Assessing Officer noticed that the assessee entered into transactions of payment of job work charges to a related party, viz., M/s Razormed Inc. during the financial year relevant to assessment year under consideration without obtaining prior approval of the Central Government in accordance with the provisions of section 297 of the Companies Act, 1956.
On being called upon to explain as to why such job work charges be not disallowed in accordance with the provisions of Explanation to section 37(1) of the Income-tax Act, 1961 (hereinafter also called ‘the Act’), the assessee submitted that the post facto approval for the transactions with the related parties undertaken during the year, was obtained from the Company Law Board on payment of compounding charges for the condonation of delay and hence there was no violation of law. Not convinced with the assessee’s submissions, the AO opined that the facts of post facto approval and the con donation of delay by the Ministry of Corporate Affairs were not relevant because on the day of payment of such expenditure, there was no prior approval to the job charges paid to M/s Razormed Inc., which triggered the Explanation to section 37(1) of the Act. This led to the addition of job work charges amounting to Rs. 41.24 lac and the further dis allowance of compounding fee for condonation of delay amounting to Rs. 6,000/-. The ld. CIT(A) echoed the assessment order on this issue. The assessee is in appeal before us only on the dis allowance of job work charges and not on the dis allowance of compounding fee for con donation of delay.
A cursory look at the above Explanation to section 37(1) of the Act makes it palpable that any expenditure incurred by the assessee, for any purpose which is an offence or is prohibited by aw, shall not be deemed to have been incurred for the purpose of business and resultantly no deduction shall be allowed.
Reverting to the facts of the extant case, it is noticed that the authorities below have proceeded to make and uphold the dis allowance in terms of Explanation to section 37(1) of the Act by observing that since the payment of job work expenses was made without prior approval from the Central Government, it amounted to payment in contravention of the Companies Act. Now the position which is obtaining in the present case is that the assessee made payment for getting the job work done from its related concern, which is otherwise neither an offence nor prohibited by law, but committed a breach by not obtaining the necessary approval from the Central Government in time. Thus, on one hand the payment is otherwise for a lawful purpose, but the legality of the transaction has been shadowed by not obtaining prior approval from the Central Government. The pertinent question which arises under the present circumstances is – Can it be said that the assessee incurred an expenditure for any purpose which is an offence or which is prohibited by law?
Before we deliberate upon this question, it is of paramount importance to note that we are dealing with a deeming provision. A deeming provision or a legal fiction as it is commonly called is one whose mandate does not exist but for such provision. Because of such provision alone, the given imaginary state of affairs is taken as reality despite it being at variance with the scope of the relevant provision of the enactment. It is trite that the scope of a deeming provision has to be restricted to what is expressly stated in such a provision. There can be no inference or intendment as regards such a provision. The Hon’ble Supreme Court in CIT Vs. Amarchand N. Shroff (1963) 48 ITR 59 (SC) considered the ambit of a deeming provision and held that the fiction cannot be extended beyond the object for which it is enacted. In CIT Vs. Mother India Refrigeration Industries P.Ltd. (1985) 155 ITR 711 (SC) the same view was reiterated by holding that the “legal fictions are created only for some definite purpose and these must be limited to that purpose and should not be extended beyond their legitimate field.” The Hon’ble Bombay High Court in CIT Vs. Ace Builders P. Ltd. (2006) 281 ITR 210 (Bom.) considered a case in which the assessee was a partner in a firm which was dissolved in the year 1984 and the assessee was allotted a flat towards its credit in the capital account with the firm. The assessee showed the flat as capital asset in its books of account and depreciation was claimed and allowed from year to year. In the previous year relevant to the assessment year 1992- 93 the assessee sold the flat and invested the net sale proceeds in a scheme eligible u/s.54E of the Act and accordingly declared Nil income under the head ‘Capital gains’. The Assessing Officer opined that since the block of building ceased to exist on account of sale of flat during the year, the written down value of the flat was liable to taken as cost of acquisition u/s.54E of the Act. He further held that since the assessee had availed depreciation on such asset which was otherwise long term capital asset, the deeming provision u/s.50 would apply and it would be treated as capital gain on the sale of short term capital asset and resultantly no benefit u/s.54E could be allowed. When the matter came up before the Hon’ble Bombay High Court, it noted that sub-sections (1) and (2) of section 50 contain a deeming provision and such fiction is restricted only to the mode of computation of capita gain contained in sections 48 and 49 and hence it did not apply to other provisions. Consequently the assessee was held to be eligible for exemption uls.54E in respect of capital gain arising out of the capital asset on which depreciation was allowed. On an appraisal of the above judgments, the legal position which emerges is that whenever a legal fiction is created by way of a deeming provision, it is of paramount importance to go strictly by the express prescription of this provision. Such a deeming provision cannot be extended beyond what is expressly stated therein.
With this background, when we turn to the language of the Explanation to sec. 37(1), which is a deeming provision, it is amply borne out that it talks of disallowing any expenditure incurred by an assessee for ‘any purpose’ which is either an offence or prohibited by law. So what is contemplated for disallowance is an ‘expenditure’ incurred ‘for any purpose which is either an offence or which is prohibited by law’. When we consider the mandate of the Explanation in the light of the fact that it is a deeming provision, there remains no doubt whatsoever that the inquiry to determine the applicability or otherwise of the Explanation is restricted to ascertaining the purpose of the expenditure. In simple words, the investigation should be carried out to see the object and consideration for the expenditure incurred. If the purpose of the expenditure is either an offence or is prohibited by law, then it would suffer dis allowance. If, however, the purpose of the expenditure is neither to commit an offence nor is prohibited by any law, then there can be no question of dis allowance. It means that the offence or prohibition under law should be judged with the ‘purpose’ of the expenditure on a standalone basis divorced from the fulfillment or otherwise of the procedural formalities attached with and necessary for the incurring of such expenditure. To put it in simple words, if the expenditure is otherwise lawful and neither amounts to offence nor is prohibited by law, but the procedural provisions attached for incurring it are not complied with, no doubt irregularity will creep in, but such irregularity would not make the expenditure itself as unlawful so as to be brought within the scope of the Explanation. At the cost of repetition, we state that the Explanation, being a deeming provision, is required to be strictly followed as per its express language and not beyond that. As its language talks of disallowing any expenditure for any purpose which is an offence or which is prohibited by law’, we cannot do violence to the language by expanding its scope to also bring within its sweep the cases where the purpose of expenditure is neither an offence nor is prohibited by law, but there is a breach of some procedural provision necessary for incurring such otherwise lawful expenditure. What, therefore, turns out is that it is the expenditure alone which should be tested on the touchstone of the mandate of Explanation to section 37(1) and nothing more than that. If the expenditure itself is for a valid and lawful purpose, then, there can be no question of any dis allowance. The words ‘for any purpose’ set in place by the legislature with the ‘expenditure’ on the one hand and ‘which is an offence or which is prohibited by law’ on the other, make it abundantly clear that if the purpose of expenditure, which is sought to be disallowed is not an offence or not prohibited by law, the same cannot be brought within the scope of Explanation to section 37(1) of the Act. If, on the other hand, the purpose of expenditure is an offence or is prohibited by law, the same cannot escape the clutches of the Explanation. The natural corollary which thus follows is that if the ‘purpose’ of expenditure is not to commit an offence or is otherwise not prohibited by law, then any breach of some procedural statutory provision necessary to be complied with before incurring such expenditure, would not per se convert the otherwise lawful purpose into an offence or prohibition under law so as to attract the wrath of the Explanation. A line of distinction needs to be drawn between the cases where the purpose of the expenditure incurred itself is unlawful on one hand and the cases where the purpose of expenditure is lawful but there is some lapse in complying with the procedural provisions for incurring such expenditure on the other. Whereas the dis allowance will be called for in terms of the Explanation to section 37(1) in the first set of cases where the very ‘purpose’ of the expenditure incurred is unlawful, the second set of cases will escape the mischief of the Explanation because the ‘purpose’ of the expenditure is not unlawful. The crux of the matter is that the ‘purpose’ of the expenditure incurred should be viewed in isolation unbothered by anything else for determining whether or not the Explanation is attracted.
At this stage, it will be relevant to note the judgment of the Hon’ble Punjab & Haryana High Court in CIT vs. Dhanpat Rai & Sons (2014) 98 DTR (P&H) 209. In that case, the assessee, a publisher of books claimed deduction of expenditure incurred on account of secret nature of commission paid to the educational institutions, teachers and individuals for promotion of sales of books and supply of specimen copies of books to teachers. The dis allowance made of such secret commission by the AO was deleted by the CIT (A) as well as the Tribunal. However, the Hon’ble High Court set aside the tribunal order and remitted the matter to the Tribunal for deciding the allow ability of deduction of secret commission on the anvil of the Explanation added to section 37(1) by observing that any secret transaction/payment made to secure unfair advantage would necessarily be repugnant to law. The Hon’ble High Court held that such expenditure, if allowed, is likely to encourage illegal payment, evasion of tax and unscrupulous practices. From the above judgment, it is patent that the expenditure in the nature of secret commission aimed at securing an unfair advantage is against the public policy. As such a purpose is an offence or prohibited by law, the same is hit by Explanation to section 37(1).
As against that and adverting to the facts of the instant case, we find that the expenditure which has been instantly disallowed is a sum of Rs. 41.24 lac on account of job work charges paid by the assessee to M/s Razormed Inc. It is not the case of the Revenue and naturally cannot be that the payment of job work charges is an offence or is prohibited by law. What the authorities below have taken into consideration while making the dis allowance is that since there was no prior approval from the Central Government, the expenditure of job work charges became dis allowable. We fail to understand as to how the payment of job work charges can by any stretch of imagination be construed as offence or prohibited by law simply because the necessary permission from the Central Government was obtained belatedly. It has been noticed above that the inquiry should stop on determining the immediate purpose of expenditure, which in the present case is job work done for the assessee. The first question to be asked is whether such payment of job charges is an offence? The answer is obviously in negative. The second question is whether such payment of job charges is prohibited by law? Again the answer is in negative because no law prohibits the payment of job work charges in a manufacturing unit. When the language of the Explanation is crystal clear and does not encompass the incurring of expenses for a lawful purpose, such as the job charges, within its ambit, it is wholly impermissible to import a further requirement in the language of the Explanation to make the otherwise lawful purpose as unlawful for lack of the prior approval of the Central Government. As the ‘purpose’ of incurring the expenditure of job charges is neither an offence nor is prohibited by law, we fail to comprehend as to how the otherwise lawful purpose would become contingent upon obtaining or not obtaining the prior approval of the Central Government. Since such expenditure in itself is neither an offence nor prohibited by any law and there is a valid and lawful quid pro quo for the same, we are disinclined to uphold the view canvassed in the impugned order.
Viewed from any angle, being the operation of sub-section (5) of section 297 of the Companies Act or the non-applicability of Explanation to section 37(1) of the Act, we cannot countenance the view canvassed by the ld. first appellate authority. It is ergo held that the ld. CIT(A) erred in sustaining the dis allowance of Rs. 41.24 lac incurred on payment of job work charges. The impugned order is overturned on this issue and the dis allowance is deleted.