KALI BMH SYSTEMS PVT. LTD.,,KUMBAKONAM vs. DCIT, CIRCLE - 2 (1),, TRICHY

(अपीलाथ�/Appellant) (��थ�/Respondent) अपीलाथ� की ओर से / Appellant by : None ��थ� की ओर से/Respondent by : Shri D. Hema Bhupal, JCIT सुनवाई की तारीख/ Date of hearing : 12.09.2022 घोषणा की तारीख /Date of Pronouncement : 16.09.2022 आदेश /O R D E R

PER V. DURGA RAO, JUDICIAL MEMBER:

Table – 1A Liabilities (₹.) Assets (₹.) Capital 2000 Fixed Assets – Land 1000 Net Current Assets (NCA) 1000 (current assets – current liabilities) Total 2000 Total 2000 Clearly, any withdrawal up to ₹. 2,000/- (by assuming bank credit, or from other sources), depicted as under, would only imply withdrawal of capital: Table – 1B Liabilities (₹.) Assets (₹.) Bank 2000 Fixed Assets – Land 1000 Borrowings Net Current Assets (NCA) 1000 (current assets – current liabilities) Total 2000 Total 2000 Any withdrawal beyond this would result in negative capital, a case of withdrawal by the partners of the firm’s resources (in excess of their contribution thereto). The contribution toward a fixed asset would, in nominal terms, stand enhanced in case of revaluation, say by ₹. 4000/- (Table 2A), without having any material impact in-as-much as the firm’s capital (equity) finances its assets, the purpose of which (revaluation) would presumably be to state the firm’s assets and liabilities at their realistic values and, thus, represent more truly its net worth. A consideration which becomes largely irrelevant as the firms’ intrinsic worth remains the same, and is not to be altered in case of succession. Why, the revaluation could as well be undertaken after the succession, increasing the net-worth of the transferee-company (in nominal terms) to the same extent. Be that as it may, this enhanced net worth would not therefore stand to reduce, except by operation of economic forces/reasons, viz. fall in the market price of land; depletion of capital on account of business losses, et. al. It is, therefore, the withdrawal of this ‘enhanced’ capital (Table 2B) that presents a host of questions. To begin with, it defeats the very purpose of revaluation. Further on: Could, the revaluation credit be made to the partner’s capital accounts; Could, assuming so, the same be withdrawn; Does it not defeat the very purpose of revaluation; What, where permissible, does the said withdrawal represent; Would the partners be entitled to interest under the partnership law and, consequently, under the Act (which is assessable u/s. 28) on such enhanced capital; What is the accounting prescription – including its rationale, in the matter, etc. We depict the said scenarios as under: Table – 2A Liabilities (₹.) Assets (₹.) Capital 6000 Fixed Assets 5000 Net Current Assets (NCA) 1000 Total 6000 Total 6000 Table – 2B Liabilities (₹.) Assets (₹.) Capital Nil Fixed Assets 5000 Bank 6000 Net Current Assets (NCA) 1000 Borrowings Total 6000 Total 6000 Now, surely if this (Table 2B) position obtains as on 31st March, i.e., immediately prior to the conversion, any introduction of (up to) ₹. 6,000/- could not be said to be non-infusion of funds, the ‘new’ borrowings (from the erstwhile partners) going to either finance acquisition of further assets and/or repayment of the firm’s borrowings to any extent. There should apparently be therefore no disallowance of interest on debentures (say) issued against such infusion of funds (or borrowing). This in fact is also the premise of the impugned order. However, we say ‘apparently’ in-as-much as the same would require, apriori, examining the facts as well as the legal position, delineated in the form of various questions, to none of which the impugned order refers, much less addresses. Could, for instance, the bank borrowings, which stand utilized for withdrawal of capital, be said as made or utilized for business purposes, entitled to interest deduction? Could the capital introduced, restoring status ante, be regarded as infusion of capital? That apart, the fact of the borrowing being from the erstwhile partners is inconsequential insofar as the deduction of interest thereon, and which is what the premium on the redemption of debentures essentially is, is concerned. However, any withdrawal in excess of ₹. 2,000/- (or ₹. 6,000/- in case of revaluation) surely cannot be regarded as valid inasmuch as the same is clearly a diversion of capital of the firm for personal (non- business) purposes. The excess is only a withdrawal by the partners of the firm’s resources in excess of their contribution thereto, or an appropriation of its liabilities by them, which we may depict as per the Tables below:

Table – 3A Liabilities (₹.) Assets (₹.) Bank Borrowings 6000 Fixed Assets 1000 Net Current Assets (NCA) 1000 Partner’s Capital 4000 Total 6000 Total 6000 Table – 3B Liabilities (₹.) Assets (₹.) Bank Borrowings 10000 Fixed Assets 5000 Net Current Assets (NCA) 1000 Partner’s Capital 4000 Total 10000 Total 10000 Tables 3A & 3B represent equivalent scenarios as, in either case, no debentures could possibly be issued to the directors (erstwhile partners) on infusion of funds to the extent of ₹.4,000/- (in our example). As afore-noted, any infusion (of funds by the directors) in excess of ₹. 4,000/-, in either case, may be eligible to the regarded as, as per the terms of the introduction, either capital or borrowing, with the interest on the latter being ostensibly entitled for deduction in case of a company. We may, therefore, state that the impugned order, in which the assessment order has since merged, requires to be modified to state that only infusion in excess of the deficiency in capital (what had been earlier referred to by us as negative capital), ₹. 4000 in our example, that may arise if the capital is reckoned without revaluation in-as-much as the same is only a case of withdrawal of the firm’s resources in excess of the contribution thereto, appropriating thus the liability of the firm, would be entitled to deduction on account of interest. We shall revert to Table 3B subsequently as well. We may now dwell on certain aspects arising for consideration, enumerated earlier. The credit of the revaluation of the partner’s capital account is inconsistent with the partnership law. This is as no partner can, during the subsistence of a firm, claim credit in respect of increased valuation (of any of the firm’s assets) to any extent, as no partner can predicate his share in any of the assets of the firm. It is only at the time of the dissolution of the firm that its’ assets, in excess of that required for meeting its liabilities, can be distributed amongst the partners in the ratio of their respective capitals. And whereat, therefore, in-as-much as an asset may not admit of physical division or be otherwise desirable, revalued to obtain parity between those (partner/s) taking over the asset/s and those not. Equally, a partner, on retirement, can, similarly, instead of being paid in cash, choose his capital to be discharged, wholly or partly, by being allotted a particular asset/s. A revaluation in such a case may follow; would, rather, even as explained in A.L.A. Firm v. CIT [1991] 189 ITR 285 (SC), be desirable in-as-much as it enables the partners to settle their accounts on a more realistic basis. The (Income Tax) law recognizes such situations, contemplating it to be a transfer of the specified asset by the firm to the partner/s (or vice-a-versa, in the event of introduction of an asset by a partner in the firm), deeming in case of distribution or allotment the fair market value thereof as its transfer consideration (ss. 45(3) and 45(4)). There is no question of any partner in a firm having a defined share in any of the firm’s assets during its subsistence. As afore-noted, succession of a partnership firm by a company is not regarded as a transfer under the Act where its business is transferred as a going concern, provided, of course, it is not a device to evade tax by realizing the value of the assets by its partners, by sale of shares or otherwise. The credit on the revaluation of the asset by a firm could not therefore be made to the capital account of any of its partners (and, by implication, to all the partners), during its subsistence. This is in view of the nature of the relationship, and notwithstanding the fact that under partnership law there is no difference between a firm and the partners constituting it for the time being; the partnership only signifying a contractual relationship between them, and its name a compendious manner of referring to the partners together and their defined relationship. As explained, such a credit is not admissible under the Act as well, which regards partnership as a different person, separate and distinct from the partners, so that the transfer of an asset by one to the other is liable for capital gains u/s.

categories of fixed assets. In such cases, it is necessary to disclose the gross book value included on each basis. 13.5 Selective revaluation of assets can lead to unrepresentative amounts being reported in financial statements. Accordingly, when revaluations do not cover all the assets of a given class, it is appropriate that the selection of assets to be revalued be made on a systematic basis. For example, an enterprise may revalue a whole class of assets within a unit. 13.6 It is not appropriate for the revaluation of a class of assets to result in the net book value of that class being greater than the recoverable amount of the assets of that class. 13.7 An increase in net book value arising on revaluation of fixed assets is normally credited directly to owner's interests under the heading of revaluation reserves and is regarded as not available for distribution. A decrease in net book value arising on revaluation of fixed assets is charged to profit and loss statement except that, to the extent that such a decrease is considered to be related to a previous increase on revaluation that is included in revaluation reserve, it is sometimes charged against that earlier increase. It sometimes happens that an increase to be recorded is a reversal of a previous decrease arising on revaluation which has been charged to profit and loss statement in which case the increase is credited to profit and loss statement to the extent that it offsets the previously recorded decrease.’ [emphasis, supplied] Further, depreciation on such revalued asset/s, where depreciable, is to be provided on the enhanced value and, two, debited to the revaluation reserve to the extent it relates to the increased amount. And which, it would be noted, is consistent with the premise that what all is being done is to restate the asset at an enhanced value, and does not entail or involve any flow of funds. Thus, the withdrawal of funds by the partners in the present case is to be considered de hors the credit on account of revaluation. The withdrawal of the credit on account of revaluation (i.e., even granting the credit) suffers from another basic infirmity in law as well as accounts – the mandate of both of which we have afore-noted, and which becomes apparent when one considers as to what does the same represent, also explaining indirectly the premise of the revaluation of a capital asset for an economic entity. The asset, land in the present case, continuing to be a part of the firm’s assets, how, one wonders, could the credit of revaluation be withdrawn on payment of funds to the partners? Each accounting entry represents the relevant transaction; its purport, and considered along with the narration thereto, the purpose thereof. The credit on account of revaluation represents a part of the value of the relevant asset. The only manner, therefore, whereby the said credit could be debited (neutralized) or diminished is by transfer of the said asset to a partner/s withdrawing it from the firm – in whole or in part, as explained earlier in the context of dissolution of a partnership or retirement of a partner/s there-from. It could not be otherwise. For example, if 50 per cent. of the land is transferred to a partner/s, his account/s would stand debited by 50% of the value (₹. 5,000/-, in our example), i.e., by ₹. 2,500/-. A debit balance in his account upon such debit only makes him the firm’s – which now has only 50 per cent. of the land, debtor to that extent. The entire value of the asset (land), at ₹. 5,000/- in our example, is one, single amount, representing and forming part of the firm’s equity (net worth). The firm’s capital to that extent (₹. 5,000/-) would therefore represent the said asset. As long as therefore the said asset of the firm is retained by it, its’ capital cannot be regarded as below the said amount (refer Table-1A/2A). Proceeding further on this conceptual framework, what, then, does the scenarios at Tables 1B/2B represent? The firm has leveraged its capital, reckoned with or without revaluation, to secure borrowings, and no further. That is, the withdrawal by the partners reflects a diversion of the firm’s borrowings by them to that extent, which may depict as under: Table – 1C Liabilities (₹.) Assets (₹.) Partner’s capital 1000 Fixed Assets – Land 1000 Net Current Assets (NCA) 1000 Bank Borrowings 2000 (current assets – current liabilities) Partner’s capital 1000 Total 3000 Total 3000 Table – 2C Liabilities (₹.) Assets (₹.) Partner’s capital 1000 Fixed Assets 5000 Revaluation reserve 4000 Net Current Assets (NCA) 1000 Bank Borrowings 6000 Partner’s capital 5000 Total 11000 Total 11000 Tables 1C and 2C are thus a more correct representation of the scenarios at Tables 1B and 2B respectively. Not so considering would only imply a transfer of the fixed asset/s to the partners, i.e., not in specie, but in effect, realizing its value by monetizing it. This, it may be appreciated, is an equivalent manner of transferring a capital asset; the partners being credited the difference between the market (transfer) value and the book value, and, then ‘withdraw’ their capital. This, where coupled with a reorganization of the firm, i.e., introduction and retirement of partner/s, even if in a graded manner, amounts to a change of ownership through the medium of partnership. The practice stands cautioned against time and again by the Hon'ble Apex Court per its decisions prior to the introduction of ss. 45(3) and 45(4) (of the Act), while at the same time confirming that there could be no transfer of an asset between a firm and its partners, who have an undefined share in each of them, inasmuch as the exclusive interest of a partner gets converted into a shared interest, the same is not chargeable to capital gains u/s. 45 (viz. Sunil Siddarthabhai v. CIT [1985] 156 ITR 509 (SC) – on which reliance is placed). The withdrawal of ‘capital attributable to a fixed asset, intended to be retained as part of the capital structure of the firm, amounts to it’s monetization by the partners for their personal purposes, and is clearly impermissible, both from the stand-point of credit to the partner’s capital account (on revaluation) and its withdrawal, considered from any perspective – legal, accountancy, and also tax. Coming back to the facts of the present case, it would be now clear as to what precisely the AO means when he speaks of non infusion of funds; the partners only restoring the value of the fixed assets, since withdrawn, and which could not be regarded as infusion of fresh capital in- as-much as the fixed asset continues throughout to be the firm’s property. The other import of the foregoing is that on an introduction of ₹. 2,000/- in Scenario 1, debentures could be issued to the partners only for ₹. 1,000/-, the balance going to neutralize (credit) the negative capital. Could the assessee possibly be entitled to deduction of interest on such borrowings, i.e., to that extent these represent the increase in valuation of a firm’s (entity’s) fixed (capital) asset/s forming part of the capital structure. We think not; it being without any business purpose. That is, while the inflow of funds by the directors, to the extent of ₹. 2,000/-, substituting bank borrowings, would qualify for deduction of interest thereon (or, strictly speaking, on ₹. 1000/-), that in excess, representing only an increase in the valuation by the firm of its capital asset/s, shall not; the same being sans any business purpose, which alone would entitle the borrowing by an assessee for deduction of interest thereon u/s. 36(1)(iii). This, thus, answers the second question arising in the instant case (refer para 3). It may not be out of place to state here that the disallowance of interest (to the proportionate extent), i.e., on ₹. 4,000/- (i.e., the enhanced valuation), has nothing to do either with s. 47(xiii) or the swapping of bank borrowings with that by the directors, being issued debentures. Irrespective of the extent of the swapping, the borrowing in excess of ₹. 2,000/- (or, strictly speaking, ₹. 1,000/-), representing the firm’s assets, serves no business purpose and, accordingly, interest thereon is disallowable u/s. 36(1)(iii). The same, in fact, represents a swapping of funds by leveraging the value of the firm’s asset/s. The position would be different, we may clarify, where the bank borrowings were assumed to finance genuine business losses. Though this has nothing in common with or to do with revaluation of assets by a business entity, credit on account of which and its subsequent withdrawal is the issue in the present case, we yet consider it relevant to state this as it may well be that revaluation in a given case is resorted so as to not reflect negative capital on account of operational losses, since financed by bank borrowings. The bank borrowings in such a case represent financing of such losses; the firm’s capital being insufficient to absorb the same. There is no depletion or withdrawal of capital by the equity holders, as in the present case, in such a case. The inference of the borrowing (debentures) as being not against revaluation reserve (funds) by the ld. CIT(A) is clearly misplaced; in fact, contrary to the basic facts of the case. This in fact is precisely why the same has been regarded as not genuine by the Revenue, a gimmick, and, in any case, not relating to the business of the assessee. We have already shown the modus operandi adopted as being in violation of the accounting principles and the partnership law. The same is also proscribed under the Act, being inconsistent with the clear terms of the relevant provision (s.36(1)(iii)), which allows interest only on the borrowings made for business purposes, while the borrowing in the present case is made only to enable siphoning of funds under the guise of enhanced capital. The foregoing would also resolve the anomaly in Scenario-3, represented by Tables 3A and 3B. While Table 3A would bar interest on bank borrowings to the extent of ₹. 4,000/-, allowing it thus only on ₹. 2,000/-, Table-3B, again, apparently allows interest on bank borrowings up to ₹. 6,000/-. The assessee, thus, merely by enhancing fixed asset/s, is able to obtain interest deduction on capital to that extent, i.e., ₹. 4,000/-. As discussed hereinbefore, this would not be a business purpose (except where the funds released by the bank are deployed in business, though lost through losses, so that it does not result in any increase in net current assets or the net worth of the company), and therefore disallowable u/s. 36(1)(iii). Our graded approach, however, necessitated drawing a distinction between the three categories/scenarios, marked by respective tables, which we may summarize as under: Scenario-1:Borrowing represents the firm’s capital (Table-1A/1B). Scenario-2: Borrowing includes enhanced capital, on account of revaluation (Table-2A/2B). Scenario-3: Borrowing includes diversion of capital, i.e., even in excess of capital/enhanced capital (Table-3A/3B). Clearly, only the borrowing, be it from bank or that by the directors, as reflected under Scenario-1, more correctly represented by Table 1C, would be eligible for deduction of interest thereon. Considered thus, the proposition advanced for being accepted by us is in principle very simple.

Shorn of all nuances, regard for which however had to be made by us, the simple question that arises for answer in the present case can be presented, with reference to a partnership firm, which entity is entitled to deduction of interest on partner’s capital, as: Whether the interest on partner’s capital could be allowed in computing the firm’s business income to the extent the said capital consists of increased valuation of the firm’s fixed asset/s? That is, could, for example, a firm claim interest on enhanced partner’s capital merely by revaluing an asset? This is as, if, yes, there is no reason for not allowing deduction of interest on the entire debentures issued in the present case. The answer to the two questions is though clearly in the negative, and for the same reasons discussed at length in this order. It is only the partner’s capital, which is by definition the positive difference between the firm’s assets and liabilities, which could be regarded as the firm’s capital, on which deduction of interest, subject to the relevant conditions, is allowable under the Act (s. 36(1)(iii) r/w. s. 40(b)(iv)). The firm’s assets are recorded at cost, defined u/s. 43(1), subject to the exceptions laid u/s. 43A and proviso to s. 36(1)(iii). The same, as shall be noted, are largely in agreement with the accounting standards, being AS-10. It is in view of this settled position of law that we also endorse the AO’s construing the assessee’s claim, referring to McDowell & Co. Ltd. (supra), as largely an exercise in tax evasion. The revaluation in the present case has no purpose except to claim tax deduction on interest on a higher level of borrowings. An analogy, to our mind, would be a firm (or any entity) claiming depreciation on the enhanced value of an asset, otherwise eligible for depreciation under the Act, using the tax neutral event of succession, as u/s. 47(xiii), for the purpose. The ld. CIT(A) clearly has misdirected himself in the instant case. We, in view of the foregoing, accordingly, uphold the AO’s action qua the disallowance of the interest (premium) on the debentures, i.e., as relatable to the revaluation of land by the successee firm, Kali Material Handling Systems.