Exempt-income disallowance and treaty PE deductions: domestic section 44C limits cannot restrict allowable head office under Article 7(3).

Expenditure relating to exempt income may be disallowed in principle, with the interest component requiring verification of the nexus between borrowed funds and tax-free investments and the administrative and management expenses confined to 2% of the exempt income. Treaty computation of permanent establishment profits under Article 7(3) permits deduction of business expenses without importing the domestic restriction in section 44C, so the head office expenditure cap under that provision does not apply. The overall position is that exempt-income related disallowance can stand partly, while treaty-based deduction of head office expenses is not limited by section 44C.

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Issues: (i) Whether disallowance of expenditure relatable to exempt income was sustainable, including the interest component and the administrative and management expenses; (ii) whether section 44C could be applied to restrict deduction of head office expenditure in computing the profits of the permanent establishment under Article 7(3) of the treaty.

Issue (i): Whether disallowance of expenditure relatable to exempt income was sustainable, including the interest component and the administrative and management expenses.

Analysis: The disallowance was upheld in principle for expenditure incurred in relation to exempt income. For the interest component, the matter required verification of the nexus between borrowed funds and investment in tax-free bonds, and the quantification was therefore restored to the Assessing Officer. For administrative and management expenses, the disallowance was restricted to 2% of the exempt income.

Conclusion: The disallowance relating to exempt income was sustained in principle, with the interest component remanded for recomputation and the administrative and management expenses restricted to 2%.

Issue (ii): Whether section 44C could be applied to restrict deduction of head office expenditure in computing the profits of the permanent establishment under Article 7(3) of the treaty.

Analysis: Article 7(3) was held to permit deduction of expenses incurred for the business of the permanent establishment without the domestic restriction contained in section 44C. On that footing, the statutory limitation under section 44C could not be imported to curtail the allowable head office expenditure.

Conclusion: Section 44C was held inapplicable to the computation of the permanent establishment's profits under Article 7(3).

Final Conclusion: The appeals were resolved by sustaining the exempt-income disallowance in part, remanding the interest aspect for verification, and rejecting the application of section 44C to the treaty computation of permanent establishment profits.

Ratio Decidendi: Where treaty provisions governing permanent establishment profits permit deduction of business expenses without domestic limitation, the domestic restriction cannot be applied to curtail the allowable deduction; expenditure relatable to exempt income may nevertheless be disallowed, with quantification depending on the proven nexus and the nature of the expense.

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