Disallowance u/s 14A in absence of exempt income unsustainable

Baghban Packaging LLP. Vs PCIT (ITAT Ahmedabad)

ITAT Ahmedabad held that where no exempt income is earned by the assessee there is no case for making any disallowance under Section 14A of the Income Tax Act.

Facts- The present appeal is filed by the assessee against order passed by PCIT in exercise of the revisionary power u/s 263 of the Income Tax Act.

Notably, PCIT found that the assessment order passed by AO is erroneous so as to cause prejudice to the interest of the revenue since AO made no disallowance of expenses incurred by the assessee for earning exempt income in terms of section 14A.

Conclusion- Held that where no exempt income is earned by the assessee there is no case for making any disallowance under Section 14A of the Act.

The finding of the ld. PCIT that the Assessing Officer was bound by CBDT Circulars including those contrary to the decision of the Hon’ble jurisdictional High Court – we cannot agree with the same. As rightly pointed out by the learned Counsel for the assessee, the circulars issued by the CBDT are binding on their officers only to the extent that they are not in contradiction to the judicial interpretation of provisions of law. Circulars cannot override express provisions of law as interpreted by the Courts.

Held that neither of the reasons by the Ld. PCIT for holding the assessment order erroneous so as to cause prejudice to the Revenue, is sustainable in law . We therefore set aside the order of the ld. PCIT passed in exercise of his revisionary jurisdiction u/s 263 of the Act and allow the appeal of the assessee.

FULL TEXT OF THE ORDER OF ITAT AHMEDABAD

This appeal filed by the assessee is directed against the order passed by the learned Principal Commissioner of Income-Tax-3, Ahmedabad [hereinafter referred to as “PCIT”] dated 28.03.2022, in exercise of his revisionary powers under Section 263 of the Income-tax Act, 1961 [hereinafter referred to as “the Act”], for the Assessment Year 2017-18.

2. The assessee has challenged the order passed by the learned PCIT, raising the following grounds before us:-

“1. The Learned Pr. Commissioner of Income – Tax – 3, Ahmedabad has erred in passing an order u/s.263 of the LT. Act, 1961 setting aside the Assessment Order passed u/s.143(3) of the I.T. Act, 1961 dtd. 19.10.2019 and directing the Assessing officer to make fresh assessment after examining the issue.

2. The Learned Pr. Comm. of Income Tax – 3, Ahmedabad has erred in holding that provisions of Sec.14A r.w.r.8D are applicable even if no exempt income was earned by the assessee and that the Assessing Officer has passed the Assessment order without making addition u/s.14A of the Act towards disallowance of expenditure to the tune of Rs.21,26,959/-.

3. The Learned Pr. Comm. of Income Tax – 3, Ahmedabad has erred in holding that the entire amount of depreciation of Rs.34,48,97,336/- claimed on goodwill of Rs.1,83,94,52,457/- need to be disallowed in view of the proposition that as per AS-14 no goodwill is generated in case of pooling of interest method ignoring the fact that no amalgamation or other merger has taken place in the year under consideration.

4. The Learned Pr. Comm. of Income Tax – 3, Ahmedabad has erred in treating the order as erroneous only on account of the fact that the assessment has not been converted into Complete Scrutiny as against Limited Scrutiny by the Assessing Officer.”

3. The learned Counsel for the assessee, during the course of hearing before us, pointed out that the learned PCIT found the assessment order passed by the Assessing Officer in the present case under Section 143(3) of the Act to be erroneous so as to cause prejudice to the interest of the revenue, on the following two grounds:-

i) that the Assessing Officer made no disallowance of expenses incurred by the assessee for earning exempt income in terms of provisions of Section 14A of the Act;

ii) that the Assessing Officer has not made proper inquiry regarding assessee’s claim of depreciation on goodwill which otherwise was not allowable to the assessee.

4. With respect to the issue of disallowance of expenses under Section 14A of the Act, the contention of the learned Counsel for the assessee before us was that the assessee’s case had been selected for “limited scrutiny” for the purpose of scrutinizing the expenses debited to the Profit and Loss account for earning exempt income and the issue had been thoroughly examined by the Assessing Officer and noting that no exempt income had been earned by the assessee, he had made no further disallowance of expenses following the proposition of law laid down in this regard by the Hon’ble jurisdictional High Court in the case of CIT vs. Corrtech Energy (P.) Ltd., [2015] 372 ITR 97 (Guj.). His contention, therefore, was that the view taken by the Assessing Officer was a plausible view and, therefore, the view of the ld. PCIT that the disallowance ought to have been made under Section 14A of the Act by invoking Rule 8D of the Income-Tax Rules, 1962 only tantamounted to change of opinion, which would not result in the assessment order being erroneous. Even otherwise, he pointed out, that the case of the ld. PCIT for holding that the Assessing Officer ought to have made disallowance under Section 14A of the Act was that as per the CBDT Circular No.5/2014 ,which clarified that expenses relatable to earning of exempt income have to be considered for disallowance irrespective of the fact whether any such income has been earned during the financial-year, was binding on the Assessing Officer. In this regard, he drew our attention to paragraph No. 6.1 of the ld. PCIT’s order holding so:-

“6.1 Submission of the assessee is considered but the same is not found acceptable for the following reasons:

[A1 It is true that during the assessment proceedings, the then AO raised the query in this regard vide notice u/s 142(1) dt. 30.09.2019 [ABP Pg 5-71 and reply was filed by the assessee LLP vide letter dt. 07.10.2019 [APB Pg 8-101 but the AO failed to compute the disallowable amount by applying Rule 8D in this case. CBDT vide Circular No. 5/2014 has clarify that the expenses which are relatable to earning of exempt income have to be considered for disallowance irrespective of the fact that whether any such income has been earned during the year or not. It is settled legal position that Circulars are binding on Revenue Authorities as held in the case of K.P Varghese v/s ITO 131 ITR 597 SC. Thus not following the binding instruction is an error as provided in clause (c) of Explanation to Sec 263 of the Act. Besides this, it is evident from notice u/s 263 of the Act. Besides this, it is evident from notice u/s 142(1) and reply filed by the assessee thereto inter alia assessment order (where no discussion has been made about this point) that ld. AO accepted the claim of the assessee without application of mind. Hence, there remains no doubt in my mind that impugned assessment order was erroneous as well as prejudicial to the interest of revenue.

[B] It is observed from the Balance Sheet, that, value of investment in Mutual Funds is shown as on 31.03.2017 at Rs. 42,53,91,884. As on 31.03.2016, there was NIL investment that can fetch exempt income. This is true that during the current year, the assessee has not shown any “exempt income” in statement of income. However, one should not lose sight of clear-cut instruction of CBDT vide circular No. 05/2014 which provides for disallowance out of relatable expenses even if there is no exempt income earned during any particular year. CBDT vide Circular No. 05/2014 dated 11.02.2014, prescribes that, even if no exempt income was earned by the assessee from the investment in a particular year, provisions of section 14A r.w.r. 8D are still applicable in that year. In the P&L account for AY 2017­18, no interest expenses have been incurred. It is undisputed fact that during the year, the assessee has huge investment to the tune of Rs. 42,53,91,884 which is capable of earning ‘exempt income’ although not earned during this particular year. So, provision of Sec 14A is still attracted in this year. However, various administrative expenses totaling to Rs. 39,01,175 and Employees benefit expenses totaling to Rs. 35,95,347 have been claimed. Further, out of total asset of Rs. 179,40,98,918, it is observed that, investment in Mutual fund investment is Rs. 42,53,91,884, which is 23.71% of total assets. Therefore, definitely some of the administrative expenses and employee benefit expenses must be attributable to the investment in mutual funds. Accordingly, amount disallowable u/s 14A is calculated in the manner provided in Rule 8D as under:

The AO being Revenue Authority is bound to follow the Circular issued by the CBDT i.e. Circular No.05/2014 dated 11.02.2014, which states that, even if no exempt income was earned by the assessee from the investment in a particular year, provisions of Section 14A r.w.r. 8D are applicable in that year. However, the AO failed to make any inquiry with regard to disallowance to be made u/s 14A of the I.T. Act, 1961 and claim was allowed in the same. The order passed by the AO is therefore not only erroneous but also prejudicial to the interest of revenue.”

5. The learned Counsel for the assessee contended that though the CBDT Circulars are binding on the Revenue Officers and there is no dispute with respect to this fact, but at the same time they cannot overrule the decision of the High Courts on the issue. That therefore the AO could not be bound by CBDT instructions interpreting law in contradiction to that as laid down by courts He referred to the decisions of the Hon’ble Delhi High Court in the following cases for the said proposition:-

i) PCIT Vs. IL & FS Energy Development Company Ltd., [2017] 399 ITR 483 (Delhi);

ii) Cargo Motors (P.) Ltd. Vs. DCIT, [2023] 453 ITR 554 (Delhi).

6. With respect to the issue of assessee’s claim of depreciation on goodwill which, as per the ld. PCIT, the Assessing Officer had not examined and which otherwise was not allowable to the assessee resulting in the ld. PCIT holding that the assessment order was erroneous causing prejudice to the interest of the revenue, the learned Counsel for the assessee contended that the assessee’s case was taken up for ‘limited scrutiny’ for the purpose of examining only the issue of expenses disallowable having been incurred for the purpose of exempt income in terms of Section 14A of the Act. The issue of claim of depreciation on goodwill was not one of the reasons for limited scrutiny and the Assessing Officer having not examined this aspect was, therefore, not in error. He pointed out that Courts have consistently held that the assessment order cannot be held to be erroneous on account of non-examination of an issue which was outside the purview of limited scrutiny by the Assessing Officer. He specifically referred to the following two decisions of the Hon’ble High Courts before us:-

i) PCIT vs. Naga Dhunseri Group Ltd., [2023] 146 com 424 (Calcutta);

ii) PCIT vs. Shark Mines and Minerals (P.) Ltd., [2023] 151 com 71 (Orissa)

7. The learned DR, on the other hand, drew our attention to the order of the ld. PCIT where he had dealt with this contention raised by the assessee before him and dismissed it holding that the Assessing Officer had power to expand the scope of limited scrutiny by taking prior approval of the PCIT concerned and having not done so in respect of the issue of claim of depreciation on goodwill, the Assessing Officer’s order was erroneous. He drew our attention to paragraph no. 9.2 of the order of the ld. PCIT dismissing the assessee’s objection as above:-

“9.2 Assessee has also argued that present case was selected for “limited scrutiny” for disallowance of expense in relation to exempt income, so AO was not authorized to investigate any other issue viz. claim of depreciation on goodwill. Contention of the assessee is not found acceptable because the AO could have expanded the scope of scrutiny by converting it from limited to complete scrutiny with the prior approval of PCIT concerned. Hence objection of the assessee in this regard is not found tenable.”

8. Even otherwise, he referred to the elaborate discussion made by the ld. PCIT vis-à-vis the issue of claim of depreciation on goodwill finding it to be not allowable to the assessee and pointing out that the Assessing Officer having not inquired into this issue, his order was erroneous causing prejudice to the interest of Revenue. He further pointed out that the ld. PCIT had also referred to Explanation (2) to Section 263 of the Act listing circumstances in which the assessment order was to be deemed to be erroneous and pointed out that one of the conditions listed therein at clause

(c) was that “the order has not been made in accordance with any order, direction or instruction issued by the Board under section 119”. The learned DR contended that considering the specific instruction by the Board that where the Assessing Officer comes across any issue beyond the scope of limited scrutiny, he ought to seek approval of the ld. PCIT and expand the scope of the assessment and in the present case the Assessing Officer having not done so in regard to the issue of claim of depreciation on goodwill, clause (c) of Explanation (2) to Section 263 had become applicable referring the assessment order erroneous.

9. We have heard the contentions of both the parties and gone through the order of the ld. PCIT. With regard to the finding of the ld. PCIT of the assessment order being erroneous on account of issue of disallowance of expenses under Section 14A of the Act not having been examined by the Assessing Officer in the light of the circular issued by the CBDT in this regard, i.e. Circular No.5/2014, we are not in agreement with ld. PCIT. It is not disputed that the assessee had not earned any exempt income during the year. It is also not in dispute that the jurisdictional High Court has laid down that where no exempt income is earned by the assessee there is no case for making any disallowance under Section 14A of the Act. In the light of these facts, undoubtedly, the view taken by the Assessing Officer in making no disallowance under Section 14A of the Act is, therefore, clearly in accordance with law as interpreted by the Hon’ble jurisdictional High Court. The finding of the ld. PCIT that the Assessing Officer was bound by CBDT Circulars including those contrary to the decision of the Hon’ble jurisdictional High Court – we cannot agree with the same. As rightly pointed out by the learned Counsel for the assessee, the circulars issued by the CBDT are binding on their officers only to the extent that they are not in contradiction to the judicial interpretation of provisions of law. Circulars cannot override express provisions of law as interpreted by the Courts. The Hon’ble Delhi High Court in the cases of IL & FS Energy Development Company Ltd. (supra) has categorically held so holding as under:-

“17. The words “in relation to income which does not form part of the total income under the Act for such previous year” in the above Rule 8 D (1) indicates a correlation between the exempt income earned in the AY and the expenditure incurred to earn it. In other words, the expenditure as claimed by the Assessee has to be in relation to the income earned in ‘such previous year’. This implies that if there is no exempt income earned in the AY in question, the question of disallowance of the expenditure incurred to earn exempt income in terms of Section 14A read with Rule 8D would not arise.

18. The CBDT Circular upon which extensive reliance is placed by Mr. Hossain does not refer to Rule 8D (1) of the Rules at all but only refers to the word “includible” occurring in the title to Rule 8D as well as the title to Section 14A. The Circular concludes that it is not necessary that exempt income should necessarily be included in a particular year’s income for the disallowance to be triggered.

19. In the considered view of the Court, this will be a truncated reading of Section 14 A and Rule 8D particularly when Rule 8D (1) uses the expression ‘such previous year’. Further, it does not account for the concept of ‘real income’. It does not note that under Section 5 of the Act, the question of taxation of ‘notional income’ does not arise. As explained in CIT v. Walfort Share & Stock Brokers (P.) Ltd. [20101 326 ITR 1/192 Taxman 211 (SC), the mandate of Section 14A of the Act is to curb the practice of claiming deduction of expenses incurred in relation to exempt income being taxable income and at the same time avail of the tax incentives by way of exemption of exempt income without making any apportionment of expenses incurred in relation to exempt income. Consequently, the Court is not persuaded that in view of the Circular of the CBDT dated 11th May 2014, the decision of this Court in Cheminvest Ltd. (supra) requires reconsideration.

20. In Redington (India) Ltd. v. Addl. CIT [20171 392 ITR 633/77 com 257 (Mad.), a similar contention of the Revenue was negated. The Court there declined to apply the CBDT Circular by explaining that Section 14A is “clearly relatable to the earning of the actual income and not notional income or anticipated income.” It was further explained that,

“The computation of total income in terms of Rule 8D is by way of a determination involving direct as well as indirect attribution. Thus, accepting the submission of the Revenue would result in the imposition of an artificial method of computation on notional and assumed income. We believe thus would be carrying the artifice too far.”

21. The decisions in CIT v. Lakhani Marketing Inc. [2014] 49 com 257/226 Taxman 45 (Mag.), CIT v. Winsome Textile Industries Ltd. [2009] 319 ITR 204, CIT v. Shivam Motors (P.) Ltd. [2015] 230 Taxman 63/55 taxmann.com 262 (All.) have all taken a similar view. The decision in Taikisha Engineering India (P.) Ltd. (supra) does not specifically deal with this issue.

22. It was suggested by Mr. Hossain that, in the context of Section 57(iii), the Supreme Court in CIT v. Rajendra Prasad Moody [1978] 115 ITR 519 explained that deduction is allowable even where income was not actually earned in the AY in question. This aspect of the matter was dealt with by this Court in Cheminvest Ltd. (supra) where it reversed the decision of the Special Bench of the ITAT by observing as under:

’20. Since the Special Bench has relied upon the decision of the Supreme Court in Rajendra Prasad Moody (supra), it is considered necessary to discuss the true purport of the said decision. It is noticed to begin with that the issue before the Supreme Court in the said case was whether the expenditure under Section 57 (iii) of the Act could be allowed as a deduction against dividend income assessable under the head “income from other sources”. Under Section 57 (iii) of the Act deduction is allowed in respect of any expenditure laid out or expended wholly or exclusively for the purpose of making or earning such income. The Supreme Court explained that the expression “incurred for making or earning such income”, did not mean that any income should in fact have been earned as a condition precedent for claiming the expenditure. The Court explained:

“What s. 57(iii) requires is that the expenditure must be laid out or expended wholly and exclusively for the purpose of making or earning income. It is the purpose of the expenditure that is relevant in determining the applicability of s. 57(iii) and that purpose must be making or earning of income. s. 57(iii) does not require that this purpose must be fulfilled in order to qualify the expenditure for deduction. It does not say that the expenditure shall be deductible only if any income is made or earned. There is in fact nothing in the language of s. 57(iii) to suggest that the purpose for which the expenditure is made should fructify into any benefit by way of return in the shape of income. The plain natural construction of the language of s. 57(iii) irresistibly leads to the conclusion that to bring a case within the section, it is not necessary that any income should in fact have been earned as a result of the expenditure.”

21. There is merit in the contention of Mr. Vohra that the decision of the Supreme Court in Rajendra Prasad Moody (supra) was rendered in the context of allowability of deduction under Section 57(iii) of the Act, where the expression used is “for the purpose of making or earning such income.” Section 14A of the Act on the other hand contains the expression “in relation to income which does not form part of the total income.” The decision in Rajendra Prasad Moody (supra) cannot be used in the reverse to contend that even if no income has been received, the expenditure incurred can be disallowed under Section 14A of the Act.’

23. The decisions of the ITAT in Ratan Housing Development Ltd. (supra) and Relaxo Footwears Ltd. (supra), to the extent that they are inconsistent with what has been held hereinbefore do not merit acceptance. Further, the mere fact that in the audit report for the AY in question, the auditors may have suggested that there should be a disallowance cannot be determinative of the legal position. That would not preclude the Assessee from taking a stand that no disallowance under Section 14 A of the Act was called for in the AY in question because no exempt income was earned.

24. For all of the aforementioned reasons, this Court is of the view that the CBDT Circular dated 11th May 2014 cannot override the expressed provisions of Section 14A read with Rule 8D.”

10. In view of the same, we hold that the view taken by the Assessing Officer in making no disallowance under Section 14A of the Act being in consonance with law as interpreted by the Courts; there is no error in the order of the Assessing Officer. The order of the ld. PCIT on this aspect of disallowance of expenses under Section 14A of the Act is accordingly set aside.

11. Coming to the next aspect relating to the claim of depreciation on goodwill, it is an admitted fact that the assessee’s case was selected for limited scrutiny and the reason was examining the disallowance of expenses pertaining to the earning of exempt income in terms of provisions of Section 14A of the Act. The Revenue does not dispute this fact before us. In the light of these facts, we fail to understand how the Assessing Officer could have travelled beyond the scope of assessment and how the assessment order could have been held to be erroneous for not having travelled beyond the scope of assessment which was directed to the Assessing Officer. The Assessing Officer had acted in accordance with the scope which was delineated to him. The assessment order cannot be held erroneous for the Assessing Officer having not crossed the boundary for scrutiny which was set out before him. The Hon’ble Orissa High Court in the case of Shark Mines and Minerals (P.) Ltd. (supra) has categorically held that the assessment order cannot be held to be erroneous for not having travelled beyond the scope of issues which form part of the limited scrutiny. We have noted that the basis of the ld. PCIT for rejecting this contention raised by the assessee before us that the Assessing Officer could have expanded the scope of assessment has also been dealt with by the Hon’ble High Court. The Hon’ble High Court has noted that to expand the scope of assessment, the Assessing Officer has to seek prior permission of the superior officer in terms of the CBDT Instruction No. 7/14 dated 26th September, 2014 and Instruction No. 20/15 dated 19th December, 2015. The Hon’ble High Court observed, therefore, that the Assessing Officer could not have suo moto examined issues which were beyond the scope of limited scrutiny and, therefore, the ld. PCIT could not have found fault in the order of the Assessing Officer for not having done what the Assessing Officer was not permitted to do as per its own instructions and rules. The relevant findings of the Hon’ble Orissa High Court in the case of Shark Mines and Minerals (P.) Ltd. (supra) in this regard at paragraph no. 10 of the order is as under:-

“10. What persuades this Court to reach this conclusion is the requirement in law that if the AO has to go beyond the scope of the issues for which ‘limited scrutiny’ has to be undertaken by him, he has to seek prior permission of the superior officer in terms of the CBDT Instruction No. 7/14 dated 26th September, 2014 and Instruction No. 20/15 dated 19th December, 2015. Consequently, it was not open to the Pr. CIT while exercising suo motu revisional power under section 263 of the Act to find fault with the assessment order of the AO on the ground of its being erroneous on an issue not covered by the ‘limited scrutiny’ when the AO could not have possibly examined such issue. To reiterate, in the present case, the limited scrutiny was in respect of excess disallowance under section 40A(3) of the Act whereas the SCN under section 263 was regarding the FIFO method of valuation of closing stock adopted by the Assessee. These were, as rightly noted by the ITAT, unconnected issues and the assessment order could not have been held to be “erroneous and prejudicial to the interest of Revenue” when the AO could not have travelled beyond the issues forming subject matter of the ‘limited scrutiny.’”

12. The Hon’ble Calcutta High Court has reiterated this proposition of law in the case of Naga Dhunseri Group Ltd. (supra); therefore, we have no hesitation in holding that the findings of the ld. PCIT holding the assessment order erroneous on an issue which was beyond the scope of limited scrutiny was not in accordance with law. The contention of the learned DR that, as per Clause (c) of Explanation (2) to Section 263 of the Act, the Assessing Officer’s act of not having expanded the scope of his assessment was in contravention of the directions of the CBDT and, therefore, the assessment order was erroneous – we do not concur with the same. The purpose of clause (c) of Explanation (2) to Section 263 of the Act is to bring out the circumstance that where the Assessing Officer does not follow the circulars and instructions issued by the CBDT, the assessment order is to be treated as deemed to be erroneous. In the present case, the circular ld. DR referred to, which is power to the Assessing Officer to expand the scope of assessment by seeking necessary approval from the senior; does not direct the Assessing Officer to necessarily expand the scope of assessment. Therefore, to say that the Assessing Officer in the present case, by not expanding the scope of assessment, had acted contradictory to the CBDT Circular is an incorrect understanding of the said circular. Even otherwise, we have noted that the ld. PCIT had invoked clause (a) of Explanation (2) to Section 263 in the said case, that the Assessing Officer had not conducted proper inquiry relating to the issue of claim of depreciation on goodwill, and not clause (c) of Explanation (2) as contended by the learned DR before us. The Revenue cannot improve upon the case made out by the authorities below in any case. Therefore, for this reason also, we dismiss this contention of the learned DR.

13. In view of the above, we hold that neither of the reasons by the Ld. PCIT for holding the assessment order erroneous so as to cause prejudice to the Revenue, is sustainable in law . We therefore set aside the order of the ld. PCIT passed in exercise of his revisionary jurisdiction u/s 263 of the Act and allow the appeal of the assessee.

14. In effect, the appeal of the assessee is allowed.

Order pronounced in the open Court on 26/07/2023 at Ahmedabad.