SHRI. POLLAMREDDY SREEDHAR REDDY,BENGALURU vs. PRINCIPAL COMMISSIONER OF INCOME TAX, BENGALURU-1, BENGALURU

PER CHANDRA POOJARI, ACCOUNTANT MEMBER:

1. The impugned order is opposed to law and facts of the case insofar as it is prejudicial to the interest of the Appellant – General Ground 2. The impugned order of revision is invalid and unwarranted inasmuch as the order sought to be revised was passed by the Ld. AO after due application of mind and after examining all the documentary evidence and considering all the explanations given by the Appellant in relation to all expenditure including those sought to be disallowed u/s 14A and the Ld. PCIT has merely substituted his own opinion in exercising jurisdiction u/s 263. – Tax effect approx.. Rs.3,62,457/- plus interest

Pollam Reddy Shreedhar Reddy, Bangalore

Page 2 of 16 3. Without prejudice to the above grounds, the action of the Ld. PCIT in directing the AO to determine the disallowance u/s 14A is untenable and unwarranted for the following reason: a) The disallowance u/s 14A is unwarranted as there was no exempt income earned during the year. b) Without prejudice to the above, the disallowance u/s 14A is untenable as the profits or losses of a partner arise from a contractual obligation and not as a result of capital investment and as such has no relationship to the capital standing to the credit of the partner. Therefore, the computation provisions provided u/s 14A r.w Rule 8D fail when applied to Partner's Capital Account.

-Tax effect as same ground 2 4. The Ld. CIT erred in not appreciating the fact that the payment made to clubs towards entrance was in furtherance of business and no personal element was involved and directing the same to be disallowed only amounts to substitution of the Ld. PCIT's opinion in place of that of the Ld. AO. – Tax effect approx.. Rs.6,929/- plus interest.

Pollam Reddy Shreedhar Reddy, Bangalore

Page 3 of 16 and 143(3B) of the Income-tax Act,1961 ['the Act' for short] on 21/01/2021 accepting the returned income of the Assessee. The Assessee had shown his capital A/c balance in M/s Sree and Sree Builders under the head Investments in his Balance Sheet. The Ld. PCIT was of the opinion that disallowance u/s 14A of the Act ought to have been made on the balance appearing under the head Investments since the income from partnership firm was exempt in the hands of the partner and proceeded to pass her order directing the AO to re-examine the disallowance u/s 14A of the Act. The Assessee had also claimed expenditure paid to clubs as entrance fees for meeting clients during the year. However, the Ld. PCIT has set aside this issue as well on the ground that this is personal expenditure and is to be disallowed. Aggrieved by the order of the Ld. PCIT, the Assessee went in appeal before us.

The relevant extract of section 263 is produced hereunder:

"Revision of orders prejudicial to revenue 263(1)………..

Explanation 2.—For the purposes of this section, it is hereby declared that an order passed by the Assessing Officer {(or the Transfer Pricing Officer, as the case may be,] shall be deemed to be erroneous in so far as it is prejudicial to the interests of the revenue, if in the opinion of the Principal Chief Commissioner or Chief Commissioner or Principal Commissioner or Commissioner,—

Pollam Reddy Shreedhar Reddy, Bangalore

Page 4 of 16 (a) the order is passed without making inquiries or verification which should have been made; (b) the order is passed allowing any relief without inquiring into the claim; (c) the order has not been made in accordance with any order, direction or instruction issued by the Board under section 119; or (d) the order has not been passed in accordance with any decision which is prejudicial to the assessee, rendered by the -jurisdictional High Court or Supreme Court in the case of the assessee or any other person."

3.1 The ld. A.R. submitted that from the above, it can be seen that in order to invoke the deeming provision, the order of the Ld. AO had to have been passed without making inquiries or verification. In the assessee's case, several information has been called for which has been duly furnished during the course of assessment proceedings including a specific query regarding disallowance u/s 14A of the Act and assessment has been accordingly completed. These matters are recorded in the order passed u/s 143(3) of the Act and this fact has also been fairly acknowledged by the Ld PCIT in her order. The assessee has explained each item of expenditure in profit and loss account in his submissions made before the Ld. AO dated 12/08/2020, thus leaving no doubt that no expenditure has been claimed as deduction against taxable business income and which relate to exempt income (whether received or otherwise). This should leave no doubt that the Ld. AO has duly verified information on expenses claimed against business income and did not find it necessary to invoke section 14A of the Act after due application of mind. Thus, the ld. A.R. submitted that it is not open to the PCIT to substitute her own views in place of that of the AO and direct revision of the order. This view is supported by the Hon'ble

Pollam Reddy Shreedhar Reddy, Bangalore

Page 5 of 16 Supreme Court in the case of Malabar Industrial Co. Ltd. v CIT (243 ITR 83).

Pollam Reddy Shreedhar Reddy, Bangalore

Page 6 of 16 These issues provoked the ld. Principal CIT to exercise jurisdiction u/s 263 of the Act since AO has not made any enquiry on these two issues. Being so, in our opinion, there is no infirmity in exercising jurisdiction by ld. Principal CIT u/s 263 of the Act, so as to set aside the assessment order passed u/s 143(3) of the Act dated 21.1.2021. Thus, exercise of jurisdiction u/s 263 of the Act by the ld. Principal CIT is upheld.

6.2 We have gone through the notice issued u/s 142(1) of the Act dated 28.7.2020 requesting the assessee to furnish details on or before 12.8.2020. With regard to other expenses, the claim of the assessee is that this expenditure included in advertisement expenditure, which is amounting to Rs.9,34,156/- and the assessee has filed the details of advertisement and business promotion expenditure vide assessee’s letter dated 12.8.2020 filed by Raghav &

Pollam Reddy Shreedhar Reddy, Bangalore

Page 7 of 16 Associates, Chartered Accountants, Hanumanthanagar, Bangalore. However, we do not find that this expenditure does not include this club membership. On the other hand, it includes the following:- a) Advertisement charges paid to BBMP – Municipal Corporation of Bangalore towards bill board charges - Rs.8,53,486/- b) Business promotion expenses - Rs. 80,700/- Total - Rs.9,34,156/- 6.3 Therefore, the ld. Principal CIT is justified in terms of clause (a) to explanation (2) to section 263 of the Act that the order passed by AO is without making enquiries or verification he should have made. Accordingly, we do not find any infirmity with regard to exercise of jurisdiction by ld. Principal CIT on this issue as the order of the AO deemed to be erroneous in so far as it is prejudicial to the interest of revenue.

7.2 The ld. A.R. submitted that a perusal of Profit and Loss Account (relating to business income) reveals that there are only two items of expenditure which can (iterated, can and not shall) qualify for computing disallowance u/s 14A, if any viz.,

Pollam Reddy Shreedhar Reddy, Bangalore

Page 8 of 16 Employee Expenses and Finance Costs. Expenditure on Purchases, Operating expenses (break-up available in Schedule 14 to the Financial Statements) and Depreciation are all completely related to business income of the assessee. The issue of investments made out of mixed funds being hit by Section 14A is no more res intergra since the issue is now settled by the decision of the Supreme Court in the _case of Principal Commissioner of Income-tax v. Shapoorji Pallonji & Co. Ltd. [2022] 141 taxmann.com 509 (SC) wherein it has held that where both interest-free and interest bearing funds were available with assessee, it is to be presumed that investments were made out of interest-free funds with an observation that sufficient interest-free funds were available with assessee which was far in excess of the loans. The assessee had furnished the complete details of every item in the profit & loss account wherein he had demonstrated that he had sufficient capital balance for his investments in the partnership firm and the borrowings had no nexus to the investment. Even the employee cost has been demonstrated to be wholly related to the individual business of the assessee. These have been analyzed by the Ld. AO himself and no adverse findings with respect to the same have been recorded. The ld. A.R. submitted that from the above it can be seen that the Ld AO has chosen not to make additions u/s 14A after due application c mind and thereafter has passed the order. 7.3 On the issue of applicability of Section 14A to share of profits from a firm the ld. A.R. extracted Section 14A of the Act as below:

‘Expenditure incurred in relation to income not includible in total income.

14A. (1) For the purposes of computing the total income under this Chapter, no deduction shall be allowed in respect of expenditure

Pollam Reddy Shreedhar Reddy, Bangalore

Page 9 of 16 incurred by the assessee in relation to income which does not form part of the total income under this Act. (2) The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under this Act. (3) The provisions of sub-section (2) shall also apply in relation to a case where an assessee claims that no expenditure has been incurred by him in relation to income which does not form part of the total income under this Act: Provided that nothing contained in this section shall empower the Assessing Officer either to reassess under section 147 or pass an order enhancing the assessment or reducing a refund already made or otherwise increasing the liability of the assessee under section 154, for any assessment year beginning on or before the 1st day of April, 2001.'

7.4 He submitted that a plain reading of the section would show that to attract the provisions of section 14A, expenditure should be incurred to earn exempt income. The disallowance of legitimate expenditure incurred towards earning taxable income cannot be made merely because the Assessee has earned exempt income. This view is supported by the decision of the Hon'ble Supreme Court in the case of Rajasthan State Warehousing Corpn. v CIT (242 ITR 450). He submitted that The proposed disallowance is untenable for the following reasons: i. The Assessee is a partner in the firm M/s Sree & Sree Builders & Promoters. The closing balance of Partner's Capital A/c as at 31st March 2018 is INR 11.80 Crores. During the AY 2018-19, an amount of INR 3.16 Crores was introduced. The partner's share of profit in a partnership firm is exempt u/s 10(2A). However, the Pollam Reddy Shreedhar Reddy, Bangalore

Page 10 of 16 exemption applies only when there is a profit in the partnership firm. In the present case, the partnership firm was still in its initial stages for the year under assessment and there was no income earned by the firm. He further submitted that the return of the partnership firm for AY 2018-19 was also subject to scrutiny and the order passed u/s 143(3) of the Act. Since the firm itself did not earn any income during the year under assessment, the assessee also did not earn any income from the firm. He relied on the decision of the High Court of Karnataka in the case of PCIT Bangalore v Sterling Developers (P) Ltd. (129 taxmann.com 116) wherein it was held that the disallowance u/s 14A is not attracted when the Assessee has not earned any exempt income. Without prejudice to the above, he also relied on the decision of the High Court of Delhi in the case of Joint Investments Pvt Ltd v CIT (2015) 372 1TR 694 (Delhi) wherein it was held that the disallowance, if any, u/s 14A cannot exceed the exempt income itself. ii. He submitted that as per section 4 of the Indian Partnership Act 1932, a partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. Further, the share of profit of a partner is decided by the contract executed between the partners and not on the basis of capital standing to the credit of the partner. A partner may be entitled to a share of profit even without bringing in any capital. The assessee holds 35% interest in the firm. However, the capital contribution of the assessee is more than 60% of the Pollam Reddy Shreedhar Reddy, Bangalore

Page 11 of 16 total capital of the partnership firm as evidenced from the financial statements of the partnership firm attached. Therefore, introducing capital into the firm is not a sine qua non of a partnership or for determining profit share.

7.5 The ld. A.R. submitted that the expenses sought to be disallowed should have nexus to the income which is exempt. As elucidated above, there is no nexus between the share of profit in a partnership firm and the capital standing to the credit of the partner. The disallowance u/s 14A cannot be made on an ad hoc basis. In case the AO is unable to determine the quantum of expenditure to be disallowed or if the AO records his dissatisfaction regarding the correctness of the Appellant's claim of expenditure incurred in relation to exempt income, the provisions of Rule 8D may be applied to quantify the disallowance. The provisions of Rule 8D is reproduced below:

'Method for determining amount of expenditure in relation to income not includible in total income. 8D. (1) Where the Assessing Officer, having regard to the accounts of the assessee of a previous year, is not satisfied with— (a) thf correctness of the claim of expenditure made by the assessee; or (b) the claim made by the assessee that no expenditure has been incurred, in relation to income which does not form part of the total income under the Act for such previous year, he shall determine the amount of expenditure in relation to such income in accordance with the provisions of sub-rule (2). (2) The expenditure in relation to income which does not form part of the total income shall be the aggregate of following amounts, namely:—

Pollam Reddy Shreedhar Reddy, Bangalore

Page 12 of 16 (1) the amount of expenditure directly relating to income which does not form part of total income; and (ii) an amount equal to one per cent of the annual average of the monthly average of the opening and closing balances of the value of investment, income from which does not or shall not form part of total income : Provided that the amount referred to in clause (i) and clause (ii) shall not exceed the total expenditure claimed by the assessee.' 7.6 At the outset, the ld. A.R. submitted that the balance in the capital account itself is a result of various transactions such as amounts brought in, share of profit, remuneration and interest on capital credited and as reduced by amounts withdrawn and share of losses. This resultant figure could result in a positive or a negative number. Assuming without admitting that provisions of section 14A r.w Rule 8D are applicable in the assessee's case, the ld. A.R. submitted that Rule 8D is a deeming provision and it is not possible to go beyond what the provision specifies. The method of computation under Rule 8D fails on many occasions if it is applied to a partner's capital A/c. One such situation is when a partner has overdrawn his capital in the firm resulting in a negative balance in the account. There is no provision in Rule 8D which provides for a situation where the resultant disallowance is a negative figure. Therefore, the computation provisions fail when applied to partner's capital A/c. The Supreme Court in the case of CIT vs. B C Srinivasa Shetty (128 ITR 294) has laid down the principle that when the computation provisions fail, the charging provisions also cannot apply since the income and tax thereon cannot be computed. Therefore, the ld. A.R. submitted that the revision order passed by the Ld. PCIT is untenable and the same ought to be quashed. For these and such other arguments

Pollam Reddy Shreedhar Reddy, Bangalore Page 13 of 16 that may be submitted from time to time, the ld. A.R. requested to examine the case in the light of justice and grant the relief sought for.

TOTAL LONG TERM 5,97,967,791.30 6,35,84,661.01 BORROWINGS 9.1 It is also noted that in the year under consideration, the assessee had borrowed additional business loan from Axis Bank and outstanding amount as on 31.3.2018 was Rs.1,91,58,681/-. So it is the duty of the assessee to show that borrowed funds have not been used to invest in firm which yielded exempted income. The contention of the ld. A.R. is that in the assessment year under consideration, the assessee is having no exempt income earned from Pollam Reddy Shreedhar Reddy, Bangalore

Page 14 of 16 the partnership firm, as such the provisions u/s 14A read with rule 8D cannot be applied. For this purpose, he relied on the judgement of Hon’ble Karnataka High Court in the case of M/s. Sterling Developers Pvt. Ltd. (129 taxmann.com 116) (Karn.), wherein held as follows: 7. “Thus, in the fact situation of the case, it was an admitted position that no dividend or exempt income was claimed by the assessee during the relevant previous year. It is well settled in law that if no exempt income has accrued to the assessee, the provisions of section 14A do not apply to the fact situation of the case. The aforesaid view has been taken by this Court in 'PRL. Commissioner of Income-tax and another v. M/s. Novell Software Development (India) Pvt. Ltd.' in decided on 16-1-2021 as well as by Delhi and Madras High Courts, reference of which has been made in paragraph 6 of the aforesaid decision.”

9.2 In our opinion, for making disallowance it has to be established on record that how much borrowed funds have been invested in exempted yielding investment and the assessee has to prove that borrowed funds have not been used for making investment in exempted income yielding assets. Hence, the contention of the assessee has to be examined by the AO as to whether exempted income earned by the assessee or not. The AO shall decide the issue, keeping in view of the decision of Hon’ble Supreme Court in the case of Max Opp Investments Ltd. Vs. CIT reported in 402 ITR 640 (SC) and also the decision of Special Bench in the case of ACIT Vs. Vireet Investments Pvt. Ltd. reported in 165 ITD 27.

Pollam Reddy Shreedhar Reddy, Bangalore

Page 15 of 16 10. Next argument of assessee’s counsel is that when both interest free and interest-bearing funds are available with the assessee, it was to be presumed that investment in exempted yielding assets were made out of interest free funds. For this purpose, he relied on the judgement of Hon’ble Supreme Court in the case of Principal CIT Vs. Shapoorji Pallonji Company Ltd. (288 taxman 661) (SC). However, it was also noticed in that judgement that assessee had not utilized interest bearing borrowed funds for making interest free advances as assessee had its interest free funds far in excess of interest bearing. Hence, this judgement has no application to the facts of the assessee’s case. Accordingly, the issue is set aside to the file of AO to examine the applicability of section 14A of the Act read with Rule 8D of the Income Tax Rules.

Order pronounced in the open court on 20th July, 2023