ACIT-CC-7(3), MUMBAI vs. LODHA DEVELOPERS LIMITED (FORMERLY KNOWN AS MACROTECH DEVELOPERS LIMITED), MUMBAI

On the issue of applicability of section 14A disallowance to the computation of book profit under section 115JB, the CIT(A) recorded that no disallowance of direct expenditure under Rule 8D(2)(i) had been made in the present case. Relying upon the judicial precedents cited by the assessee, the CIT(A) held that disallowance computed under section 14A read with Rule 8D cannot be added back while computing book profit under section 115JB of the Act.

The CIT(A) also examined the nature of Debenture Redemption Reserve and the computation mechanism under section 115JB. Relying upon judicial precedents, including decisions of the Hon’ble Supreme Court and the Hon’ble Bombay Lodha Developers Limited High Court, the CIT(A) held that DRR represents an ascertained liability and cannot be treated as a reserve for the purpose of Explanation 1 to section 115JB. The CIT(A) further held that rejection of the claim merely on the ground that it was not made in the original return was not justified. Accordingly, the addition of Rs. 37.50 crore to the book profit was deleted.

Aggrieved by the order of CIT(A) the Revenue is in appeal before us raising following grounds of appeal:

On the facts and in the circumstances of the case and in law, the Ld. CIT(A) erred in deleting the disallowance under section 14A of the Income-tax Act, 1961 which was computed by the Assessing Officer in accordance with the prescribed method under Rule 8D and was fully supported by CBDT Circular No. 5 of 2014.

On the facts and in the circumstances of the case and in law, the Ld. CIT(A) failed to consider that the assessee had substantial investments capable of yielding exempt income and that no claim of expenditure in such context was unreasonable. The Assessing Officer, after recording proper satisfaction, rightly invoked the provisions of Section 14A read with Rule 8D, and computed the disallowance of Rs. 78,91,710 as per the formula laid down by law and upheld by the Hon’ble Supreme Court in the case of Godrej & Boyce Mfg. Co. Ltd.

On the facts and in the circumstances of the case and in law, the Ld. CIT(A) erred in allowing the deduction of Rs. 37.50 crores towards Debenture Redemption Reserve (DRR) while computing book profit Lodha Developers Limited under section 115JB, despite the fact that the claim was not made in the original return of income and was made only during the course of assessment proceedings, which is contrary to the ratio laid down by the Hon’ble Supreme Court in Goetze (India) Ltd. v. CIT [(2006) 284 ITR 323 (SC)].

The appellant craves leave to add to, alter, amend, modify and/or delete any or all of the above said grounds of appeal

We have carefully considered the rival submissions, perused the orders of the Assessing Officer and the learned CIT(A), and examined in detail the break-up of software expenditure, invoices, and explanations placed on record by the assessee. We have also carefully considered the reliance placed by the assessee on the decision of the coordinate Bench of the Tribunal in its own case for A.Y. 2015–16 in & 1594/Mum/2019, particularly paragraphs 21 and 22 thereof, wherein ERP expenditure was held to be revenue in nature.

At the outset, it is necessary to note that the allowability of software expenditure as capital or revenue is a fact-dependent Lodha Developers Limited determination, and the principle of consistency cannot be mechanically applied without examining the nature of software, rights acquired, and functional role of such software in the relevant assessment year. In the said decision for A.Y. 2015–16, the coordinate Bench, after examining the facts of that year, recorded a finding that the ERP expenditure incurred by the assessee consisted primarily of stand-alone licence fees and user rights, which did not form part of the profit-making apparatus but merely facilitated the conduct of business more efficiently. Applying the functional test, and relying upon the judgment of the Hon’ble Bombay High Court in CIT v. Raychem RPG Ltd., the Bench held that such ERP expenditure was revenue in nature. However, on a careful examination of the nature of software expenditure incurred in the year under consideration, we find that the facts are materially distinguishable from those prevailing in A.Y. 2015–16.

In the present year, the assessee has incurred software expenditure aggregating to Rs. 1,42,14,455/-, comprising multiple items, many of which involve one-time acquisition of licences, capacity-based system enhancements, enterprise-level software, storage and backup solutions, and perpetual usage rights, which together constitute a significant augmentation of the computer infrastructure of the assessee.

We have, therefore, examined the software expenditure item- wise, on the basis of the details and evidences furnished by the assessee, by applying the functional test, namely whether the Lodha Developers Limited software constitutes part of the profit-making apparatus of the assessee or merely facilitates the carrying on of business operations more efficiently or profitably. In doing so, we have taken into consideration the nature of the software, the rights acquired thereunder, the manner of acquisition, and whether such expenditure results in enduring enhancement of the computer or system infrastructure or is confined to facilitating routine operational or managerial functions. Where the software is found to merely aid the management in conducting the business more efficiently, without forming an integral part of the capital framework, the expenditure is liable to be treated as revenue in nature; however, where the software results in augmentation of system capacity, infrastructure, or functionality forming part of the enduring profit-making structure, the expenditure assumes the character of capital outlay. The findings are summarized below:

From the above, it is evident that capital software expenditure aggregates to Rs. 1,37,32,744/-, whereas revenue software expenditure aggregates to Rs. 4,81,711/-, fully tallying with the total software expenditure of Rs. 1,42,14,455/-.

In particular, the expenditure of Rs. 96,18,320/- incurred towards SWOS Microsoft Office licences represents a one-time acquisition conferring perpetual usage rights across the organisation for 605 users. Such software enables and enhances the effective utilisation of computer hardware itself and forms an integral part of the computer system. Similarly, expenditure on Lodha Developers Limited storage upgrades, backup software, virtualisation platforms, and specialised engineering and design software results in enduring benefit by expanding system capacity, resilience, and functional capability. Unlike the ERP expenditure examined by the coordinate Bench for A.Y. 2015–16, which was found to be primarily in the nature of facilitating software and licence renewals, the software expenditure in the present year involves capital accretion to the IT infrastructure. Accordingly, the decision of the coordinate Bench relied upon by the assessee, though binding on the proposition of law, is distinguishable on facts, and cannot be applied mechanically to the present assessment year.

The learned CIT(A), while deleting the entire disallowance, proceeded on the footing that the issue was fully covered by the earlier decision in the assessee’s own case. To this extent, we are unable to concur with the approach of the learned CIT(A), as the nature, scale, and functional impact of the software expenditure in the present year is demonstrably different.

At the same time, once the expenditure is held to be capital in nature, the assessee is entitled to depreciation as per law. As per Appendix I to the Income-tax Rules, 1962, applicable for A.Y. 2016–17, depreciation on “computers including computer software” is allowable at the rate of 60 percent on written down value, subject to the condition relating to period of use as provided under section 32(1) of the Act.

The learned DR pointed out that the assessee had made substantial investments in equity and preference shares capable of yielding exempt income. It was further noted that the assessee had earned exempt income of Rs. 22,31,000/- during the relevant previous year. The learned DR relied on the order of Assessing Officer who rejected the assessee’s contention that no expenditure was incurred for earning exempt income and invoked the provisions of section 14A read with Rule 8D and computed the disallowance at Rs. 78,91,710/-, comprising proportionate interest expenditure under Rule 8D(2)(ii), and administrative expenditure under Rule 8D(2)(iii).

The learned AR relied on the order of CIT(A) and submitted that the assessee had its own interest-free funds amounting to Rs. 1030 crores were substantially in excess of the average value of investments of Rs. 130 crores, and therefore no disallowance of interest under Rule 8D(2)(ii) was warranted. With regard to the disallowance under Rule 8D(2)(iii),the CIT(A) noted that the assessee’s contention that only investments yielding exempt income should be considered had not been specifically raised before the Assessing Officer. Accordingly, while accepting the legal proposition laid down by the Special Bench in ACIT v. Vireet Investment Pvt. Ltd., the CIT(A) restored this limited aspect to the file of the Assessing Officer with a direction to recompute the Lodha Developers Limited disallowance by considering only those investments which had actually yielded exempt income during the year.

On the issue of adding the disallowance under section 14A to the book profit under section 115JB, the CIT(A) held that, in the absence of any disallowance of direct expenditure under Rule 8D(2)(i), no addition could be made to the book profit on account of section 14A disallowance.

The learned AR supported the decision of the CIT(A).

We have carefully considered the rival submissions and perused the orders of the lower authorities. So far as the disallowance of interest under Rule 8D(2)(ii) is concerned, we find that the learned CIT(A) has recorded a clear finding of fact that the assessee’s own interest-free funds were substantially higher than the investments made. This factual finding has not been controverted by the Revenue by bringing any material on record. In such circumstances, the presumption that investments have been made out of own funds operates, and no disallowance of interest expenditure under Rule 8D(2)(ii) is called for. We, therefore, find no infirmity in the order of the learned CIT(A) on this aspect.

With regard to the disallowance under Rule 8D(2)(iii), we find that the learned CIT(A) has followed the binding decision of the Special Bench of the Tribunal in ACIT v. Vireet Investment Pvt. Ltd., and has merely directed the Assessing Officer to recompute the disallowance by considering only those Lodha Developers Limited investments which have yielded exempt income during the year. We do not find any error in this direction.

As regards the addition of disallowance under section 14A to the book profit computed under section 115JB, we note that the learned CIT(A) has held that no such addition is permissible in the absence of disallowance under Rule 8D(2)(i). This finding is in consonance with settled judicial position, and no contrary authority has been brought to our notice by the Revenue.

The Revenue, in its grounds, has placed reliance on CBDT Circular No. 5 of 2014 dated 11.02.2014 as well as on the decision of the Hon’ble Supreme Court in Godrej & Boyce Manufacturing Co. Ltd., in support of the disallowance made under section 14A read with Rule 8D.

As regards CBDT Circular No. 5 of 2014, the Circular clarifies that disallowance under section 14A is attracted even where the dominant intention of holding investments is not to earn exempt income and that expenditure incurred “in relation to” exempt income is to be disallowed irrespective of the head under which such income falls. However, it is well settled that such circulars are clarificatory in nature and cannot override or dilute the statutory requirements of section 14A as interpreted by judicial authorities. In the present case, the learned CIT(A) has not disputed the applicability of section 14A per se. The relief granted by the CIT(A) is based on factual findings, namely that the assessee’s own interest-free funds far exceeded the value of Lodha Developers Limited investments, and therefore no disallowance of interest under Rule 8D(2)(ii) was warranted. The Circular does not mandate disallowance of interest expenditure in a situation where, on facts, no nexus between borrowed funds and investments is established. To that extent, the reliance placed on the Circular by the Revenue does not advance its case.

Coming to the reliance placed on the judgment of the Hon’ble Supreme Court in Godrej & Boyce Manufacturing Co. Ltd., we find that the said decision lays down two important propositions: (i) section 14A is constitutionally valid, and (ii) the Assessing Officer must record objective dissatisfaction, having regard to the accounts of the assessee, before invoking Rule 8D.

In the present case, the learned CIT(A) has not disturbed the legal applicability of section 14A. On the contrary, he has examined the manner of computation under Rule 8D and has granted relief only to the extent warranted on facts and law. Further, the finding that the assessee’s own funds were substantially higher than the investments has not been controverted by the Revenue. Once such a factual finding stands, the presumption recognised by judicial precedents comes into play, and disallowance of interest under Rule 8D(2)(ii) does not survive. Further, with respect to disallowance under Rule 8D(2)(iii), the learned CIT(A) has merely directed the Assessing Officer to recompute the same in accordance with the decision of Lodha Developers Limited the Special Bench in Vireet Investment Pvt. Ltd., by considering only those investments which have yielded exempt income during the year. This direction is consistent with the statutory framework and does not run contrary to the ratio laid down in Godrej & Boyce.

Thus, neither CBDT Circular No. 5 of 2014 nor the decision of the Hon’ble Supreme Court in Godrej & Boyce Manufacturing Co. Ltd. supports the Revenue’s case for sustaining the disallowance as originally computed by the Assessing Officer in the facts of the present case.

In view of the above discussion, Ground Nos. 3 and 4 raised by the Revenue are dismissed. Addition of Debenture Redemption Reserve (DRR) of Rs. 37.50 crores to book profit under section 115JB - (Ground No. 5 and 6) 35. By way of these grounds, the Revenue has assailed the action of the learned CIT(A) in deleting the addition of Rs. 37,50,00,000/- made by the Assessing Officer on account of Debenture Redemption Reserve (DRR) while computing book profit under section 115JB of the Act.

The Revenue has contended that the claim for reduction of DRR was not made in the original return of income and was raised only during assessment proceedings, and DRR represents a “reserve” and not an ascertained liability and, therefore, ought Lodha Developers Limited to have been added back to the net profit in terms of Explanation 1 to section 115JB.

The learned AR took us through the revised computation of income, placed on paper book page No.51 and also the Note No. 3 forming part of financial statement placed on paper book page No. 21and submitted that during the course of assessment proceedings, the assessee filed a revised computation of book profit and Form 29B, claiming deduction of Debenture Redemption Reserve of Rs. 37.50 crores while computing book profit under section 115JB and the Assessing Officer rejected the claim. Before the CIT(A), the assessee submitted that the DRR represents a provision for an ascertained liability, as the liability to redeem debentures is certain and enforceable, and DRR does not fall within any of the clauses of Explanation 1 to section 115JB warranting its addition back.

The learned AR further submitted that, it would be necessary to examine whether such DRR can be characterized as a “reserve” or as a “provision for meeting liabilities other than ascertained liabilities” for the purposes of computation of book profit under section 115JB of the Act. It was submitted that the mere nomenclature of an item in the financial statements is not determinative of its true nature. The description “Debenture Redemption Reserve” is a nomenclature mandated by the provisions of the Companies Act, 2013, and the same, by itself, does not conclude that the amount constitutes a reserve. What is material is the purpose for which the amount is set aside and the Lodha Developers Limited nature of the obligation sought to be met. The learned AR submitted that any amount set aside specifically for meeting a known and enforceable liability cannot be regarded as a reserve. In the present case, the amount transferred to DRR is earmarked exclusively for the purpose of redemption of debentures, which is a definite and existing obligation of the assessee. The liability to redeem debentures is neither contingent nor uncertain, and the amount set aside can be utilized only for that specific purpose. Accordingly, the DRR is clearly in the nature of a provision for a known and ascertained liability and not a reserve. In support of this proposition, the learned AR placed strong reliance on judicial precedents, including the judgment of the Hon’ble Supreme Court in National Rayon Corporation Limited v. CIT [1997] 227 ITR 764 (SC).The learned AR relied on the order of CIT(A) who accepted the submissions of the assessee.

The learned Departmental Representative supported the assessment order and reiterated that the claim was not made in the original return of income and was claimed in revised computation of income submitted during the course of assessment proceedings.

We have carefully considered the rival submissions, perused the orders of the lower authorities, and examined the notes forming part of the audited financial statements, particularly the disclosure under the head “Reserves and Surplus”, as well as the revised computation of MAT liability placed on record.

At this stage, the learned Authorised Representative further submitted that, even assuming without admitting that the DRR has been created by debiting the profit and loss account, it would still be necessary to examine whether such DRR can be characterized as a “reserve” or as a “provision for meeting liabilities other than ascertained liabilities” for the purposes of Explanation 1 to section 115JB.The learned AR submitted that the nomenclature of an item is not conclusive of its true nature.

In support of this proposition, reliance was placed on the judgment of the Hon’ble Supreme Court in National Rayon Corporation Limited v. CIT (Supra), wherein the Hon’ble Supreme Court has categorically held that amounts set apart for redemption of debentures cannot be regarded as reserves. The Hon’ble Supreme Court observed that debentures represent secured loans and that the liability to redeem such debentures continues to exist even if the redemption is to take place at a future date. It was further held that amounts set apart to meet such liabilities cannot be treated as reserves, as reserves do not Lodha Developers Limited include amounts retained by way of providing for known liabilities.

We find merit in the aforesaid submissions. Judicial precedents have consistently held that Debenture Redemption Reserve represents a provision for a known and enforceable obligation, namely redemption of debentures, and therefore does not fall within the mischief of Explanation 1 to section 115JB, which contemplates addition of only those items which are in the nature of reserves or provisions for unascertained liabilities and which have been debited to the profit and loss account.

Further, the objection of the Assessing Officer that the claim was not made in the original return of income is also devoid of merit. The computation of book profit under section 115JB is a statutory exercise, and the Assessing Officer is duty-bound to compute the correct book profit on the basis of the audited accounts. The decision of the Hon’ble Supreme Court in Goetze (India) Ltd. merely restricts the power of the Assessing Officer to entertain a fresh claim under the normal provisions of the Act without a revised return. The said decision does not curtail the powers of the appellate authorities, nor does it override the mandate of correct computation of MAT liability under section 115JB.

In the present case, the revised computation of MAT does not seek any impermissible deduction. It merely reflects the correct starting point of profit before appropriation to Debenture

In view of the above discussion, and having regard to the accounting treatment, statutory framework, and binding judicial precedents, we find no infirmity in the order of the learned CIT(A) in directing deletion of the addition of Rs. 37.50 crores made to the book profit on account of Debenture Redemption Reserve.

In view of the foregoing, Ground Nos. 5 and 6 raised by the Revenue are dismissed.

In the result, the appeal filed by the Revenue is partly allowed for statistical purposes.