Disallowance u/s. 36(1)(iii) unjustified as interest-free funds exceeds loan to subsidiary: ITAT Ahmedabad

Oriental Enterprise Pvt Ltd Vs ACIT (ITAT Ahmedabad)

ITAT Ahmedabad held that disallowance u/s. 36(1)(iii) of the Income Tax Act unjustified as interest-free funds exceeds loan to the subsidiary and loan was advanced for commercial expediency.

Facts- The assessee-company was engaged in the business of manufacturing and trading of engineering equipment for chemicals, petrochemicals, fertilizers, textiles and other industries. The assessee also acts as agents of indigenous manufacturers from various industries viz. chemicals, textiles, plastics, machine toolsets, as well as sole concessionaries of number of foreign manufacturers from various countries.

The assessee filed its return of income for the A.Y. 2016-17 on 14-10-2016 declaring total income of Rs.10,25,170/-. The case was selected for complete scrutiny under CASS and notices were issued under sections 143(2) and 142(1) of the Act, and the assessment order was passed by the AO u/s .43(3) of the Act, assessing total income to Rs.3,42,96,135/-.

The assessee preferred an appeal before Ld.CIT(A), who partly allowed the appeal of the assessee.

Conclusion- Held that the onus is on the AO to prove the cessation or remission of liability with concrete evidence, liabilities shown in the balance sheet are considered existing until there is evidence to the contrary, simply non-payment over a period or debts becoming time-barred do not automatically constitute cessation of liability and there must be clear and specific evidence of cessation or remission for liabilities to be considered as ceased under Section 41(1) of the Act. Thus, the addition of Rs.1,35,94,166/- as cessation of liability under Section 41(1) of the Act, was unjustified as AO did not provide sufficient evidence to establish that the liabilities had ceased during the year under consideration.

Held that that CIT(A) erred in upholding the disallowance of Rs.26,25,000/- under Section 36(1)(iii) of the Act. The assessee has successfully demonstrated that it had sufficient interest-free funds to cover the loan to the subsidiary, and the loan was advanced for commercial expediency, thus qualifying for interest deduction under Section 36(1)(iii) of the Act.

FULL TEXT OF THE ORDER OF ITAT AHMEDABAD

These appeals are filed by the Assessee and Revenue as against the separate orders dated 28/07/2023 (for AY 2016-17appeals) and dated 23/08/2023 (for AY 2018-19) passed by the Commissioner of Income-tax (Appeals), National Faceless Appeal Centre (NFAC), Delhi [hereinafter referred to as “Ld.CIT(A)” in short]arising out of the assessment order dated 26/12/2018 (for AY 2016-17) and dated25/08/2021 (for AY 2018-19) passed by the Assessing Officer (AO) under section 143(3) / 144B of the Income Tax Act, 1961 (hereinafter referred to as “the Act”).

Facts of the case:

2. The assessee-company was engaged in the business of manufacturing and trading of engineering equipment for chemicals, petrochemicals, fertilizers, textiles and other industries. The assessee also acts as agents of indigenous manufacturers from various industries viz. chemicals, textiles, plastics, machine toolsets, as well as sole concessionaries of number of foreign manufacturers from various countries. The assessee filed its return of income for the A.Y. 2016-17 on 14-10-2016 declaring total income of Rs.10,25,170/-. The case was selected for complete scrutiny under CASS and notices were issued under sections 143(2) and 142(1) of the Act, and the assessment order was passed by the AO u/s .43(3) of the Act, assessing total income to Rs.3,42,96,135/-. The assessee preferred an appeal before Ld.CIT(A), who partly allowed the appeal of the assessee. The summary of additions and decision of the Ld.CIT(A) is tabulated as follows:

3. The Grounds of appeal(s) before us are:

3.1. Revenue’s Grounds of Appeal in ITA No.732/Ahd/2023 – for AY 2016-17 & Assessee’s Grounds of Appeal in ITA No. 661/Ahd/2023 – for AY 2016-17.

3.2. The Ld. Authorised Representative of the Assessee (AR) and the Ld. Departmental Representative of the Revenue (DR)argued before us and explained the issues involved. Now, we deal with various grounds one by one as follows:

Revenue’s Ground No.1 relates to the addition of the AO on account of cessation of liability u/s 41(1) of the Act for Rs.1,35,94,166/-.

4. During the assessment proceedings, the (AO) examined the details of sundry creditors. It was found that several trade payables had been outstanding for more than three years. The AO scrutinized these trade payables and treated them as cessation of liability under Section 41(1) of the Income Tax Act, 1961.The total amount involved is Rs.1,35,94,166/-. The AO identified several creditors with balances outstanding for more than three years. The AO noted that the assessee failed to submit sufficient verification details, such as confirmation from these parties, PANs, addresses, or any other supporting documents. The AO also observed that the assessee provided only ledger copies from their own books, but failed to submit confirmations or any communications from the creditors and no evidence was provided to demonstrate that these amounts were still payable or that any payments had been made in subsequent years. Due to the lack of evidence, the AO concluded that these liabilities had ceased to exist and treated the outstanding amount as income under Section 41(1) of the Act. The assessee argued that these liabilities were still outstanding and would be paid in subsequent years and mentioned that some balances were returned as ‘kasar/vavav’ in subsequent years and offered to tax.

5. Before the Ld.CIT(A), the assessee argued that the time provided by the AO to furnish the confirmation of accounts from the creditors was insufficient (only four days), which was why they could not collect the confirmations in time. The assessee also stated that accounts were subject to statutory audit as per the Companies Act and tax audit as per Section 44AB of the Income Tax Act. The Auditors had not raised any adverse remarks or qualifications regarding the outstanding liabilities, certifying the genuineness of the books of accounts. The assessee contended that the liabilities were acknowledged in the balance sheet, and mere non-payment for a period does not mean that the liabilities have ceased. The assessee also contended that the liabilities were still payable and should not be treated as cessation of liability. The assessee also argued that the burden of proving cessation of liability lies with the AO and the AO failed to establish that the liabilities had ceased during the year under consideration. During appellate proceedings before the Ld.CIT(A), the assessee cited several judicial precedents where it was held that liabilities outstanding for long periods could not be treated as ceased solely based on the passage of time.

5.1. The Ld.CIT(A) observed that the assessee had provided audited ledger accounts, and there was no dispute regarding the year-end balances recorded therein. The inability to verify the addresses or PANs of the creditors did not justify invoking Section 41(1) of the Act. The Ld.CIT(A) noted that even when a debt becomes time-barred, the liability does not cease. The Ld.CIT(A) placed reliance on the decision(s)of the Hon’ble Kerala High Court (Liquidator, Mysore Agencies (P.) Ltd. v. CIT) [1978] 114 ITR 853 and the Hon’ble Bombay High Court (CIT v. Chase Bright Steel Ltd (No.2)) [1989] 177 ITR 128. The Ld.CIT(A) relied on the decision of Hon’ble Gujarat High Court in the case of CIT-Il v. Nitin S. Garg [2012] 22 taxmann.com 59, which supports the view that liabilities shown in the balance sheet cannot be presumed to have ceased. The Ld.CIT(A) emphasized that the mere lapse of time does not lead to the cessation of liability, and sufficient evidence was not provided by the AO to prove that the liabilities had ceased to exist during the year under consideration. The Ld.CIT(A) deleted the addition.

5.2. Before us, the Ld.AR placed the reliance on decision of Hon’ble Gujarat High Court in case of PCIT Vs Adani Agr (P.) Ltd. [2020] 118n taxmann.com 307. The Ld. DR relied on the order of AO and pointed out that the assessee only produced ledger copies of such creditors.

6. We have heard the parties, perused the material available on the record and noted the judicial precedents relied on by the assessee and the Ld.CIT(A). The judicial precedents collectively establish the principles regarding cessation of liability under Section 41(1) of the Act, which held that the onus is on the AO to prove the cessation or remission of liability with concrete evidence, liabilities shown in the balance sheet are considered existing until there is evidence to the contrary, simply non-payment over a period or debts becoming time-barred do not automatically constitute cessation of liability and there must be clear and specific evidence of cessation or remission for liabilities to be considered as ceased under Section 41(1) of the Act.

6.1. Considering the Ld.CIT(A)’s findings, we conclude that the addition of Rs.1,35,94,166/- as cessation of liability under Section 41(1) of the Act, was unjustified. The AO did not provide sufficient evidence to establish that the liabilities had ceased during the year under consideration. The liabilities were duly reflected in the assessee’s audited balance-sheet and the Ld.CIT(A)’s reliance on judicial precedents was appropriate and well-founded. Accordingly, we uphold the Ld.CIT(A)’s decision to delete the addition of Rs.1,35,94,166/- made by the AO under Section 41(1) of the Act. Therefore, Revenue’s this ground is dismissed.

Revenue’s Ground No.2 relates to disallowance u/s 37(1) on account of 10% of Trade Payables.

7. During the assessment proceedings, the AO scrutinized the sundry creditors. For trade payables outstanding for less than one year, the AO questioned the genuineness and verification of these payables. Consequently, the AO disallowed 10% of the total trade payables under Section 37 of the Income Tax Act, 1961, amounting to Rs. 1,06,18,997/-. The AO noted that the assessee furnished only the names and amounts of trade payables without any supporting documents like ledgers, bank statements, or purchase bills. No details regarding payments made in subsequent years were provided. No confirmation of these trade payables, communication copies, PANs, or addresses of these parties were supplied to facilitate independent inquiry by the AO. Due to the inability to verify the genuineness of the expenditure, the AO, relying on his discretion, disallowed 10% of the total trade payables.

7.1. Before the Ld.CIT(A), the assessee argued that their accounts were subject to statutory and tax audits, which did not raise any adverse remarks regarding the genuineness of the sundry creditors. The assessee stated that they had provided sample ledger accounts and details for subsequent years to demonstrate that the creditors were genuine, and the amounts were eventually paid. The assessee also contended that the AO did not provide sufficient time to collect and submit confirmations from all creditors. The assessee argued that the ad-hoc disallowance of 10% was arbitrary and without basis. They emphasized that the AO should have disallowed the entire amount if he doubted the genuineness, instead of an arbitrary percentage. The Ld.CIT(A) highlighted that for an expenditure to be disallowed under Section 37, it must not be wholly and exclusively for the purpose of business. The CIT(A) noted that the AO accepted the purchases or expenses related to the creditors as genuine in the earlier years or the current year. The Ld.CIT(A) found that the AO did not provide any concrete evidence to prove that the expenses were not incurred for business purposes. The Ld.CIT(A) emphasized that disallowing 10% of the creditors’ balances based on estimation and without specific evidence was not justified. The assessee placed reliance on the decision(s) in case of Om Prakash Joshi vs. ITO 123 TTJ 246 (Jodhpur Bench) and Sonic Biochem Extractions (P.) Ltd. 35 taxmann.com 463 (Mumbai – Trib.).

7.2. The Ld. DR placed reliance on the order of AO and pointed out that the assessee could not provide PANs and addresses of such trade payables and, therefore, the AO could not verify the genuineness of the same. The Ld.AR, on the other hand, relied on the order of the Ld.CIT(A) and stated that the AO has accepted the purchase and expenses related to such payable therefore disallowing 10% on ad-hoc basis is purely guesswork. He placed reliance on decision of Hon’ble Supreme Court in case of Umacharan Shaw & Bros [1959] 37 ITR 271.

8. Upon thorough review of the findings and decision of the Commissioner of Income Tax (Appeals), we conclude that the Ld.CIT(A) meticulously analyzed the basis on which the Assessing Officer (AO) made the disallowance. The AO’s decision to disallow 10% of the sundry creditors was primarily due to the lack of supporting documentation and the inability to verify the genuineness of these creditors. The assessee had provided sample ledger accounts, audited financial statements, and details for subsequent years to demonstrate the genuineness of the creditors. The Ld.CIT(A) observed that the statutory and tax audits had not raised any adverse remarks regarding these liabilities, thus supporting the assessee’s claim. The Ld.CIT(A) noted that the AO did not furnish specific evidence to support the claim that the expenses were not incurred for business purposes. The AO’s approach of making an ad hoc disallowance of 10% without concrete evidence was deemed arbitrary and unjustified. The assessee relied on various judicial precedents which established that disallowances must be based on substantive evidence rather than estimations or assumptions. Cases such as, Om Prakash Joshi vs. ITO, Sonic Biochem Extractions (P.) Ltd.(supra), and CIT v. Chase Bright Steel Ltd. (No.2)(supra) reinforced the principle that arbitrary disallowances are not permissible. The Ld.CIT(A) also highlighted the inconsistency in the AO’s actions, where similar liabilities were treated differently under Sections 41(1) and 37(1) of the Act. This contradictory approach further undermined the AO’s position. The Ld.CIT(A) further emphasized the need for judicial consistency and adherence to established legal principles. Disallowances under Section 37(1) of the Act should be made only when there is clear evidence that the expenditure is not for business purposes.

8.1. Considering the detailed and reasoned findings of the Ld.CIT(A), we conclude that the disallowance of Rs. 1,06,18,997/- under Section 37(1) of the Act, was unjustified and arbitrary. The Ld.CIT(A) correctly identified that the AO failed to provide substantial evidence to support the disallowance. The assessee’s documentation, including audited financial statements and ledger accounts, sufficiently demonstrated the genuineness of the expenses. The reliance on judicial precedents was appropriate, and these precedents underscore the necessity for concrete evidence rather than estimations or assumptions when making disallowances. The AO’s approach lacked the required substantiation, leading to an erroneous addition. Therefore, we uphold the CIT(A)’s decision to delete the disallowance of Rs.1,06,18,997/- under Section 37(1) of the act.. The Revenue’s this ground is dismissed.

Revenue’s Ground No.3 is relating to disallowance of personal expenses of Rs. 1,28,273/-.

9. During the assessment proceedings, the AO scrutinized various expenses claimed by the assessee. It was found that certain expenses appeared to be personal in nature and were disallowed under Section 37 of the Income Tax Act, 1961. The total disallowance amounted to Rs.1,28,273/-. Expenses in Question were Gift Articles of Rs.64,382/- and Entertainment Expenses of Rs.63,891/- The AO observed that the expenses claimed under ‘Gift Articles’ and ‘Entertainment Expenses’ were inherently personal. The payments for these expenses were made in cash, raising further doubts about their authenticity and business necessity. The assessee provided only the ledger accounts of the mentioned expenses without any supporting documents such as vouchers, bills, or receipts. In the absence of detailed evidence to substantiate these expenses the AO questioned the legitimacy as business expenses.

10. Before the Ld.CIT(A), the assessee argued that the all payments were below the threshold limit for cash payments prescribed under Section 40A(3) of the Income Tax Act. The tax auditor had not reported these expenses as personal or non-genuine in the tax audit report, implying their acceptance as business expenses. The assessee maintained that the expenses on gifts and entertainment were legitimate business expenditures incurred for promoting business relationships and entertaining clients. The Ld.CIT(A) acknowledged that the expenses were petty cash expenses, and the non-availability of supporting bills and vouchers did not inherently prove the personal nature of the expenses. The Ld.CIT(A) noted that the AO did not bring any material on record to show that the gift articles were given to the directors or other personnel for personal purposes rather than for business promotion. Similarly, the Ld.CIT(A) noted that entertainment expenses incurred in cash without supporting documentation did not conclusively indicate personal use.

10.1. Upon reviewing the Ld.CIT(A)’s detailed findings and conclusions, we agree that the disallowance of Rs.1,28,273/- was not substantiated with adequate evidence by the AO. The AO’s decision was based on assumptions rather than concrete proof of personal use. The assessee demonstrated that the expenses were incurred for business purposes, and the tax auditor’s acceptance further supported this claim. Therefore, we uphold the CIT(A)’s decision to delete the disallowance of Rs.1,28,273/- under Section 37(1) of the Act. The Revenue’s this ground is dismissed.

Assessee’s Ground No.1 is relating to Disallowance Interest on Loan to Subsidiary of Rs. 25,25,000/-.

11. During the assessment proceedings, the AO scrutinized a loan given by the assessee to its subsidiary, M/s. Oriental Nicco Projects Pvt. Ltd., amounting to Rs.1.75 crores. The assessee claimed that the loan was given at an interest rate of 15%, but no interest income was reflected in the financial statements. The AO also observed that the assessee incurred interest expenses on its borrowings amounting to Rs.1,02,15,827/-. The AO questioned the interest-free nature of the loan, particularly given that the assessee itself had incurred interest expenses during the same period. Consequently, the AO, after concluding that the borrowed funds were not being used exclusively for business purposes, disallowed proportionate interest of Rs. 26,25,000/- (calculated at 15% of Rs. 1,75,00,000/-) under Section 36(1)(iii) of the Act.

12.Before the Ld.CIT(A), the assessee argued that it had sufficient interest-free funds to cover the loan to the subsidiary, and hence no disallowance of interest expenditure was warranted. The assessee provided a breakdown of its interest-free funds, including share capital, general reserves, and unsecured loans, totalling to Rs.17,89,98,524/- as of 31.03.2016. The assessee cited the decision of Hon’ble Supreme Court in the case of Munjal Sales Corporation v. CIT [2008] 298 ITR 298 (SC), where it was held that if sufficient interest-free funds are available, no disallowance of interest can be made. The assessee also relied on other judgments from the Gujarat High Court and ITAT Ahmedabad, which supported the principle that disallowance of interest cannot be made if interest-free funds exceed the interest-free advances. The assessee maintained that the loan to the subsidiary was for business purposes, supporting the operations of the subsidiary, which is integral to the assessee’s business strategy.

12.1. The Ld.CIT(A) considered the assessee’s claim of having sufficient interest-free funds but found it unconvincing. The Ld.CIT(A) noted that the share capital and reserves were accumulated over 45 years, making it difficult to ascertain whether these specific funds were used for advancing the loan to the subsidiary. The Ld.CIT(A) observed that the assessee did not maintain separate accounts for interest-free and interest-bearing funds. All available funds were intermingled, and no conclusive evidence was provided to demonstrate that the interest-free funds were used for the loan to the subsidiary. The Ld.CIT(A) highlighted that the assessee incurred interest expenses on borrowings totalling to Rs.3.64 crores, which suggests that the assessee did not have sufficient interest-free funds to advance the loan to the subsidiary without utilizing interest-bearing funds. The Ld.CIT(A) distinguished the facts of the assessee’s case from the judicial precedents cited. The Ld.CIT(A) noted that those cases involved situations where clear evidence of separate interest-free funds was available, unlike in the assessee’s case. The Ld.CIT(A) found no evidence to suggest that the loan to the subsidiary was given for business expediency or to exercise control over the subsidiary. The Ld.CIT(A) upheld the AO’s decision to disallow Rs.26,25,000/- under Section 36(1)(iii) of the Act.

13. Before us, the Ld.AR stated that the Ld.CIT(A) relied on the decision of Hon’ble Rajasthan High Court in case of Indian Savings Products Ltd. (265 ITR 250), where it was not a question of law and in fact the assessee company has interest free funds which are more than 10 times the loan given. From the audited financial statements, the Ld.AR explained the details of own funds as on 31-3-2016 which are as follows:

13.1. The AR also reiterated assessee’s reliance on Hon’ble Supreme Court’s decision in the case of Munjal Sales Corporation (supra).He also placed reliance on decisions of Hon’ble Gujarat High Court in case of CIT Vs. Torrent Leasing and Finance Pvt. Ltd. in TA 625 of 2006 and CIT Vs. Raghuvir Synthetics Ltd. [2013] 36 taxmann.com 275.The Ld.AR also stated that the assessee has charged interest in F.Y. 2016-17. He placed reliance on the decision of Hon’ble Supreme Court in the case of Reliance Industries (261 Taxman 165). The Ld.AR further stated that the assessee has recovered Service Charges of Rs. 70 Lacs in F.Y. 2014-15 and Sold goods worth Rs.2.39 Cr. in the current financial year and, therefore, there is interlinked business interest of two companies and the money has been given for commercial expediency. He placed reliance on the decision of Hon’ble Supreme Court in case of SA Builders (288 ITR 1).The DR, on the other hand, relied on the orders of lower authorities.

14. Upon review of the facts and the judicial precedents presented by the Ld.AR and considering the findings and decision of the Ld.CIT(A), we reach to conclusion that the Ld.AR has demonstrated, with reference to the audited financial statements as of 31-03-2016, that the assessee had substantial interest-free funds available, totalling to Rs.17,62,44,918/-(comprising Rs.12,12,00,000/- in share capital and Rs.5,50,44,918/- in reserves and surplus). This amount far exceeds the loan of Rs.1,75,00,000/- extended to the subsidiary. The Ld.AR relied on the Hon’ble Supreme Court’s decision in Munjal Sales Corporation(supra), where it was held that if an assessee has sufficient interest-free funds, no disallowance of interest under Section 36(1)(iii) of the Act can be made. The Hon’ble Supreme Court emphasized that the existence of such funds justifies the inference that the loan was advanced from these interest-free resources. Additionally, the Ld.AR cited the decision of the Hon’ble Supreme Court in Reliance Industries Ltd.(supra), affirming that when interest-free funds are sufficient to cover the loan, it can be presumed that the loan was given out of those funds, making interest disallowance unwarranted. The Ld.AR also referenced the Hon’ble Gujarat High Court’s decision in Torrent Leasing and Finance Pvt. Ltd.(supra), where it was held that if interest-free funds are available and exceed the loan amount, no disallowance is permissible under Section 36(1)(iii) of the Act. The Supreme Court’s decision in S.A. Builders Ltd.(supra), emphasized the concept of “commercial expediency,” stating that interest on borrowed funds used to provide an interest-free loan to a sister concern is allowable if the loan serves a business purpose. The Ld.AR contended that the loan in this case was given for commercial expediency, as evidenced by the service charges and sales transactions between the assessee and the subsidiary.

14.1. The Ld.CIT(A) had rejected the assessee’s claims, largely relying on the decision of the Hon’ble Rajasthan High Court in Indian Savings Products Ltd. (265 ITR 250), where the facts differed significantly from the present case. The Ld.AR argued that this case was not applicable as it did not involve a substantial question of law and was factually distinct.

14.2. The Ld.CIT(A) did not sufficiently consider the availability of substantial interest-free funds, and the principle of commercial expediency as laid down in the precedents cited by the assessee. The Ld.AR further substantiated the loan’s commercial purpose by highlighting that the assessee recovered service charges of Rs.70 lakhs in FY 2014-15 and sold goods worth Rs.2.39 crores in the current financial year to the subsidiary. This business relationship underscores the interlinked business interests and the commercial rationale behind the loan, aligning with the Hon’ble Supreme Court’s observations in S.A. Builders Ltd.

14.3. The concept of the fungibility of funds is crucial in tax assessments, particularly in cases involving the disallowance of interest under Section 36(1)(iii) of the Act. When funds are considered fungible, it means that money from various sources, whether interest-bearing or interest-free, is interchangeable and indistinguishable once it is deposited into a common pool, such as a company’s bank account. The doctrine that funds are fungible has been supported by various judicial precedents including those relied on by the assessee.

14.4. In light of the above considerations, we find that the Ld.CIT(A) erred in upholding the disallowance of Rs.26,25,000/- under Section 36(1)(iii) of the Act. The assessee has successfully demonstrated that it had sufficient interest-free funds to cover the loan to the subsidiary, and the loan was advanced for commercial expediency, thus qualifying for interest deduction under Section 36(1)(iii) of the Act. The judicial precedents cited by the assessee clearly support the allowance of such interest deductions.

Accordingly, we overturn the Ld.CIT(A)’s decision and directs the deletion of the disallowance of Rs.26,25,000/-. The appeal on this ground is allowed in favour of the assessee.

Assessee’s Ground No. 2 and 3 relates to disallowance under Section 14A read with Rule 8D amounting to Rs. 52,07,537/-.

15. During the assessment proceedings, the AO identified that the assessee had made significant investments, income from which was claimed as exempt from tax. However, the assessee did not disallow any expenses related to earning this exempt income. The assessee claimed that no expenditure was incurred to earn the exempt income and therefore did not disallow any amount under Section 14A of the Act in its return of income. The AO was not satisfied with the assessee’s claim that no expenses were incurred for earning the exempt income and invoked Section 14A of the Act and applied Rule 8D of the Income Tax Rules, 1962. The details of calculation of disallowance after application of Rule 8D are:

• Direct Expenses: The AO found no direct expenses attributable to earning the exempt income and hence did not disallow any amount under this head.
• Interest Disallowance:
  • The AO computed the proportionate disallowance of interest expenses as follows:
  • Interest Paid (A): 1,02,15,827/-.
  • Average Value of Exempt Investments (B): 1,29,22,8268/-.
  • Average Value of Total Assets (C): 60,53,10,487/-.
  • Disallowed Interest:

(A×B)/C=(1,02,15,827×1,29,22,8268)/60,53,10,487=Rs.21,80,985/−.

• Administrative/Other Expenses Disallowance:
  • The AO computed this as 0.5% of the average value of investments generating exempt income:

• • Disallowance:

(B) * 0.5% = 0.5%×1,29,22,8268=Rs.30,26,552/−

Total Disallowance under Section 14A:Interest Expenses: Rs. 21,80,985/-. (+) Administrative/Other Expenses: Rs. 30,26,552/- = Rs. 52,07,537/-.

16. Before the Ld. CIT(A), The assessee argued that the AO did not correctly apply the provisions of Rule 8D of IT Rules, particularly in relation to the interest disallowance. They contended that the AO did not properly segregate the funds used for earning exempt income from those used for business purposes. The assessee claimed that it had sufficient interest-free funds to make the investments that generated exempt income, and therefore, no interest expense should be disallowed under Rule 8D(2)(ii) of IT Rules. The assessee challenged the calculation of the indirect expenses disallowance, arguing that it was excessive and not in line with the actual expenses incurred. The Ld.CIT(A) partly upheld the AO’s application of Rule 8D of IT Rules, but directed the AO to verify the assessee’s claims regarding the interest expenses and to recalculate the disallowance accordingly. The Ld.CIT(A) recognized the need to ensure that only expenses directly attributable to exempt income should be disallowed and that a fair assessment of the assessee’s funds should be made. The Ld.CIT(A) referred to judicial precedents which emphasize that the AO must record proper satisfaction before invoking Rule 8D of IT Rules. The Ld.CIT(A) also recognized the principle that if sufficient own funds are available, they should be presumed to have been used for making the investments, thus avoiding interest disallowance.

17. Before us, the Ld.AR argued that the assessee has not earned any exempt income during the year under consideration. He placed on record the details from the financial statements that no dividend is received from the subsidiary. The Ld.AR placed reliance on the decision of Hon’ble Gujarat High Court in case of Corrtech Pvt. Ltd. 45 com 116. The Ld.AR further argued that the AO mistakenly referred to tax Audit Report of A.Y. 2015-16 where the disallowance u/s.14A of the Act, was worked out by the assessee and the assessee has not worked out such disallowance as it has not earned any exempt income during the year. The Ld.AR also placed reliance on the decision of Hon’ble Gujarat High Court in case of Gujarat Flurochemicals Ltd. [2013] 155 taxmann.com 135, where it was held that the disallowance cannot exceed exempt income. The Ld.AR also argued that when the issue is covered by the decision of Hon’ble Jurisdictional High Court, the Ld.CIT(A) should not have restored the matter back to AO. The Ld. DR relied on the order of CIT(A).

18. Upon careful consideration of the facts, judicial precedents and the arguments presented by the Ld.AR, we note that the Ld.AR argued with reference to the financial statements, that the assessee did not earn any exempt income during the year under consideration. Specifically, no dividend was received from the subsidiary, which was a key point of contention in the disallowance made by the AO. We note that the Ld.AR provided clear evidence from the financial records to substantiate this claim. We also note the reliance placed by the Ld.AR on the decision of the Hon’ble Gujarat High Court in the case of Corrtech Energy Pvt. Ltd. v. DCIT (Supra), where it was held that in the absence of any exempt income, the provisions of Section 14A and Rule 8D of IT Rules, could not be invoked. The Hon’ble Gujarat High Court’s decision clearly establishes that if no exempt income is earned during the relevant year, there is no basis for applying Section 14A to disallow any expenditure. The Ld.AR also cited the case of Gujarat Flurochemicals Ltd.(supra), wherein it was ruled that the disallowance under Section 14A cannot exceed the amount of exempt income. Although this case primarily dealt with the quantum of disallowance, it further reinforces the principle that disallowance should be directly linked to the actual exempt income earned. We also note that the AO mistakenly referred to the tax audit report for the Assessment Year (AY) 2015-16, where the assessee had worked out a disallowance under Section 14A. However, for the AY under consideration, no such disallowance was warranted because no exempt income was earned. This mistake highlights the lack of a proper basis for the AO’s decision to apply Section 14A of the Act for the relevant year. We also noted the Ld. AR’s argument that, given the Hon’ble Jurisdictional High Court’s decisions, the Ld.CIT(A) should not have restored the matter back to the AO. The AR emphasized that when a legal issue is covered by a Hon’ble Jurisdictional High Court’s ruling, the lower authorities should follow that ruling without remanding the case, as this could result in unnecessary prolongation of the litigation.

18.1. In light of the above findings, we conclude that the disallowance under Section 14A read with Rule 8D of IT Rules was not warranted for the assessment year in question. Accordingly, we overturn the Ld.CIT(A)’s decision and directs that the disallowance of Rs.52,07,537/- under Section 14A read with Rule 8D of IT rules be deleted in full. The appeal on these grounds is allowed in favour of the assessee, reaffirming the principle that disallowance under Section 14A of the Act is inapplicable in the absence of exempt income. The appeal of the assessee on these grounds is allowed.

19. In Revenue’s appeal, in ITA No.807/Ahd/2023, relating to A.Y. 2018-19 the grounds before us are:

“1. On the facts and circumstances of the case, Ld.CIT(A) erred in deleting addition of Rs.2,66,47,479/- made u/s.37(1) of the Act without appreciating that the assessee could not substantiate the expenditure with supporting evidence that it is laid out or expended wholly and exclusively for the purposes of the business?

2. The appellant craves to add, modify, amend or alter any grounds of appeal at the time of, or before, the hearing of appeal. It is prayed that the order of the CIT(A) on the above issues be set-aside and that of the Assessing Officer be restored.”

20. The return of income for the A.Y. 2018-19 was filed by the assessee on 28-03-2019 declaring total income of Rs.76,65,130/- . The case was selected for compulsory scrutiny and the AO passed order u/s.143(3) of the Act with following additions:

1. Employees’ Contribution to Provident Fund & ESI – Amount Added: Rs.13,76,711/- The AO concluded that the assessee failed to deposit employees’ contributions to the Provident Fund (PF) and ESI within the due dates specified.

2. Trade Payables: Amount Added: Rs.2,66,47,479/- The AO disallowed 10% of the total trade payables due to inadequate documentation and failure to provide proof of the genuineness of transactions. The lack of response from third parties to section 133(6) notices also contributed to this disallowance.

21. The assessee filed an appeal before the Ld.CIT(A), who partly allowed the grounds of appeal and deleted the addition of Rs.2,66,47,479/-u/s 37(1) of the Act.

22. Aggrieved by the order of the Ld.CIT(A), the Revenue filed an appeal before us with above grounds.

23. Before us, the Ld. DR relied on the order of AO and pointed out that due to the lack of adequate supporting evidence and the absence of third-party confirmations, the AO concluded that the genuineness of the trade payables could not be verified. On the other hand, the Ld.AR relied on the order of CIT(A).

24. We have noted the findings of the Ld.CIT(A) and carefully reviewed the evidence provided by the assessee, who had submitted various documents, including ledger accounts, details of PANs and confirmation letters from creditors. Additionally, the assessee provided sample invoices and explanations regarding the non-response to notices issued under Section 133(6) of the Act. The Ld.CIT(A) found that the assessee had indeed submitted sufficient evidence to substantiate the trade payables. The Ld.CIT(A) criticized the AO’s approach of making a 10% ad-hoc disallowance of the trade payables. The AO’s decision was based on a general assumption rather than specific evidence of non-genuine transactions. The Ld.CIT(A) emphasized that disallowing a percentage of trade payables without proper evidence or examination of each transaction is not justified. The Ld.CIT(A) highlighted that the assessee’s accounts were audited under both the Companies Act and Section 44AB of the Income Tax Act, 1961. The Audit Reports did not contain any adverse remarks regarding the genuineness of the trade payables. The Ld.CIT(A) noted that the AO did not adequately consider the significance of these audit reports, which should have been a strong factor in favour of the assessee. The Ld.CIT(A) observed that similar disallowances made in previous assessment years were deleted on appeal. The Ld.CIT(A) underscored the importance of judicial consistency and found no reason to deviate from the decisions made in prior years, where similar disallowances were not upheld.

24.1. We have noted that the assessee provided detailed replies to the AO regarding the trade payables associated with five specific parties during the assessment proceedings. These responses were critical in contesting the AO’s decision to disallow 10% of the trade payables under Section 37 of the Act. The assessee’s replies demonstrate a genuine effort to substantiate the trade payables, and these should have been given due weight in the assessment proceedings.

24.2. We have carefully examined the case, considering both the submissions made by the assessee and the findings of the Ld.CIT(A). After a thorough review of the facts and evidence, we uphold the decision of the Ld.CIT(A) to delete the addition of Rs.2,66,47,479/- made by the AO under Section 37 of the Act. We concur with the Ld.CIT(A) that the assessee had provided comprehensive documentation to substantiate the trade payables in question. This included ledger accounts, confirmation letters from the creditors, and sample invoices. We note that these documents are standard and credible forms of evidence in substantiating business transactions. We agree with the Ld.CIT(A)’s finding that the AO’s disallowance of 10% of the trade payables was arbitrary and lacked a rational basis. The AO’s reliance on assumptions and the non-response to notices under Section 133(6) of the Act, and without considering the extensive evidence provided by the assessee, is deemed improper. We emphasize that disallowances must be based on concrete evidence and not on mere conjecture or ad-hoc estimations. We also uphold the findings of the Ld.CIT(A)in concluding that the AO erred in including the amount of Rs.78,99,295/- relating to The Bengal Mills Stores Supply Co., which had already been added to the assessee’s income in a previous assessment year. We agree that including this amount in the current disallowance would result in double taxation, which is against the principles of natural justice. We acknowledge the unique circumstances surrounding the trade payable to Shivam Water Treaters Pvt. Ltd., which was under NCLT proceedings. We find that the Ld.CIT(A) rightly considered these circumstances in accepting the legitimacy of the trade payable despite the absence of certain confirmations. We also note that similar disallowances made in previous years were not upheld on appeal, reinforcing the importance of judicial consistency.

24.3. In light of the above findings, we conclude that the Ld.CIT(A) has correctly deleted the addition made by the AO. We find no merit in the revenue’s appeal and accordingly dismiss the same.

25. In the combined result, the Revenue’s appeals in ITA Nos.732/Ahd/2023 for AY 2016-17 & 807/Ahd/2023 for AY 2018-19are dismissed, whereas the Assessee’s appeal in ITA No.661/Ahd/2023 for AY 2016-17 is allowed.

Order pronounced in the Open Court on 27th August, 2024 at Ahmedabad.