ACIT, NEW DELHI vs. M/S. ASSOCIATED LAW ADVISERS, NEW DELHI

We will first take up the assessee’s appeal wherein the following grounds have been raised:-

The brief facts qua the first issue raised by the assessee are that the assessee is a partnership firm engaged in the profession of legal services, (i.e. it is a law firm). During the course of assessment proceedings, the Assessing Officer, on a perusal of the balance sheet, noted that under the head “current liabilities”, a sum of Rs.42,91,289/- is appearing and out the said current liabilities, sum of Rs.5 lakhs and for Rs.2,88,680/-, the Assessing Officer accepted assessee’s reply; but for balance sums aggregating to Rs.35,02,609/-, AO sought assessee’s clarification to which assessee submitted that these payments are in the nature of advance payment received from the clients for making payment of fees to Senior Advocates to appear on behalf of the clients before Hon'ble High Court and Supreme Court and for incurring of expenditure on behalf of the clients.

Before the ld. CIT(A), assessee submitted that the ‘current liabilities’ under this head consist of three categories of payments received from the clients;

The ld. CIT (A), incorporated various details of bills and invoices submitted by the assessee with regard to all the three categories of clients at pages 6 to 8 of the appellate order. From these details, he pointed out certain defects to sustain the addition which, for the sake of ready reference, are reproduced hereunder:-

Before us, the ld. Sr. counsel for the assessee, Shri C.S. Aggarwal, after explaining the entire facts, submitted that under all the three categories of payment received in advance from the clients, money has kept in the fiduciary capacity to meet out the expenditures and obligations on behalf of its clients, like making payment of fees to the Senior Advocates engaged for the purpose of such clients or to meet out the litigation expenses, etc. In none of the three categories, money belonged to the assessee and the same is retained as trust money. Therefore, the same cannot be reckoned as income of the assessee even under cash system of accounting. In support, he relied upon the following decisions/judgments:-

So far as the discrepancies pointed out by the ld. CIT(A) in his impugned order, following rebuttal had been submitted by the ld. counsel for the assessee before us in the form of written submission which clarifies the factual points raised by the Ld. CIT(A):-

Thus, it was submitted by Shri C.S. Agarwal that even under the cash system of accounting, basic principle of law is that income can only be taxed when it is recognized as income by the payer. Each and every receipt cannot be taxed as income unless such receipts partake the character of income or has actually resulted an income at all. Here in this case, it cannot be in dispute that payments which are received by the assessee (under the head “current liabilities”) are in the nature of advance and only when accounts are finalized, assessee credit it to the profit & loss account. In support, he also filed photocopies of the bills and invoices and also dates of receipt of amount and how the same has been adjusted in the subsequent year. Thus, he submitted that the addition cannot be sustained.

On the other hand, the ld. Sr. D.R. strongly relied upon the order of the ld. CIT(A) and submitted that under the cash system of accounting, assessee should have accounted for all the receipts and whatever payment has been made for meeting out the expenses to other professionals, the same should be debited as expenditure. Thus, the entire receipts in the case of the assessee has to be treated as income and any outgoing related for earning of income should be allowed as expenditure and, therefore, the Assessing Officer and the ld. CIT(A) have rightly confirmed the addition.

We have heard the rival submissions and perused the relevant finding given in the impugned order as well as the material referred to before us. The assessee is a law firm, which is rendering services mostly to its foreign clients. The system of accounting adopted by the assessee is that, bills and invoices are raised for advance payment of fees or expenditure from its clients; firstly, which are in the category of making payment of fees to Senior Advocates who are engaged to represent the matters before the Hon'ble High Court and Supreme Court on behalf of such clients; secondly, advance for incurring expenses like court fees, payment to Registrar of Companies and various other litigation expenses; and lastly, there are double payments which in few cases are adjusted against future services or expenditure. After discharging the payments on behalf of the clients, the balance amount is recognized as income which is offered for tax. This system of accounting is being adopted from earlier years which has been stated to be accepted by the Department and in support, scrutiny assessment for assessment year 2009-10 has also been filed before us, wherein similar system of recognizing the income and the accounting practice of the assessee has been accepted. Under all the three categories of payments, which has been discussed hereinabove, it is seen that money received by the assessee was the money of the clients received in the fiduciary capacity. It is a kind of trust money of the client, for which assessee has to discharge certain obligations while representing the case of its clients before various Courts and other legal and arbitration proceedings. From perusal of various ‘Memo of fees raised to the clients, we find that the amount which has been raised to the clients are on account of advance payment for filing of proposed petitions, fees for Senior Advocates for various hearings, including fees for junior counsel, Court fees, miscellaneous expenses, etc. In the said memo of fees itself, there is a categorical note below that this is advance money which shall be used by the assessee firm to make payments from time to time, like while making payment to the arbitrators and Senior Advocates for which TDS would be deducted by the assessee and specific request was made by the client not to deduct TDS on such payment. Even in the ‘memo fees’ for seeking advance money for incurring expenditure also, it is seen that various heads of proposed expenditure are mentioned like photocopy; courier charges; local counsel fees; charges for hotel and taxi charges; clerk, etc. The legal fee of the assessee firm is separately charged by the assessee for which income has been recognized in the year of receipt and has been offered for taxation. Nowhere it is the case of the Assessing Officer or the ld. CIT(A) that the payment received from various clients do not carry any obligation for making payment for Senior Advocates engaged to represent the matters of the clients or for incurring of expenditure on behalf of the clients during the course of litigation proceedings or arbitration proceedings. The Revenue’s case is simply that whatever has been received from the clients has to be recognized as income and whatever has been paid is to be treated as expenditure and this has been justified on the ground that under the cash system of accounting, this procedure should be followed.

We are unable to appreciate such a contention of the Revenue because under the Income Tax Act, what is chargeable to tax is ‘income’ that is received, accrued or deemed to receive or accrue in India in the previous year relevant to the year for which assessment is made. In short, income tax is levy of income and, therefore, one has to see whether the receipts has resulted into income or not. If any amount or receipt is received by the assessee for discharging of any obligation on or on behalf of the principal, or money has been entrusted by the principal, then it partakes the character of somebody else’s money, i.e. principal’s money, here in this case client’s money. If money has been received in the fiduciary capacity for discharging the obligation on or on behalf of the principal/client, then such money received for discharging of obligation cannot be reckoned as income. Under the Income Tax Act every receipt cannot be an income as it has to fall in the category of income first, chargeable to tax and under a relevant head. Money received as trust or in a fiduciary category cannot be ipso facto be recognised as income belonging to the assessee chargeable to tax. In the case of Solicitors and Law firms, money are received in advance for discharging obligations on behalf of clients like making payments for engaging of Senior Advocates, who generally charge advance fees for representing any legal or arbitration proceedings before any Court or likewise, certain expenditures which are to be incurred on behalf of the clients for such legal proceedings, especially when clients are foreign based and day-to-day requirement of meeting the expenditures cannot be easily available from clients, then as a matter of practice, Solicitors/Law firms demand advance money for discharging such obligation and the balance money is either refunded or adjusted against the fess which is ostensibly is income chargeable to tax. Such a system in the case of Solicitors has been well accepted and settled by the Hon'ble Calcutta High Court in the case of CIT vs. Sandersons and Morgans [1970] 75 ITR 433. This judgment has been followed by various Courts and Hon'ble Delhi High Court in the case of CIT vs. Om Prakash Khaitan [2015] 376 ITR 390 (Delhi), has accepted such a practice. In the case before the Hon’ble Delhi High Court, assessee was a proprietor of the firm of Solicitors and Advocates and was following cash system of accounting. He used to receive advance from his clients for various legal matters and such advances received were kept in a separate ledger account in the name of the clients where all the expenses were debited from time to time and at the end of the year, credit balance in the account where matters are unsettled, the same were carry forwarded to the next year as sundry creditors and matters, which are settled in this year were transferred to the profit & loss account. In that case also, the Assessing Officer held that since assessee adopted cash system of accounting, taxation of the income cannot be differed to the subsequent year and income is to be taxed in the year in which it was received. The Tribunal held that, firstly, in the earlier year similar addition made by the Assessing Officer had been deleted and; secondly the issue of lawyers accepting money from the clients on account to defray the expenses and appropriating fees as income only upon completion of a case cannot be faulted with and the characterization of receipt can take place only at the time of appropriation, i.e., in the case of fees only when the services was offered or when the assessee decides on the quantum of fees, is the correct way of recognizing the income. The entire advance received cannot be treated as income. This finding of the Tribunal got upheld by the Hon'ble High Court, wherein the Hon'ble High Court concluded that for lawyers and law firms, characterization of receipt can take place only at the time of appropriation, i.e., in case of fees only when the services were rendered or as and when assessee decides on the quantum of fees and not before that. Even the other judgments, which has been relied upon by the ld. counsel for the assessee are also to the similar effect. Thus, we hold that the amounts, which are appearing under the head “current liabilities”, cannot be taxed as income in this year, as the advance money cannot partake the character of an income, because the assessee was entrusted with the money for discharging of various legal obligations on behalf of its clients and held the money in fiduciary capacity and the money was recognised as client’s money in its accounts. Accordingly, the addition of Rs.35,02,609/- is deleted.

So far as the second issue of disallowance under section 14A of Rs.71,122/- is concerned, the brief facts are that the assessee has earned dividend income of Rs.38,057/- and income from mutual funds of Rs.8,59,847/-,which were claimed as exempt from tax under section 10(34) and 10(35).

During the course of the assessment proceedings, assessee was required to give details of expenditure incurred in relation to the exempt income as to why expenses should not be added back in terms of provisions of section 14A. In response assessee submitted that from the perusal of the profit & loss account and balance sheet as well as bank statements, it can be seen that no expenditure whatsoever has been incurred for for the purpose of earning of exempt income. Further, so far as income in respect of unit of mutual funds were concerned, the same has been offered for taxation, therefore, qua this amount, rule 8D cannot be applied. The Assessing Officer however observed that assessee’s reply is not found satisfactory and held that disallowance has to be made under section 14A in accordance to rule 8D and accordingly, worked out the disallowance under section rule 8D(2)(iii) at Rs.71,122/-. This disallowance has been confirmed by the ld. CIT(A) also.

Before us, Shri C.S. Agarwal submitted that when assessee had submitted before the Assessing Officer that none of the expenditure debited to the profit & loss account can be attributed for the purpose of earning of exempt income and assessee has also demonstrated before the Assessing Officer about the nature of accounts and expenses, then the Assessing Officer should have first satisfied himself about the correctness of the assessee’s claim and then only could have proceeded to apply rule 8D. Here in this case, the Assessing Officer has not examined the nature of accounts or the expenditure and has simply proceeded to make disallowance under rule 8D, which cannot be upheld. In support, he relied upon the judgments of the Hon'ble Delhi High Court in the cases of CIT vs. Taikisha Engineering India Ltd. reported in [2015] 370 ITR 338 (Delhi); and CIT vs. I.P. Support Services India (P.) Ltd. Reported in [2015] 378 ITR 240 (Delhi).

On the other hand, the ld. Sr. D.R. strongly relied upon the order of the ld. CIT(A) and submitted that the Assessing Officer did reject assessee’s explanation on the ground that it is not found satisfactory. This itself goes to show that the Assessing Officer was satisfied that assessee’s claim is not correct and, therefore, he is justified in proceeding to make disallowance under rule 8D.

We have heard the rival submissions and also perused the relevant find given in the impugned order. The assessee before the Assessing Officer had categorically submitted that the looking to the nature of expenditure debited in the profit & loss account as well as pointed from other details like bank statements and balance sheet that no expenditure whatsoever has been incurred for earning of income by way of dividends which very paltry sum. It was further submitted that the income in respect of units of mutual funds and gross amount of income has been offered for taxation. After such a claim, under the provisions of sub section (2) & (3) of section 14, it was incumbent upon the Assessing Officer having regard to the accounts of the assessee and the nature of expenses debited, to examine the correctness of the claim that whether any expenditure in relation to the exempt income has been incurred or not. If the Assessing Officer fails to satisfy himself in this regard, then ostensibly he cannot proceed to apply rule 8D. The law does not envisages that wherever there is an exempt income, expenditure has to be disallowed. It is required to be seen, whether expenditure has been incurred by the assessee in relation to the earning of exempt income or not and this can be examined having regard to the accounts of the assessee and the nature of expenditure debited. Here in this case, the Assessing Officer has failed to satisfy himself about the correctness of the assessee’s claim and, therefore, in view of the principle laid down by the Hon'ble Delhi High Court in the case of H.T. Media Ltd. Vs. Pr. CIT reported in 85 taxmann.com 113 (Delhi), the Assessing Officer cannot proceed to make disallowance under section 14A. The Hon'ble Jurisdictional High Court has once again reiterated that it is mandatory and incumbent upon the Assessing Officer to record such satisfaction and in the absence of such ‘satisfaction’ no disallowance can be made under section 14A. The Hon'ble High Court concluded that; firstly, where there was a failure by Assessing Officer to comply with mandatory requirement of section 14A(2) read with rule 8D(1)(a) to record his satisfaction as required thereunder, then question of applying rule 8D(2)(iii) does not arise; and secondly, where Assessing Officer had failed to establish any direct nexus between investments made by assessee and interest expenditure incurred, then it not correct to remand the matter concerning deletion of disallowance of interest under clause (ii) of rule 8D(2) to Assessing Officer for fresh determination. Accordingly, on the facts of the present case disallowance of Rs.71,122/- made by the Assessing Officer is directed to be deleted. Accordingly, the appeal of the assessee is allowed.

Now we will take up the Revenue’s appeal wherein the following ground has been raised:-

At the outset, the ld. counsel for the assessee submitted that the tax effect on the disputed amount is only Rs.6,91,599/- because here the issue is, whether long term capital gain of Rs.33,57,275/- derived by the assessee is liable for exemption under section 54EC or not. Even if the exemption is not allowed, then capital gain chargeable to tax is @ 20% plus cess and if tax is calculated on such capital gain, then it works out to Rs.6,91,599/- which is much less than the revised limit of Rs.10 lakhs as per CBDT Circular No.21/2015 dated 10/12/2015.

The ld. D.R. too admitted that the tax effect is much below the prescribed monetary limit of Rs.10 lakhs, therefore, the appeal of the Revenue is not maintainable. Accordingly, we hold that the Revenue’s appeal is not maintainable and is dismissed in limine on the ground that the monetary limit for filing of appeal is much below the monetary limit of Rs.10 lakhs.

In the result, appeal of the assessee is allowed and the appeal of the Revenue is dismissed.