2025 (6) TMI 1196 - AT - Income Tax

Exemption u/s 11 - surplus funds of a charitable institution can be used for the purpose of other than objectives of the Trust or not? - HELD THAT - A careful perusal of Section 13(1)(d) 13(1)(c) 13(2) and 13(3) it will reveal that the status of the Institution cannot be changed from charitable to non charitable Institution if a minor violation is there. Sub-clause (3) of Section 13 would provide that if undue benefit is being provided to any Institution or individual because of its proximity with the Management then that undue benefit is to be brought to tax but Section 11 and 12 would not be denied to the overall Society/Institution. Therefore CIT(A) has erred in not analytically examining the issue and the AO has erred in denying the exemption as a whole to the assessee. He ought to have examined more analytically what is the objective of making advance to any related person and then he ought to have worked out for any interest income can be allocated/assumed on such investment. It is also pertinent to note that AO cannot make addition of surplus over expenditure in the Society. He has to grant benefit under Section 11 and 12. The only exception is disallowance of any amount which was unduly extended by the assessee to the persons mentioned in clause 13(3). Therefore we deem it appropriate to set aside both the orders and relegate both the issues to the file of AO for fresh adjudication. Appeals are allowed for statistical purposes.

Summary

The core legal questions considered by the Tribunal revolve around the applicability of Sections 11, 12, and 13 of the Income Tax Act, 1961 to a charitable trust engaged in educational activities. Specifically, the issues include: (i) whether the trust's interest-free advances to related parties violate Sections 13(1)(c) and 13(1)(d) read with Section 13(3), thereby disallowing exemption under Section 11; (ii) whether the Assessing Officer (AO) was justified in computing notional interest on such advances and including it in income; (iii) whether the surplus funds of the trust, exceeding 15% of gross receipts, were correctly taxed given the application of funds test under Section 11(5); and (iv) the correctness of assessing the trust as an Association of Persons (AOP) instead of granting exemption under Sections 11 and 12.

Regarding the first issue on the applicability of Sections 13(1)(c) and 13(1)(d) concerning interest-free advances to related parties, the legal framework mandates that any income of a trust directly or indirectly applied for the benefit of persons specified in Section 13(3) shall not be excluded from total income, and exemption under Section 11 shall not apply to such income. The AO held that the trust had advanced Rs. 37.57 crores interest-free to related parties, thereby violating these provisions, and computed notional interest at 12% amounting to Rs. 4.5 crores as income. However, the Commissioner of Income Tax (Appeals) [CIT(A)] deleted this addition, reasoning that the AO lacked a specific charging section to justify taxing notional interest and that the imposition of such interest was not maintainable. The CIT(A) found no nexus between the loans raised and advances given, and noted prior years' acceptance of similar transactions without disallowance. The Tribunal noted that while the AO's approach to impose notional interest was flawed without a specific charging provision, the CIT(A) also failed to conduct an analytical examination of whether the advances violated Section 13 or whether the trust's charitable status was impacted. The Tribunal emphasized that minor violations under Section 13 do not convert a charitable trust into a non-charitable one but may attract tax on undue benefits to related persons. Consequently, the matter was remanded for fresh adjudication with directions to the AO to examine the objective and nature of advances and determine taxable income accordingly.

On the second issue concerning the surplus funds and application of income under Section 11(5), the AO identified a surplus of Rs. 12.79 lakhs after analyzing gross receipts and application of funds. The AO contended that since the trust violated Sections 13(1)(d) and 11(5), it was not entitled to exemption and assessed the surplus as income. The assessee argued that it had applied more than 95% of its gross receipts to charitable purposes, exceeding the 85% threshold under Section 11(5), and thus no disallowance was warranted. The Tribunal observed that surplus funds of a charitable institution are not akin to those of a business entity; such funds are held in fiduciary capacity and must be applied solely to charitable objectives. Accumulated surplus, if not applied in the prescribed manner, is taxable. However, the Tribunal found that the AO erred in taxing the surplus without properly considering the application of funds and the trust's compliance with Section 11(5). It held that the AO must grant exemption under Sections 11 and 12 unless there is a clear violation. The Tribunal set aside the AO's order on this issue and remanded it for fresh consideration.

Regarding the third issue of the status of the trust as an AOP for assessment purposes, the AO assessed the trust as an AOP due to the alleged violation of Sections 13(1)(c) and 13(1)(d), thereby denying exemption under Sections 11 and 12. The assessee challenged this, asserting that it was a registered charitable trust with valid registrations under Sections 12A and 10(23C), and that its activities and application of income were in conformity with the law. The Tribunal noted that the status of the institution cannot be altered to a non-charitable entity merely on account of minor violations. It emphasized that the trust's registration and prior acceptance by the Revenue supported its charitable status. The Tribunal concluded that the AO erred in denying exemption and changing the status to AOP without proper analysis and directed the AO to reconsider the matter afresh in accordance with law.

In addressing the competing arguments, the Tribunal balanced the Revenue's concern over potential misuse of charitable funds with the assessee's submissions and prior consistent treatment. It acknowledged the AO's duty to scrutinize interest-free advances to related parties but underscored the necessity of a reasoned and specific charging provision before taxing notional interest. It also recognized that minor infractions under Section 13 attract tax only on undue benefits and do not strip the trust of its charitable status. The Tribunal criticized the CIT(A) for lack of analytical depth but found the AO's approach equally flawed for being hasty and not adequately supported by evidence.

The Tribunal's conclusions were that both the AO and CIT(A) erred in their respective approaches. The AO improperly imposed notional interest and taxed surplus without due analysis, while the CIT(A) failed to examine the issues analytically. The Tribunal remanded both issues to the AO for fresh adjudication, allowing the trust to present its case fully and directing the AO to decide in accordance with the law and facts.

Significant holdings include the following verbatim reasoning by the CIT(A), upheld in principle by the Tribunal: "Without having any specific charging section, the AO cannot estimate notional interest @ 12% on those advances. Upon perusal of the detailed written submission, it is seen that charging notional interest on those advances made in the assessment order is not maintainable." The Tribunal further articulated the principle that "surplus funds of a charitable Institution who enjoys benefit of Section 11 and 12, are not akin to surplus funds of a business house... The Trust is not enjoying those funds as its own funds. It is being held in a fiduciary capacity... Thus, funds can never be used for any other purpose except for charitable activity."

The core principles established are: (i) interest-free advances by a charitable trust to related parties may attract tax on undue benefits under Section 13(3) but do not ipso facto deny exemption under Sections 11 and 12; (ii) notional interest cannot be imposed without a specific charging provision; (iii) surplus funds must be applied in accordance with Section 11(5) and failure to do so may attract tax, but proper analysis is essential; (iv) minor violations under Section 13 do not alter the charitable status of the trust; and (v) the AO must conduct a reasoned examination of facts and law before denying exemption or altering the status of a trust.

Ultimately, the Tribunal allowed both appeals for statistical purposes and remanded the matters for fresh adjudication, thereby preserving the trust's right to exemption subject to proper scrutiny and application of law.