DCIT CC 5(3), MUMBAI vs. MR. AJIT KUMAR RESOLUTION PROFESSIONAL OF ESKAY KNIT (INDIA), MUMBAI

The brief facts of the case are that the assessee, engaged in the business of manufacturing cotton yarn, circular knitted fabrics, hosiery and processing of cloth. The assessee filed its return of income on 29.09.2012 declaring a loss of ₹41,61,78,272/-. The Assessing Officer issued notice under section 143(2) on 07.08.2013 and thereafter issued notices under section 142(1) calling for various details. Since the assessee did not furnish complete details and supporting records, the Assessing Officer proceeded to complete the assessment under section 144 of the Act on 31.03.2015 and assessed the loss at ₹18,37,91,129/- after making various additions and disallowances.

During the course of assessment proceedings, the Assessing Officer first examined the gross profit disclosed by the assessee. The assessee had shown a GP rate of 8.39% on turnover of ₹1,051.53 crores as against a GP rate of 15.43% on turnover of ₹930.01 crores in the immediately preceding year. The Assessing Officer asked the assessee to furnish party-wise details of purchases and sales exceeding ₹25,000/-, including names, addresses, PAN and VAT numbers, as well as purchase invoices, transport receipts, octroi and cess receipts, stock registers, details of receipt and sale of goods and evidence of payments through the bank. The assessee furnished only partial details and stated that the supporting books, bills and vouchers had been destroyed in a fire. The Assessing Officer did not accept the plea that the tax audit report alone was sufficient to establish the genuineness of purchases and sales.The Assessing Officer thereafter independently obtained addresses of some purchase and sale parties from the MCA website, issued notices under section 133(6) of the Act and deputed the Inspector for local enquiries. The Assessing Officer also asked the assessee to produce the purchase and sale parties, but the assessee did not produce them. The Assessing Officer further relied upon the survey conducted under section 133A in the Tayal Group on 10.09.2013, during which the Investigation Wing had found instances of bogus expenditure and transactions between group concerns. The Assessing Officer also took note of the statements of Shri Pravin Kumar Tayal and the auditor concerning reconstruction of the books after the fire and held that the assessee could have reconstructed and produced the books but had failed to do so. The Assessing Officer therefore held that the correctness of the books could not be verified.

The Assessing Officer accordingly rejected the books of account under section 145(3). The Assessing Officer also considered the assessee's explanation that the fall in GP was because of in lack of working capital, adverse conditions in the textile industry, increase in raw-material prices, higher power, labour and interest costs and delay in TUFS subsidy. However, the Assessing Officer did not find the explanation to be supported by evidence. Though the fall in GP as compared with the preceding year was about 7%, the Assessing Officer estimated an addition at 1.75% of the turnover of ₹1,051.53 crores and made a GP addition of ₹18,40,18,485/-.

The Assessing Officer examined the increase in working capital borrowings. The working capital loan had increased by ₹26.06 crores over the preceding year. The Assessing Officer asked the assessee to explain the purpose and utilisation of the borrowed funds and to furnish supporting evidence. Since the assessee did not furnish satisfactory evidence showing actual utilisation of the increased borrowing for business purposes, the Assessing Officer estimated interest at 14% per annum for six months and made an ad hoc disallowance of ₹1,82,40,810/-.

The Assessing Officer also noticed from AIR information that assessee had made cash deposits of ₹28,15,037/- in Corporation Bank and ₹1,08,93,786/- in State Bank of India, aggregating to ₹1,37,08,823/-. The assessee stated that the deposits were out of cash sales. The Assessing Officer did not accept the explanation because the assessee did not furnish the cash book, details of customers, bills, invoices or other supporting evidence. The Assessing Officer

The Assessing Officer further noticed that the assessee had made investments of ₹24.49 crores in equity shares. The assessee had not made any disallowance under section 14A of the Act. The assessee submitted that no exempt income had been earned during the year and therefore section 14A of the Act did not apply. The Assessing Officer rejected this contention and held that expenditure could be disallowed even in the absence of exempt income. The Assessing Officer invoked Rule 8D and made a disallowance of ₹1,64,19,025/-, comprising of interest expenditure of ₹1,51,94,570/- under Rule 8D(2)(ii) and administrative expenditure of ₹12,24,455/- under Rule 8D(2)(iii).

Aggrieved by the assessment order, the assessee carried the matter before the learned CIT(A). As regards the rejection of books and the GP addition, the learned CIT(A) agreed with the Assessing Officer that the books were not reliable. The learned CIT(A) found that the assessee had failed to furnish complete addresses, PAN and VAT details of parties, purchase bills, delivery challans, transport receipts, octroi receipts, stock records and confirmations of purchase parties. The learned CIT(A) further observed that the enquiries conducted by the Assessing Officer under section 133(6) of the Act and through the Inspector did not support the genuineness of several parties and some addresses did not even exist. The learned CIT(A) also took note of the assessee's failure to produce reconstructed books or the parties even at the appellate stage. The learned CIT(A) therefore held that the Assessing Officer had sufficient reasons to reject the books under section 145(3) of the Act and to make a best judgment assessment under section 144 of the Act.

However, the learned CIT(A) did not accept the exact rate of GP adopted by the Assessing Officer. The learned CIT(A) noticed that the Assessing Officer had increased the disclosed GP rate of 8.39% to 10.14% by making an addition of 1.75%, but had not given any cogent reason for adopting precisely 1.75%. The learned CIT(A) compared the assessee with another group company, M/s K- Lifestyle & Industries Ltd., which was engaged in the same line of business and whose GP had been estimated at 11.39%. The learned CIT(A) considered that some allowance should still be given for differences in scale and the business factors pointed out by the assessee, but held that a further increase of 0.75% was justified. The learned CIT(A) therefore enhanced the GP addition by ₹7,88,65,065/- and increased the total GP addition from ₹18,40,18,485/- to ₹26,28,83,550/-. Ground No. 1 was accordingly dismissed with enhancement.

Finally, on the disallowance under section 14A, the learned CIT(A) found that the assessee had admittedly not earned any exempt dividend income during the year. The learned CIT(A) noticed that the Special Bench decision in Cheminvest Ltd., on which the Assessing Officer had relied, had subsequently been reversed by the Hon'ble Delhi High Court, which held that section 14A of the Act would not apply where no exempt income had been received or was receivable during the relevant previous year. The learned CIT(A) also relied upon the decision of the Mumbai Tribunal in the case of another group concern, M/s Krishna Knitwear Technologies Ltd., wherein the Tribunal had followed the same principle. The learned CIT(A), therefore, held that in the absence of any exempt income, the Assessing Officer could not invoke section 14A read with Rule 8D and directed deletion of the disallowance of ₹1,64,19,025/-.

Thus, the learned CIT(A) partly allowed the appeal. The learned CIT(A) upheld the rejection of the books of account and further enhanced the GP addition to ₹26,28,83,550/-, deleted the interest disallowance of ₹1,82,40,810/-, confirmed the unexplained cash deposit addition of ₹1,37,08,823/- under section 69A, and deleted the disallowance of ₹1,64,19,025/- made under section 14A read with Rule 8D.

The Department is in appeal before us against the order passed by CIT(Appeals) against the additions deleted by the CIT(Appeals).

We have heard the rival submissions and perused the material available on record.

The Department has raised two grounds. Ground No. 1 is with respect to deletion of the disallowance of ₹1,82,40,810/- on account of interest attributable to the incremental working capital borrowing, whereas Ground No. 2 is with respect to deletion of the disallowance of ₹1,64,19,025/- made under section 14A read with Rule 8D.

As regards Ground No. 1, the Assessing Officer noticed that the assessee's working capital borrowing had increased by ₹26.06 crores during the year. The Assessing Officer asked the assessee to furnish details regarding the purpose and utilisation of the borrowed funds. Since the assessee did not furnish the complete supporting evidence sought by the Assessing Officer, the Assessing Officer presumed that the assessee had not utilised the incremental borrowing wholly for business purposes. The Assessing Officer thereafter adopted an interest rate of 14% and estimated interest for a period of six months at 7% of ₹26.06 crores, thereby making an ad hoc disallowance of ₹1,82,40,810/-.

The learned CIT(A), however, examined the Balance Sheet and found that the assessee had working capital borrowings of ₹252 crores as against closing inventory of ₹212.88 crores and trade debtors of ₹171.34 crores, aggregating to ₹384.22 crores. The learned CIT(A) therefore found that the working capital borrowing was only about 65% of the current assets. The learned CIT(A) further observed that the Assessing Officer had not brought any material on record to establish that the assessee had diverted any part of the borrowed funds for non- business purposes or had advanced the borrowed money interest-free to sister concerns or related parties. The learned CIT(A) also noticed that the assessee's turnover had increased from about ₹930 crores to ₹1,052 crores during the year. On these facts, the learned CIT(A) held that the Assessing Officer had made the disallowance merely on an assumption and deleted the same.

We find no infirmity in the order of the learned CIT(A). The basic requirement for making a disallowance of interest on the ground of non-business utilisation is that the Assessing Officer must establish some nexus between the interest-bearing borrowed funds and their diversion for non-business purposes. Merely because the assessee did not furnish every document sought by the Assessing Officer would not, by itself, establish that the borrowed funds were diverted outside the business.

In the present case, the Balance Sheet itself showed substantial inventory and debtors aggregating to ₹384.22 crores against working capital borrowings of ₹252 crores. These are normal business assets for which an assessee engaged in manufacturing and trading would ordinarily require working capital. The Assessing Officer did not identify any specific non-business investment, interest-free loan, advance to a related concern or withdrawal to which the incremental borrowing of ₹26.06 crores could be linked. In the absence of such nexus, the Assessing Officer could not simply presume that the incremental working capital borrowing had been used for purposes other than the assessee's business.

The Hon'ble Bombay High Court in CIT v. Reliance Utilities & Power Ltd. [2009] 313 ITR 340 (Bom.) held that where both interest-free funds and borrowed funds are available and the assessee has sufficient own funds, a presumption arises that the investment has been made from the assessee's own funds. The principle has subsequently been applied by the Hon'ble Bombay High Court while considering disallowance of interest expenditure as well.

The principle is relevant here because the Assessing Officer has to first establish the factual nexus before disallowing interest. The Assessing Officer had the Balance Sheet before her. Once the Balance Sheet confirmed substantial business current assets and the Department could not identify any corresponding non-business diversion, an estimated disallowance based simply upon 7% of the incremental borrowing had no basis.

The manner in which the Assessing Officer quantified the disallowance is also significant. The Assessing Officer adopted the rate of 14% and then assumed utilisation for six months, thereby arriving at 7% of ₹26.06 crores. The Assessing Officer did not establish the actual dates on which the incremental borrowings arose, the specific amounts outstanding during different periods, or the particular non-business purposes for which the borrowed funds were utilised. The computation was therefore entirely on an estimation basis.

The learned CIT(A), on the other hand, examined the actual financial position and found that the assessee had current assets substantially exceeding the working capital borrowing and the turnover had also increased by about 13%. The learned CIT(A) further observed that the Assessing Officer had not demonstrated diversion of borrowed funds. We therefore find that the learned CIT(A) correctly appreciated the factual position and rightly deleted the ad hoc disallowance.

Accordingly, Ground No. 1 raised by the Department is dismissed.

Coming to Ground No. 2, the Department has challenged the deletion of the disallowance of ₹1,64,19,025/- made by the Assessing Officer under section 14A read with Rule 8D.

The learned CIT(A) noticed that the Hon'ble Delhi High Court had subsequently reversed the Special Bench decision in Cheminvest Ltd. and had held that section 14A of the Act would not apply where the assessee had not received or earned exempt income during the relevant previous year. The learned CIT(A) also relied upon the decision of the Mumbai Tribunal in the case of another group concern, M/s Krishna Knitwear Technologies Ltd., and deleted the entire disallowance.

We find that the issue is covered by the settled legal position applicable to the year under consideration. The Hon'ble Delhi High Court in Cheminvest Ltd. v. CIT [2015] 378 ITR 33 (Del.) held that section 14A does not apply where no exempt income is received or receivable during the relevant previous year. The Delhi High Court has continued to follow this principle in subsequent decisions.

We find that the view taken by the learned CIT(A) is supported by the decisions of the jurisdictional Hon'ble Bombay High Court. In Principal CIT v. Red Chillies Entertainment (P.) Ltd. [2020] 116 taxmann.com 770 (Bom.), the Hon'ble Bombay High Court considered the specific question whether disallowance under section 14A read with Rule 8D could be made where the assessee had not earned any exempt income during the relevant previous year. The Hon'ble High Court held that in the absence of any exempt income arising during the relevant previous year, no occasion to make a disallowance under section 14A could arise. The Revenue's challenge to the order of the Tribunal deleting the disallowance was accordingly rejected.

The issue is still more directly covered by the judgment of the Hon'ble Bombay High Court in Principal CIT v. Kohinoor Project (P.) Ltd. [2020] 121 taxmann.com 177 (Bom.)/[2021] 276 Taxman 180/[2020] 425 ITR 700 (Bom.). In that case also, the assessee had made substantial investments in shares but had not earned any exempt income during the relevant previous year. The Assessing Officer made a disallowance under section 14A read with Rule 8D. The Hon'ble High Court, after considering the language of section 14A(1) and the decision of the Hon'ble Delhi High Court in Cheminvest Ltd. v. CIT [2015] 378 ITR 33 (Delhi), held that the expression "income which does not form part of the total income" contemplates the existence of actual exempt income during the relevant previous year. The Hon'ble High Court therefore held that section 14A would not apply where no exempt income was received or was receivable during the relevant previous year. The mere existence of investments which could potentially yield exempt income in future was held to be insufficient for invoking section 14A of the Act.

The above legal position is further supported by the judgment of the Hon'ble Bombay High Court in Principal CIT v. Ajit Ramakant Phatarpekar [2021] 124 taxmann.com 124 (Bom.)/[2021] 277 Taxman 543/[2020] 429 ITR 319 (Bom.). In that case, the assessee had earned exempt dividend income of only ₹45,371/-, whereas the Assessing Officer had computed a substantially higher disallowance under section 14A. The Hon'ble High Court, following Nirved Traders (P.) Ltd. v. Dy. CIT, held that the disallowance under section 14A cannot exceed the exempt income actually earned by the assessee during the relevant assessment year. The Court therefore rejected the Revenue's challenge.

Thus, the principle emerging from the aforesaid decisions of the jurisdictional High Court is clear. The operation of section 14A is linked to exempt income arising during the relevant previous year. Where no exempt income is earned or receivable, there can be no disallowance under section 14A; and where some exempt income is earned, the disallowance cannot exceed such exempt income. The mere fact that the assessee holds investments which are capable of yielding exempt income cannot, by itself, justify a disallowance under section 14A of the Act.

In the present case, it is not the case of the Revenue that the assessee had earned any exempt income during the year under consideration. Therefore, respectfully following the binding judgments of the Hon'ble Bombay High Court in Red Chillies Entertainment (P.) Ltd. (supra) and Kohinoor Project (P.) Ltd. (supra), and also taking support from Ajit Ramakant Phatarpekar (supra), we find no infirmity in the order of the learned CIT(A) deleting the disallowance of ₹1,64,19,025/- made by the Assessing Officer under section 14A read with Rule 8D.

Accordingly, Ground No. 2 raised by the Department is dismissed.

In the result, the appeal filed by the Department is dismissed.