the deduction of head office expenses to 5% of the adjusted total income. There are certain disallowances set out in section 40, like payment of income tax etc., which by their very nature, are not expense. Thus it can be noticed that a common thread permeating through all such sections is that disallowance has been provided in respect of expenses which are otherwise deductible. It is because of such limit or breach of stipulation that the otherwise deductible expense becomes non-deductible or deductible at a lower level. We find that position is quite different in so far as section 14A is concerned. This section contains a fundamental principle that any expenditure incurred in relation to an income not includible in total income, shall not be allowed as deduction. This section, at the very threshold itself, snatches away the deductibility of expenses incurred in relation to an exempt income. It is not a case that the expenses are otherwise deductible but have become non-deductible due to the operation of section 14A. Rather, the expenses do not qualify for deduction at the very first instance. This position u/s 14A is in sharp contrast to other sections as discussed above, such as 37, 40, 43, and 44C. Whereas these later sections apply to take away the deduction of expenses, which are otherwise allowable and have entered into the basket of deductible expenses , section 14A restricts the entry of certain expenses into the basket of deductible expenses. This is the underlying distinction between section 14A and the other set of sections providing for disallowance. Further, it is relevant to note the place of residence of section 14A. Unlike the sections providing for disallowances as discussed above falling in Chapter IV-D dealing with the income from business or profession, section 14A has been placed in Chapter IV itself, next to section 14, which classifies income under different heads of income. Because of this basic principle of not allowing deduction of any expense incurred in relation to an exempt income enshrined in section 14A, the distinction between disallowance under this section and other specific sections as discussed above, assumes significance. It is thus patent that the set of specific sections of disallowances stand on a different pedestal from section 14A.

5.10 At this stage, it may be relevant to note para 4 of Article 7 as per which : ‘No profits shall be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods or merchandise for the enterprise.’ As per this para, no profits can be attributed to a PE in respect of purchase of goods for the general enterprise. The pertinent question which arises is that when no profits can be attributed to the PE in respect of such purchases, is it permissible to include expenses in relation to such purchase in the total expenses of the PE for claiming deduction in determination of its business profits? The answer is obviously in negative. The reason for such negative answer is that when no income in respect of such purchases can be included in the ‘business profits’ of the PE, then naturally, no expenses in relation to such purchases can be allowed as deduction in computing the business profits of the PE. The same logic applies for not allowing deduction for any expenses in relation to an income, which does not constitute part of the ‘business profits’.

5.11 In view of the above discussion, we are of the considered opinion that the contention of the learned AR about no disallowance of expenses in relation to exempt income is liable to be rejected because when the exempt income itself does not form part of the ‘business profits’ of the assessee, there can be no scope for allowing deduction of expenses incurred in relation to such income. We order accordingly. As the interest income from tax free bonds per se is not includible in the ‘business profits’ of the permanent establishment and further the assessee has also claimed exemption in that regard which has been rightly granted as well, the expenses incurred in relation to such interest income cannot equally be allowed as deduction.

5.12 The next point urged by the learned AR was that tax free securities were held by the assessee as stock-in-trade and hence the provisions of section 14A cannot apply to disallow any expenditure notwithstanding the fact that the interest income is exempt. We find that similar contention was raised before the Mumbai Bench of the Tribunal in the case of JCIT v. American Express Bank Limited in ITA No. 5904/Mum/2000 for the A.Y. 1997-98. In that case the assessee relied on the judgment of the Hon’ble Kerala High Court in the case of CIT v. Smt. Leena Ramachandran [[2011] 339 ITR 296 (Ker.)] for raising a proposition that no disallowance can be made u/s 14A because the securities were held as investment. The Mumbai Bench considered this issue at length in the light of the judgment of the Hon’ble jurisdictional High Court in the case of Godrej & Boyce Mfg. Co. Ltd. v. DCIT [[2010] 328 ITR 81 (Bom)]. Vide its order dated August, 2012, the tribunal has held in that case that disallowance u/s 14A is warranted as the operation of section 14A does not ceases where the dividend income is only incidental to the shares held as stock in trade. Respectfully following the ratio decidendi of this precedent de hors specific reference to section 14A, we hold that the expenses incurred in relation to the income which does not form part of ‘business profits’ cannot be allowed as deduction. This contention of the learned AR is also rejected.

5.13 It is worthwhile to note that the AO made a reference to section 14A for the purposes of making disallowance of interest in relation to the exempt interest income from tax free securities. Reference to such section, while considering the disallowance under the Act is fine, but in considering the computation of income under the DTA, the epitome of such reference is to be considered in the light of discussion made in preceding paras, as not allowing any deduction for expenses in relation to exempt income. Similar was the contention of the ld. DR in support to the ground challenging the deletion of disallowance of expenses in relation to exempt income albeit it has been symbolically narrated with reference to the same provision. Be that as it may it is a trite law that there can be no fetters on the power of the tribunal to allow or disallow a claim on different plea. The Hon’ble Supreme Court in CIT v. Mahalakshmi Textiles Mills Ltd. [1967] 66 ITR 710 (SC) has held so. The Hon’ble Calcutta High Court in Steel Containers Ltd. v. CIT [1978] 112 ITR 995 (Cal) has held that the disallowance of expenses by the Revenue under one section can be upheld by the tribunal under another section, if it is sustainable under such other provisions. Similar view has been expressed by the Hon’ble Delhi High Court in CIT v. Jindal Equipments [2010] 325 ITR 87 (Del). In view of the foregoing discussion it is clear that no infirmity can be traced in the ground of appeal or the orders of the authorities below in so far as reference has been made to section 14A in the context of the DTA. It is so for the reason that the spirit of the disallowance is on account of not allowing any deduction for expenses incurred in relation to exempt income, which coincides with the intent and the language of section 14A.

5.14 Lastly it was argued on behalf of the assessee that if at all any disallowance of interest was to be made, that should be restricted to interest for one day alone as the amount borrowed from Reserve Bank of India on 12.11.1998 for purchasing tax free bonds was repaid on the next day i.e. 13.11.1998. Similar contention raised before the Assessing Officer, who had the benefit of the statement of bank account for the relevant period, remained uncontroverted. It is further seen that the AO has restricted disallowance only to the interest expenditure and not to any other administrative or management expenses incurred in relation to the income not chargeable to tax. It is borne out from the impugned order that the assessee has sufficient interest free funds at its disposal apart from sufficient net profit from business operations for the year. No material has been brought out on record by the ld. DR to show that finding of the ld. CIT(A) is incorrect. This factual scenario brings us to a stage where the assessee did borrow interest bearing funds for making investment in tax free bonds and repaid such loan out of its own interest free funds on the next day. There is obviously a direct nexus between the borrowing of interest bearing funds and making of investment in tax free bonds. There can be no dispute on the fact that only such part of interest can be disallowed which has been incurred in relation to the income not forming part of the ‘business profits’ of the assessee as per Article 7 of the DTA. In such a case, the disallowance of interest is definitely called for but it cannot exceed the actual amount of interest paid in respect of borrowed funds used for the purposes of making investment in tax free bonds, which in the present case is only one day. The Assessing Officer is directed to calculate disallowance on Rs. 10 crore for one day at the rate which was charged by the RBI on the loan advanced to the assessee on 12.11.1998. This will be the amount of interest paid by the assessee in relation to tax free interest income which is not included in the business profits as per Article 7 of the DTA, warranting disallowance in the computation of ‘business profits’. The impugned order is modified on this score in above terms. The ground taken by the Revenue is partly allowed pro tanto.

6. In the result, the assessee’s appeal is partly allowed and that of the Revenue is partly allowed for statistical purposes.

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Category : Income Tax (25792)
Type : Featured (4122) Judiciary (10458)
Tags : ITAT Judgments (4713) section 14a (238)

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