2007 (2) TMI 363 - AT - Income Tax

Expenditure incurred in relation to income not includible in total income Interest on borrowed capital

Summary

Issues Involved:
1. Disallowance of interest under Section 36(1)(iii) of the Income-tax Act.
2. Applicability of Section 14A of the Income-tax Act.

Issue 1: Disallowance of Interest under Section 36(1)(iii)
The assessee contended that the CIT(A) erred in upholding the disallowance of interest amounting to Rs. 4,89,225, arguing that the borrowed funds were used for business purposes and hence, the interest should be deductible under Section 36(1)(iii) of the Income-tax Act. The assessee was engaged in trading iron and steel parts and had invested Rs. 74,50,000 in shares of a sister concern, M/s. Spectra Industries Ltd., which was claimed to be for earning business profits, not dividends.

The CIT(A) upheld the Assessing Officer's decision, noting that the funds were diverted from business to invest in shares, and the interest expense was not exclusively for business purposes. The CIT(A) referenced the Madras High Court's decision in K. Somasundaram & Bros. v. CIT, emphasizing that business funds should remain within the business and not be diverted for other purposes.

The Tribunal observed that deductions under Section 36(1)(iii) could only be allowed if the borrowed funds were used for the assessee's business. It was necessary to examine whether the borrowed funds were retained for the construction business or used for investing in shares. The Tribunal noted that Section 36(1)(iii) aims to allow deductions for interest on money used for earning business income, not income from other sources.

Issue 2: Applicability of Section 14A
The Assessing Officer applied Section 14A, disallowing the interest expense, arguing that the investment in shares was to earn dividend income, which is exempt under Section 10(33). The CIT(A) concurred, stating that Section 14A prohibits deductions for expenses incurred in relation to exempt income. The assessee argued that the investment was for business profits, not dividends, and cited previous ITAT decisions to support their claim.

The Tribunal explained that Section 14A prohibits deductions for any expenditure related to exempt income. The term "expenditure" includes all forms of expenses, whether direct or indirect. The Tribunal emphasized that earning dividend income involves substantial expenses, including management and administrative costs. It referenced various ITAT decisions supporting the view that expenses related to exempt income must be disallowed.

The Tribunal highlighted the procedural provisions in sub-sections (2) and (3) of Section 14A, which mandate a specific method for computing disallowances. These provisions apply to all pending matters, and the Assessing Officer cannot make ad hoc disallowances. The Tribunal directed the CIT(A) to re-examine the case, considering whether any expenditure was incurred in relation to exempt income and to quantify the disallowance per Section 14A.

Conclusion:
The Tribunal set aside the CIT(A)'s order and remanded the case for a fresh decision, considering the provisions of Section 14A and Section 36(1)(iii). The CIT(A) was instructed to provide a reasonable opportunity for both parties to present their cases and to determine the disallowance based on the specified legal provisions. The appeal was treated as allowed for statistical purposes.