Expense allocation between SEZ eligible and non-eligible units affects section 10AA deduction calculations

The ITAT Jaipur addressed expense allocation between SEZ eligible and non-eligible units for section 10AA deduction. The AO apportioned expenses at 62% to non-eligible and 38% to eligible units based on sales percentage. The assessee admitted failing to properly apportion Rs. 49,94,866 to the exempted unit and agreed to the AO's allocation ratio of 68% non-eligible and 32% eligible units. The ITAT directed the AO to add 32% of the unallocated amount, less any amount already allocated by the assessee, with the balance to be deleted. The appeal was partly allowed.

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The primary legal issue considered in this appeal concerns the correctness of the allocation and apportionment of expenses between eligible and non-eligible units for the purpose of claiming deduction under section 10AA of the Income Tax Act. Specifically, whether the assessee's method of allocating expenses on a cost center basis, supported by audited unit-wise accounts and systematic accounting records, was rightly rejected by the Assessing Officer (AO) and the Commissioner of Income Tax (Appeals) (CIT(A))/National Faceless Appeal Centre (NFAC), who instead applied an apportionment based on turnover ratios.

Additional issues include the validity of the AO's addition to income by disallowing expenses allocated to the eligible units, the correctness of interest and penalty levied consequent to the reassessment, and the legal propriety of the authorities substituting the assessee's accounting method without adequate appreciation of the evidence and submissions.

Issue-wise Detailed Analysis

1. Allocation of Expenses for Deduction under Section 10AA

Legal Framework and Precedents: Section 10AA provides deduction in respect of profits derived from units located in Special Economic Zones (SEZs). The deduction is available only for profits attributable to the eligible units. Courts have consistently held that expenses must be properly allocated between eligible and non-eligible units to determine the correct quantum of deduction. The Madras High Court decision in CIT vs. Gimpex Ltd. (231 Taxmann 904) was relied upon by the AO, which held that the AO must ensure that common expenses are not disproportionately allocated to eligible units to inflate deductions under similar provisions (Section 80IB). This principle applies analogously to Section 10AA.

Court's Interpretation and Reasoning: The AO found that the assessee had not allocated all indirect expenses between units and had not applied a consistent or proper method of apportionment. The AO therefore apportioned indirect expenses on the basis of turnover ratios of eligible and non-eligible units, concluding that Rs. 1,57,63,792/- of expenses were allocated in excess to non-eligible units and thus disallowed the corresponding deduction under Section 10AA. The CIT(A)/NFAC upheld this approach, reasoning that the assessee failed to demonstrate a proper system of allocation and that the turnover-based apportionment was a reasonable proxy in the absence of proper records.

Key Evidence and Findings: The assessee contended that expenses were accounted on a cost center basis, with audited unit-wise accounts maintained regularly and independently at each unit's location. The assessee submitted detailed working papers, including interest cost allocation based on actual usage of funds, supported by accounting software data. The assessee also pointed to consistent acceptance of similar accounting treatment in subsequent assessment years. The AO and CIT(A) however did not accept these submissions, treating the allocation as inadequate or not properly documented.

Application of Law to Facts: The Tribunal examined the audited financials and unit-wise grouping of expenses submitted by the assessee, noting the detailed and systematic approach to cost center accounting, including direct and material indirect expenses. The Tribunal observed that the AO and CIT(A) did not sufficiently appreciate the evidence of separate books maintained at each unit, stock registers, payrolls, and regulatory compliance under SEZ laws. The Tribunal found that only a minor portion of indirect expenses amounting to Rs. 49,94,866/- remained unallocated and accepted that this amount could be apportioned on turnover basis.

Treatment of Competing Arguments: The AO and CIT(A) emphasized the lack of proper allocation and the necessity of turnover-based apportionment. The assessee argued that the turnover basis was arbitrary and ignored the commercial realities and accounting records. The Tribunal sided with the assessee's submissions on the majority of expenses, holding that the turnover-based approach should not replace a systematically adopted accounting method without proper examination of the evidence. However, the Tribunal accepted that a small portion of indirect expenses could be fairly apportioned on the turnover basis.

Conclusions: The Tribunal partially allowed the appeal by directing the AO to accept the assessee's cost center based allocation except for the minor indirect expenses of Rs. 49,94,866/-, which should be apportioned on turnover basis (32% to eligible units). This resulted in a reduction of the addition made by the AO from Rs. 1,57,63,792/- to Rs. 17,83,667/-.

2. Calculation of Turnover Ratios and Quantum of Deduction

Legal Framework and Precedents: The deduction under Section 10AA requires correct identification of turnover attributable to eligible units. The percentage of turnover is critical in apportioning expenses and profits.

Court's Interpretation and Reasoning: The AO and CIT(A) used a turnover ratio of 38% for the two SEZ units combined. The assessee contended that the correct turnover ratio was 35.71%, based on audited unit-wise accounts. The Tribunal accepted the assessee's calculation as more accurate and based on audited data.

Key Evidence and Findings: The Tribunal reviewed the turnover figures as per audited unit-wise Profit & Loss accounts submitted by the assessee and found the turnover ratio of 35.71% to be correct rather than 38% used by the AO and CIT(A).

Application of Law to Facts: The Tribunal held that the turnover ratio should be based on audited and verified unit-wise accounts rather than an arbitrary figure. This adjustment impacted the apportionment of expenses and the consequent deduction under Section 10AA.

Conclusions: The Tribunal directed that the turnover ratio of 35.71% be used for apportionment purposes, which in turn reduced the addition and increased the deduction allowable to the assessee.

3. Levy of Interest and Additional Tax Demand

Legal Framework: Interest and additional tax are leviable under various sections of the Income Tax Act when there is underreporting or short payment of tax.

Court's Interpretation: The assessee challenged the correctness of interest levied, arguing that the tax demand itself was based on an incorrect addition. The Tribunal held that interest and tax should be recalculated in accordance with the final determination of income after allowing the correct deduction under Section 10AA.

Conclusions: The Tribunal allowed consequential relief in respect of interest and tax demand, directing recalculation based on the revised income figure.

Significant Holdings

"Manufacturing expenses, Insurance Vehicle & Staff, Travelling Expenses & Adm. & Selling excluding Rent, Security, VAT, Legal & Professional charges, staff welfare, Export Expenses, Finance Charges, Bank Charges & Internet and Mobile expenses are directly attributable to represent unit and allocating the same on the percentage basis is not correct approach when the separate set of books are maintained by the assessee, get them audited by an independent chartered accountant and the same being regularly and consistently maintained."

"When the appellant has not done the allocation by applying proper criteria, the AO was constrained to apply the criteria of turnover which resulted in the allocation and addition. The submissions made by the appellant are not at all convincing and hence the addition made by the AO which is after allocating indirect expenditure amongst all the four units on the basis of turnover is found to be the correct criteria." (CIT(A) view - overturned by Tribunal except for minor amount)

"The casual or irresponsible approach of each of reviewer whether the AO and/or the CIT(A)'s is evident and they have therefore faltered in not properly understanding and considering and dealing with both the centre based accounting evident from the Grouping to the audited balance sheet (the financials) which specifically deal with accounting done at respective location and at timing of their incurrence at their respective location and separately maintained books of accounts at each Units location."

Core principles established include that a systematically adopted and documented method of expense allocation, supported by audited unit-wise accounts and underlying transaction data, should not be replaced by an arbitrary turnover-based apportionment without proper examination and rejection of the evidence. Minor indirect expenses not allocated may be apportioned on a reasonable basis such as turnover. The turnover ratio itself must be accurately determined from audited data.

Final determinations on each issue are that the assessee's cost center based accounting and allocation of expenses is largely accepted except for a small portion of indirect expenses which may be apportioned on turnover basis; the turnover ratio for eligible units is 35.71%; and consequential relief is granted on tax and interest demands.

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