ECO RECYCLING LIMITED,MUMBAI vs. CIRCLE 1 (2)(1)-MUMBAI, MUMBAI

The brief facts of the case are that the assessee, Eco Recycling Limited, is a company engaged in the business of acquiring discarded electronic equipment which had either become obsolete due to technological changes or had outlived its useful life, repairing/refurbishing such equipment and thereafter selling the same. For the Assessment Year 2018-19, the assessee filed its return of income on 30.10.2018 declaring a loss of ₹2,46,73,070/-.

During the course of assessment proceedings, the Assessing Officer observed that during the relevant financial year the assessee had obtained a loan of ₹6,17,92,288/- from IIFL and the assessee claimed interest expenditure of ₹55,26,820/- on the above loan as a business expenditure. The Assessing Officer asked the assessee to explain the purpose of the borrowed funds. The assessee submitted that out of the IIFL borrowing, a sum of ₹2,29,13,000/- was paid as security deposit in respect of premises taken on rent from Mrs. Aruna Soni, who was a director of the assessee-company and also the owner of the premises. The premises, being Flat No. 501, 5th Floor, Nilgiri CHS Ltd., JVPD, Vile Parle (West), Mumbai, were being used as the residence of Mrs. Aruna Soni, who was already residing there. The Assessing Officer examined the rent arrangement and found several features which, according to him, made the transaction commercially unviable. The Assessing Officer noted that the company had taken on rent the residential property of its own director only for the continued residence of that very director. He further noticed that the assessee paid an annual rent of ₹6,00,000/- at the rate of ₹50,000/- per month to Mrs. Aruna Soni, whereas the security deposit was stated to be ₹3 crores under the rent agreement, which was highly disproportionate to the annual rent. The Assessing Officer observed that the security deposit was approximately 50 times the annual rent and the Assessing Officer considered such arrangement unusual because the property belonged to the director herself and was being occupied by her. The Assessing Officer also noticed that, although clause 6 of the rent agreement required the licensee-company to bear electricity, water and insurance charges relating to the premises, these expenses continued to be borne by Mrs. Aruna Soni and no such expenditure was incurred by the assessee- company. The Assessing Officer further noted that the rent agreement was unregistered.

On the basis of these circumstances, the Assessing Officer was of the view that the arrangement was not a genuine business arrangement but a colourable device under which borrowed funds of the company had effectively been placed with its director as an interest-free advance in the guise of a security deposit. According to the Assessing Officer, the company had no genuine business requirement for taking the residential premises on rent because the director was already residing in the same property and continued to reside there even after execution of the agreement. The Assessing Officer also considered the disproportion between the rent and security deposit, the continued payment of utility charges by the director and the failure to act upon the terms of the agreement as circumstances demonstrating that the apparent relationship of landlord and tenant did not reflect the real nature of the transaction. The Assessing Officer accordingly held that the security deposit was not utilised for the business purposes of the assessee and the corporate structure and lease arrangement had been used to disguise an interest-free advance to the director. The Assessing Officer further observed that the arrangement appeared to have been adopted to avoid the consequences of the deemed dividend provisions under section 2(22)(e) of the Act and treated the transaction as a colourable device which required the corporate veil to be lifted. The Assessing Officer held that the amount of ₹2,29,13,000/- paid as security deposit was not for the business purposes of the assessee and he proportionately disallowed the interest attributable to such amount. Out of the total interest expenditure of ₹55,26,820/- claimed on the IIFL borrowing of ₹6,17,92,288/-, the proportionate interest relatable to ₹2,29,13,000/- was worked out at ₹20,49,382/-, which was disallowed on the ground that the corresponding borrowed funds had not been utilised for business purposes and hence the expenditure was not allowable under section 36(1)(iii) of the Act. The Assessing Officer also disallowed the rent expenditure of ₹4,25,000/- paid during the relevant financial year in respect of the same premises. The rent was held to be non-business expenditure because the arrangement was considered by the Ld.AO to be artificial and the premises were being occupied by the director herself. The Assessing Officer also initiated penalty proceedings against the assessee.

Aggrieved by the assessment order, the assessee preferred an appeal before the Ld. CIT(A).

The Ld. CIT(A) noted that the assessee had borrowed approximately ₹6.17 crores from IIFL and had paid approximately ₹2.29 crores as security deposit to Mrs. Aruna Soni, who was not only the owner of the property but also a director of the assessee-company. The Ld. CIT(A) further noted that the premises had been taken on rent for the residence of Mrs. Aruna Soni herself, who was already residing in the premises as its owner. The Ld. CIT(A) considered the security deposit to be highly disproportionate to the annual rent of ₹6 lakh and held that the assessee had failed to establish how giving such a substantial amount of interest-bearing borrowed funds to a related party, without any commercial benefit to the company, could constitute business expediency.

The Ld. CIT(A) also brought the transaction within the scope of section 40A(2)(b) of the Act, and held that the payment had been made to a related party and that the assessee had failed to establish the commercial justification for giving such a substantial amount to the director. Accordingly, the Ld. CIT(A) confirmed the disallowance of ₹20,49,382/- towards proportionate interest expenditure.

The Ld. CIT(A) also considered the contention regarding section 2(22)(e) of the Act and observed that the fact that the assessee was a listed public company did not, by itself, prevent the transaction from being examined on the basis of its substance. According to the Ld. CIT(A), the security deposit was, in substance, an interest-free advance to the director because the property was in the possession and enjoyment of the same director who had received the deposit.

Accordingly, the Ld. CIT(A) dismissed the grounds challenging the disallowance of ₹20,49,382/- towards interest and ₹4,25,000/- towards rent and confirmed the assessment on these issues. Consequently, the appeal was dismissed in its entirety.

The assessee is in appeal before us against the order passed by CIT(Appeals) dismissing the appeal of the assessee.

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

Ground No. 1 is general in nature. Since the specific issues raised by the assessee are dealt with in the subsequent grounds, this general ground does not require any separate adjudication.

The assessee has sought to justify the transaction on the ground of commercial expediency, stating that the personal property of the director was offered as security/collateral for obtaining credit facilities from IIFL and the payment of rent and security deposit was part of the arrangement. We are unable to accept this explanation.

The assessee must first establish a real and proximate nexus between the expenditure and the business purpose. In the present case, no such commercial nexus has been established. The assessee borrowed money from IIFL on which it was liable to pay interest. Instead of utilising the entire borrowing for its business, a substantial sum of ₹2.29 crore was given as interest-free deposit to its own director. The amount was described as a security deposit for taking on rent a residential flat belonging to that very director. The property was already being occupied by the director and continued to be occupied by her. Thus, the immediate and direct effect of the transaction was that interest-bearing borrowed funds of the company were placed, without any interest, with a related person, while the related person continued to enjoy the same residential property as owner.

The disproportion between the rent and the security deposit is also significant. The annual rent was only ₹6,00,000/-, whereas the security deposit was ₹2,29,13,000/-. The security deposit was therefore more than 38 times the annual rent. The assessee has not any shown commercial reason why an amount of this magnitude was required to be placed as security for a residential property which belonged to the director herself and which continued to be occupied by her. There is no material to show that the assessee obtained any corresponding business advantage from the arrangement.

The explanation that the deposit enabled the director to offer the flat as collateral for the IIFL borrowing also does not improve the assessee's case. If the real commercial purpose was to obtain finance by offering the director's property as collateral, the assessee was required to establish the precise terms of the financing arrangement and the commercial consideration for which ₹2.29 crore was required to be transferred to the director. No convincing material has been brought on record to show that the payment of ₹2.29 crore was a necessary for making the property available as collateral. On the contrary, the structure of the transaction shows that the company incurred an interest cost on borrowed funds while simultaneously placing a substantial portion of those funds interest-free with the director.

The Assessing Officer was, therefore, justified in examining the substance of the transaction rather than merely accepting the nomenclature of "security deposit". The surrounding circumstances cannot be viewed in isolation. The director was already residing in her own flat; the company took the same flat on rent for the director's continued residence; the annual rent was only ₹6 lakh; the security deposit was ₹2.29 crore; and the utility expenses which, under the agreement, were to be borne by the assessee-company continued to be borne by the director. These facts, taken cumulatively, show that there was no real business utilization of the corresponding borrowed funds.

We therefore find no infirmity in the order of the CIT(A), that the amount of ₹2,29,13,000/- was not utilised for the purposes of the business. The proportionate interest of ₹20,49,382/- attributable to such diversion of borrowed funds was accordingly not allowable under section 36(1)(iii) of the Act.

Ground No. 3 – Section 40A(2)(b) and alleged commercial expediency In Ground No. 3 the assessee has challenged the finding that the payment to the director was hit by section 40A(2)(b) of the Act.

At the outset, we agree with the assessee to the limited extent that a payment cannot be disallowed under section 40A(2)(b) of the Act merely because it is made to a person specified in that provision. Section 40A(2) of the Act requires examination of whether the expenditure is excessive or unreasonable looking into the fair market value, business needs and the benefit derived by the assessee. However, in the present case the finding of unreasonableness is not based merely on the relationship between the parties.

The statutory test under section 40A(2)(a) is not whether the recipient is a related party alone, but whether the expenditure is excessive or unreasonable looking into the fair market value, business needs and benefit derived by the assessee. In the present case, the assessee has failed on the aspect of demonstrating legitimate business need for giving ₹2.29 crore of interest-bearing borrowed funds with the director.

We are of the considered view that that the CIT(A) was justified in holding that the transaction did not have commercial justification and was covered by the mischief sought to be addressed by section 40A(2)(b) of the Act.

Ground No. 4 relates to the disallowance of rent expenditure of ₹4,25,000/- paid by the assessee-company to Mrs. Aruna Soni, who was its director and the owner of the premises.

The facts show that the assessee took on rent the residential flat owned by its own director and that the flat was used for the residence of the same director who was already residing there. Thus, before and after the transaction, the director continued to occupy the same premises as owner of the property. The assessee has not shown any business use of the property.

The circumstances surrounding the agreement are also material. The agreement was unregistered. Clause 6 required the assessee-company to bear electricity, water and insurance charges, but in actual conduct these expenses continued to be borne by the director. Thus, the parties themselves did not act consistently with the terms of the alleged lease arrangement. This circumstance therefore weakens the assessee's argument that the transaction was a genuine commercial lease.

In the present case, there is no evidence of business use of the premises. The director continued to occupy her own property, the company paid rent to her and a disproportionately large security deposit was also placed with the director. The above circumstances establish absence of commercial substance.

The assessee has contended that the CIT(A) erred in deciding the appeal without granting Video Conferencing despite the specific request made on 09.01.2025.

This ground was not argued before us and therefore the same is being dismissed as “Not Pressed”. Further, in the present case, the assessee has not been able to point out to any particular fact, document or legal submission which could not be placed before the CIT(A) in writing and which, if orally explained, would have changed the conclusion arrived at by CIT(Appeals).

The CIT(Appeals) order is a reasoned order dealing with the principal issues. We therefore do not find a sufficient basis, on the facts of the present case, to annul the order of CIT(Appeals) merely on this ground.

Ground No. 5 is accordingly dismissed.

Ground No. 6 is consequential and general in nature. We have independently examined the findings of the Assessing Officer and the CIT(A). Accordingly Ground No. 6 is dismissed.

During the penalty proceedings, in relation to the aforesaid additions discussed in the preceding parts of the order, the Assessing Officer, however, observed that immunity under section 270AA of the Act was not available where the case fell within the circumstances of misreporting specified in section 270A(9) of the Act. The Assessing Officer accordingly treated the amount of ₹24,74,382/- as income which had been misreported by the assessee. The Assessing Officer computed the tax payable on the misreported income at ₹6,37,154/- and penalty at 200% was calculated at ₹12,74,308/-. Accordingly, the Assessing Officer levied penalty of ₹12,74,308/- under section 270A of the Act.

The assessee thereafter challenged the penalty before the Ld. CIT(Appeals), and contended that the penalty under section 270A of the Act was not justified, the assessee had submitted Form 68 seeking immunity under section 270AA which had not been considered by Ld. AO and the additions/disallowances of ₹20,49,382/- towards interest and ₹4,25,000/- towards rent was only a difference of opinion between the assessee and the Assessing Officer and did not quantify as misreporting of income.

The Ld. CIT(A), after considering the assessment order, penalty order, grounds of appeal, statement of facts and written submissions held that section 270A provides for levy of penalty for under-reporting and misreporting of income and where under-reporting is in consequence of misreporting as specified under section 270A(9) of the Act, penalty is leviable at the higher rate prescribed under the section.

With regard to the immunity claimed by the assessee through Form 68 under section 270AA, the Ld. CIT(A) held that the penalty order had recorded that the assessee had sought immunity but that such immunity was not available in view of the circumstances covered by section 270A(9) of the Act. The Ld. CIT(A) specifically referred to clause (a) of section 270A(9) and held that immunity was not available where there was misrepresentation of facts.

We have heard the rival contentions and perused the material on record. The penalty has been levied on account of two disallowances made in the assessment proceedings, viz. ₹20,49,382/- towards proportionate interest expenditure attributable to the security deposit of ₹2,29,13,000/- paid to the director and ₹4,25,000/- towards rent paid to the director. The Assessing Officer treated the reduction in loss of ₹24,74,382/- as under-reporting in consequence of misreporting and levied penalty at 200% under section 270A of the Act.

We find that the entire basis of the penalty is the treatment of the aforesaid disallowances as “misreporting” of income. The assessment order, however, does not give any finding that the assessee had concealed any receipt, suppressed any investment, recorded any false entry, fabricated any document or furnished any false particulars. The transactions in question were duly recorded in the books of account and were examined by the Assessing Officer during the course of scrutiny assessment. The dispute was essentially with regard to the allowability of the expenditure and the business purpose or commercial expediency of the transactions.

Section 270A(8) of the Act provides for penalty at the rate of 200% where the under-reported income is in consequence of misreporting. Sub-section (9) specifies the circumstances which constitute misreporting of income, viz. misrepresentation or suppression of facts, failure to record investments, claim of expenditure not substantiated by any evidence, recording of a false entry, failure to record any receipt and certain failures relating to international transactions. Thus, for levy of penalty at the rate applicable to misreporting, the Revenue is required to establish that the case falls within one or more of the specific circumstances enumerated in section 270A(9) of the Act.

In the present case, the Assessing Officer has not given any particular fact which was misrepresented or suppressed by the assessee. There is no finding that the assessee concealed the existence of the security deposit, the rental agreement, the identity of the recipient, the fact that Mrs. Aruna Soni was a director of the assessee-company or the payment of rent. All these transactions were disclosed in the books of account and were the subject matter of examination during the assessment proceedings. The dispute was whether the expenditure claimed on the basis of these disclosed transactions was allowable under the provisions of the Act.

In our considered view, a claim which is held to be not allowable cannot, merely for that reason, be treated as a case of misrepresentation or suppression of facts. There is a clear distinction between an incorrect or legally unsustainable claim and misreporting of income. The fact that an expenditure is disallowed in the quantum proceedings does not, by itself, establish that the assessee had misreported its income within the meaning of section 270A(9) of the Act.

The assessee claimed that the security deposit and rent were connected with its business arrangements and sought to justify the same on the ground of business purpose and commercial expediency. The Assessing Officer did not accept such explanation and, on examination of the surrounding circumstances, held that the expenditure was not allowable. Even if the explanation of the assessee was rejected in the quantum proceedings, such rejection cannot automatically lead to the conclusion that the explanation was false or the assessee had misrepresented or suppressed any material fact.

We further find that the Ld. CIT(A), while confirming the penalty, has proceeded on the basis that the disallowances made in the assessment had been confirmed in the quantum proceedings. The confirmation of the quantum disallowances, however, cannot by itself establish the independent statutory ingredients necessary for levy of penalty for misreporting. The Ld. CIT(A) has not identified any specific act or omission of the assessee which falls within any particular clause of section 270A(9) of the Act. The finding of misreporting, therefore, cannot be sustained merely on the basis of confirmation of the quantum additions.

In these circumstances, we are of the considered view that the present case is essentially one of disallowance of expenditure arising from a difference of opinion regarding its business purpose and allowability and cannot be treated as a case of misreporting merely because the Assessing Officer did not accept the assessee's claim. The ingredients of section 270A(9) of the Act have not been established. Consequently, the penalty levied at 200% under section 270A(8) of the Act is not sustainable and is liable to be deleted.

In the result, the appeal of the assessee is allowed.