2019 (1) TMI 2069 - AT - Income Tax

Ad-hoc disallowance of expenditure @ 10% under the head Magazines Journals which was paid by the assessee to its sister concern - legitimacy and business necessity of the expenditure - HELD THAT - A bare reading of the aforesaid comparative chart will reveal that there was no consistency in incurring the impugned expenses by the assessee. It is also noticed that the percentage of the expenses for the assessment years 2007-08 2008-09 and 2009-10 to the sales turnover was at 13.71% 12.40% and 6.02%. The average of those expenses for the preceding three years comes to 10.70% (13.71 12.40 6.02 13.13 3 10.70%) and similarly the percentage of the expense over the total turnover in the succeeding assessment years i.e. from 2011-12 to 2014-15 was 10.50% (18.66 9.22 6.90 7.20 41.98 4 10.50%). From the above discussion it appears that the average of the percentage incurred in the preceding year and the succeeding year was more than 10%. In our opinion neither the AO has given any basis for making the disallowance @ 10% nor the assessee explained to the satisfaction of the AO. We therefore are of the view that in such type of cases expenses can be allowed by considering the past history as well as the average of expenses incurred in the succeeding year. In our opinion it will be fair and reasonable to estimate the expenses on account of magazines journals @ 10% of total operating revenue. We therefore direct the AO to modify his order and made the disallowance as per above directions i.e. the disallowance can be made to the extent of the expenses exceeding 10% of the total operating revenue.

Summary

The core legal questions considered by the Tribunal in these consolidated appeals pertain to the validity and reasonableness of an ad-hoc disallowance of expenditure made by the Assessing Officer (AO) under the head "Magazines & Journals" incurred by the assessee, a five-star hotel operator. Specifically, the issues include:

• Whether the disallowance of 10% of the expenditure on magazines and journals paid to a related party (sister concern) is justified under the provisions of the Income Tax Act, particularly under sections 40A(2)(b) and 4GA(2)(a).
• The legitimacy and business necessity of the expenditure on magazines and journals in the hotel industry context.
• The adequacy and sufficiency of evidence furnished by the assessee to justify the quantum and frequency of magazine purchases.
• The applicability of principles of consistency in assessment years regarding acceptance or disallowance of such expenses.
• The correctness of the AO's reliance on comparison with another hotel's expenditure and on the sale of scrap to determine the reasonableness of expenses.
• Whether the AO's disallowance was based on tangible evidence or mere conjecture and surmise.
• Whether the Tribunal should apply the directions of the Hon'ble Jurisdictional High Court for fresh adjudication and the extent of disallowance permissible.

Issue-wise Detailed Analysis

1. Justification of 10% Ad-hoc Disallowance on Magazines & Journals Expenditure

Legal Framework and Precedents: The AO invoked sections 40A(2)(b) and 4GA(2)(a) of the Income Tax Act to disallow expenditure deemed excessive or unreasonable, especially when payments are made to related parties. The principle that the tax authority cannot arbitrarily disallow expenses without evidence is well settled in various Supreme Court rulings (e.g., Commissioner of Income Tax v. Walchand & Co. (1967), CIT v. Dhanrajgirji Raja Narasirgirji (1973), CIT v. Panipat Woolen and General Mills (1976)). The courts have held that the reasonableness of business expenditure must be judged from the viewpoint of a prudent businessman, not on subjective assumptions by tax authorities.

Court's Interpretation and Reasoning: The AO, while accepting the nature of the expense as a business necessity in the hotel industry, found the quantum of magazines purchased (18,000-20,000 at Rs. 200 each) disproportionate to the hotel's capacity (120 rooms plus ancillary facilities). The AO noted lack of specific evidence on distribution and consumption of magazines, absence of detailed bills, and minimal scrap sales, which suggested to the AO that the expenditure was excessive. The AO also compared the expense ratio with another hotel (Grand Windsor Resorts Ltd.) and found the assessee's expense disproportionately high (14.42% vs. 0.05% of turnover). Consequently, the AO disallowed 10% of the expenditure.

The CIT(A) upheld the disallowance, emphasizing the twin factors of excessive purchase and the related-party nature of the transaction, which warranted a reasonable disallowance. The CIT(A) also noted the absence of evidence on competition or comparable industry expenses to justify such high expenditure.

Key Evidence and Findings: The assessee provided general explanations about the necessity of magazines for promoting the hotel brand and guest comfort, including distribution at exhibitions and to corporate clients. However, the AO found no documentary evidence of such distribution or participation in exhibitions. The scrap sale was minimal, undermining the claim that guests took away large quantities of magazines. The bills lacked detailed descriptions of magazines.

Application of Law to Facts: While the expenditure was admitted to be genuine and for business purposes, the AO and CIT(A) found the quantum excessive and unsupported by adequate evidence. The reliance on related-party transactions and lack of transparency justified a reasonable disallowance.

Treatment of Competing Arguments: The assessee argued that the disallowance was arbitrary, based on conjecture, and inconsistent with prior years where similar expenses were accepted. It contended that the AO failed to prove excessiveness or unreasonableness and that the comparison with a smaller hotel was inappropriate. The AO and CIT(A) maintained that the quantum was disproportionate and that related-party transactions warranted scrutiny.

Conclusions: The Tribunal found that the AO's disallowance was ad-hoc and lacked a concrete basis for the 10% figure. It acknowledged the assessee's inability to furnish detailed distribution evidence but noted the absence of any challenge to the genuineness of expenses. The Tribunal considered the past and subsequent years' expense ratios and concluded that a disallowance limited to the amount exceeding 10% of total operating revenue would be fair and reasonable.

2. Legitimacy and Business Necessity of Expenditure on Magazines & Journals

Legal Framework and Precedents: The principle that business expenditure wholly and exclusively laid out for business purposes is allowable is well established. The courts have repeatedly emphasized that the reasonableness of expenses must be judged from the perspective of the business and not by the tax authorities' subjective standards (Hive Communication (P.) Ltd. v. CIT (2011)).

Court's Interpretation and Reasoning: The Tribunal recognized that magazines and journals play a vital role in the hotel industry for promotion, guest engagement, and maintaining five-star standards. The assessee's explanation that magazines covered diverse fields relevant to guests' interests and were distributed in various hotel areas and external exhibitions was accepted as a legitimate business practice.

Key Evidence and Findings: The assessee demonstrated that magazines were published daily, weekly, or fortnightly and placed in guest rooms and common areas. The increase in turnover from Rs. 64.44 crores to Rs. 74.31 crores was cited as evidence of the effectiveness of this marketing strategy.

Application of Law to Facts: The Tribunal applied the principle that the tax authorities cannot substitute their judgment for that of the businessman regarding business needs. Since the AO did not dispute the genuineness of the expenditure, the Tribunal held that the expense was incurred wholly and exclusively for business purposes.

Treatment of Competing Arguments: The AO's argument that the quantum was excessive was addressed separately under the disallowance issue. The assessee's contention on business necessity was accepted.

Conclusions: The Tribunal concluded that the expenditure on magazines and journals was a legitimate and necessary business expense for the assessee's hotel operations.

3. Adequacy of Evidence Furnished by the Assessee

Court's Interpretation and Reasoning: The Tribunal noted that the assessee failed to provide detailed evidence on the distribution of magazines, dates of exhibitions, or business passes for promotional activities. The AO's observation on lack of detailed bills and minimal scrap sale was also noted.

Application of Law to Facts: While the lack of detailed evidence was a factor in the AO's skepticism, the Tribunal balanced this with the assessee's audited accounts and the absence of any adverse findings on the genuineness of the expenses.

Conclusions: The Tribunal found the evidence insufficient to fully justify the quantum but insufficient to disallow the entire expenditure. This supported the approach of limiting disallowance to the excess over a reasonable threshold.

4. Consistency in Assessment Years and Precedent Impact

Court's Interpretation and Reasoning: The Tribunal examined the chart furnished by the assessee showing turnover, magazine expenses, and disallowances over several years. It observed that for assessment years 2007-08 and 2008-09, expenses at 13.71% and 12.40% of turnover were accepted without disallowance. For the year under consideration (2010-11), the expense was 15.47%, and the AO disallowed 10%. Subsequent years showed varying percentages, some with disallowances and some without.

Application of Law to Facts: The Tribunal emphasized the principle of consistency and found that the average expense percentage over preceding and succeeding years hovered around 10%. This historical data supported the conclusion that disallowance should be limited to the amount exceeding 10% of total operating revenue.

Treatment of Competing Arguments: The AO's reliance on comparison with another hotel was rejected as inappropriate due to differences in scale and turnover. The Tribunal agreed with the assessee that no proper basis was given for the ad-hoc disallowance.

Conclusions: The Tribunal held that the disallowance should be moderated in light of consistency and historical acceptance of expenses.

5. Related Party Transactions and Section 40A(2)(b) Implications

Court's Interpretation and Reasoning: The AO's concern about payments to a sister concern was noted, as related-party transactions invite scrutiny under section 40A(2)(b) to prevent unreasonable or excessive payments. However, the Tribunal found no evidence that the price paid exceeded fair market value or that the expenditure was not for business purposes.

Conclusions: The Tribunal did not uphold the disallowance solely on the basis of related-party transactions without corroborative evidence of excessiveness or unreasonableness.

6. Sale of Scrap and Quantum of Magazines

Court's Interpretation and Reasoning: The AO used the minimal scrap sale as an indicator that the large number of magazines purchased was not consumed or distributed. The assessee explained that guests often took magazines away, leaving little scrap.

Conclusions: The Tribunal accepted this explanation and did not consider scrap sale as a reliable indicator to disallow expenses.

7. Directions of the Hon'ble Jurisdictional High Court and Fresh Adjudication

Court's Interpretation and Reasoning: The High Court had set aside the earlier Tribunal order and remanded the matter for fresh consideration, directing the Tribunal to consider the nature, use, and distribution of magazines and the reasonableness of expenditure.

Conclusions: The Tribunal complied with the directions and, after detailed analysis, allowed the expenses up to 10% of total operating revenue, modifying the AO's order accordingly.

Significant Holdings

"It is a matter of fact that purchases of magazines and journals is a business necessity of the appellant company being in the business of running of a five star hotel. It is also a matter of fact that the appellant company is new in this line of business and therefore expected to be aggressive in marketing itself and could also to be expected to be going substantially over the top in incurring such expenses."

"The twin factors of excessive or over the top purchase of such magazines and the same being purchased from its sister concern whose certain part of income is taxed at lower rate under section 80IB makes it reasonable for the Assessing Officer to make suitable disallowance under this head."

"The income tax authority has to decide whether the expenditure claimed as an allowance was incurred voluntarily and whether the expenditure was wholly and exclusively laid out for the purpose of the business."

"The legitimate business needs of the company must be judged from the viewpoint of the company itself and must be viewed from the point of view of a prudent businessman. It is not for the AO to dictate what the business needs of the company should be and he is only to judge the legitimacy of the business needs of the company from the point of view of a prudent businessman."

"The AO's disallowance of 10% was ad-hoc and without any concrete basis. Considering the past and succeeding years' expense ratios, it is fair and reasonable to allow expenses up to 10% of total operating revenue and disallow only the excess."

"No disallowance is called for the assessment year 2012-13 as the expenses claimed were 9.22% of total operating revenue, which is below the 10% threshold."

"The Tribunal directs the AO to modify the order and make disallowance only to the extent of expenses exceeding 10% of total operating revenue."

Final determinations:

• For assessment year 2010-11, the disallowance was partly allowed, limited to the excess over 10% of total operating revenue.
• For assessment year 2012-13, no disallowance was warranted as the expenses were below 10% of total operating revenue.
• The AO's ad-hoc disallowance without evidentiary basis was not sustainable.
• The expenditure on magazines and journals was held to be a legitimate and necessary business expense.
• Related-party transactions alone do not justify disallowance without proof of excessiveness or unreasonableness.
• The Tribunal followed the High Court's directions for fresh adjudication and applied principles of reasonableness, business necessity, and consistency.