2007 (2) TMI 362 - 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 expenditure.
2. Applicability of section 14A.
3. Deductibility under section 36(1)(iii) and section 57(iii).

Detailed Analysis:

1. Disallowance of Interest Expenditure:
The assessee contested the disallowance of interest expenditure amounting to Rs. 5,04,56,580 by the Assessing Officer (AO), which was attributed to investments in shares of group companies. The AO argued that the funds borrowed at interest were not used for the business purpose of development and construction of a residential project (Kandivli Project). The AO observed a consistent increase in investments in shares along with a rise in borrowings, leading to the conclusion that interest-bearing funds were used for investments rather than for the construction business. The CIT(A) upheld this view, stating that the borrowed funds were not utilized for the business of construction.

2. Applicability of Section 14A:
The CIT(A) confirmed the AO's decision based on three main reasons:
- The deduction under section 36(1)(iii) was not allowable as the borrowed funds were not used for business purposes.
- The dividend income from shares was taxable under section 56, making the interest allocable to these investments deductible only under section 57(iii).
- The dividend income was exempt from taxation, thus no deduction was permissible under section 14A for expenses related to exempt income.

The Tribunal noted that section 14A prohibits deduction of any expenditure incurred in relation to income that does not form part of the total income under the Income-tax Act. The Tribunal emphasized that the term "expenditure" under section 14A includes all forms of expenses related to earning exempt income, whether direct or indirect, fixed or variable, administrative or financial. The Tribunal cited various cases to support this interpretation, highlighting that investment decisions involve substantial expenses, including management and administrative costs.

3. Deductibility under Section 36(1)(iii) and Section 57(iii):
The Tribunal observed that deductions under sections 36(1)(iii) and 57(iii) are subject to section 14A. The Tribunal explained that procedural provisions for computing disallowance under section 14A apply to all pending matters. The AO is required to compute disallowance as per the method prescribed under sub-sections (2) and (3) of section 14A, rather than applying discretion or making ad hoc disallowances.

The Tribunal further highlighted that the deduction under section 36(1)(iii) is allowable only if the borrowed funds are utilized for the business purpose of the assessee. It referenced the case of K. Somasundaram Bros. v. CIT, where it was held that interest on borrowed funds diverted for non-business purposes cannot be claimed as business expenditure. The Tribunal emphasized that the assessee must demonstrate that the borrowed funds were used for the construction business and not for investments in shares.

Conclusion:
The Tribunal set aside the order of the CIT(A) and restored the matter for a fresh decision, directing the CIT(A) to consider the provisions of section 14A, including sub-sections (2) and (3), and section 36(1)(iii). The CIT(A) was instructed to determine if any expenditure was incurred in relation to exempt income and to quantify the disallowance accordingly. The appeal filed by the assessee was allowed for statistical purposes.