2010 (7) TMI 1238 - AT - Income Tax

Tribunal allows 18% interest rate on unsecured loans from directors under section 40A(2)(b)

Deputy Commissioner of Income Tax, Circle-1, Surat Versus Manisha Dyeing & Printing Works Pvt. Ltd.,

ITAT Ahmedabad partly allowed the assessee's appeals for assessment years 2004-05 and 2005-06 while dismissing the Revenue's cross-appeal. For 2004-05, ... - The core legal questions considered by the Tribunal in this matter pertain primarily to the disallowance of interest paid on unsecured loans under section 40A(2)(b) of the Income Tax Act, and the addition made on account of fall in gross profit margin including valuation of work-in-progress for the assessment years 2004-05 and 2005-06. Specifically, the issues are:1. Whether the interest paid on unsecured loans obtained from directors and their relatives at rates higher than secured bank loans is excessive and liable to disallowance under section 40A(2)(b) for AY 2004-05 and AY 2005-06.2. Whether the addition made on account of fall in gross profit margin, inclusive of closing stock of work-in-progress, is justified and correctly quantified for AY 2004-05.Issue 1: Disallowance of Interest on Unsecured Loans under Section 40A(2)(b)The relevant legal framework is section 40A(2)(b) of the Income Tax Act, which permits disallowance of expenditure if the payment is excessive or unreasonable. The Supreme Court in Upper India Publishing House Pvt. Ltd. v. CIT [156 ITR 585 (SC)] clarified that disallowance under this provision applies only when the expenditure is excessive and unreasonable.For AY 2004-05, the Assessing Officer disallowed Rs.10,12,500/- on the ground that the interest rate of 18% on unsecured loans from directors and relatives was excessive compared to 11.25% interest on secured bank loans. The assessee contended that the bank rate could not be the sole benchmark, relying on ITAT Gauhati's decision and the Gujarat High Court's ruling in Sirhind Steel (P) Ltd. v. CIT (184 CTR 312), which held that the department must prove excess payment to invoke section 40A(2)(b). The assessee further submitted that the higher interest was justified as it enabled the company to obtain cash discounts from principal suppliers, effectively reducing borrowing costs.The Revenue argued that the company had sufficient assets to obtain secured loans at 11.25%, and that unsecured loans at 18% were unnecessary and excessive, warranting disallowance of the excess interest.The Tribunal examined the facts and noted that the unsecured loans were taken for business purposes and that an 18% interest rate on unsecured loans was reasonable and prevailing in the market at the relevant time. It emphasized the principle from the Supreme Court that section 40A(2)(b) applies only when expenditure is excessive and unreasonable. The Tribunal therefore deleted the disallowance of Rs.10,12,500/- for AY 2004-05.For AY 2005-06, the issue was similar but with an increased interest rate of 24% on unsecured loans compared to 11.25% on secured bank loans. The Assessing Officer disallowed Rs.19,12,500/- corresponding to the excess 12.75%. The Commissioner of Income Tax (Appeals) reduced this disallowance to Rs.13,50,000/- (15%). The assessee submitted that the higher rate was market-driven, supported by supplier bills stipulating interest rates from 24% to 36% for delayed payments.The Revenue countered that the increase from 18% in the prior year to 24% was unjustified, especially as many loans were old.The Tribunal referred to a coordinate bench decision for AY 2004-05 (Empire Motors) which allowed interest at 18% as reasonable. Given that the prior year interest was 18%, and market conditions for AY 2005-06 did not justify a higher rate, the Tribunal directed the Assessing Officer to restrict the allowable interest rate to 18%, disallowing the balance 6%. Thus, the disallowance was partly allowed.Issue 2: Addition on Account of Fall in Gross Profit Margin and Work-in-Progress Valuation (AY 2004-05)The Assessing Officer observed a fall in gross profit margin from 31.93% in the preceding year to 24.68% in the year under appeal, quantifying the fall at Rs.41,82,996/-. After considering explanations and evidence, the Assessing Officer made an addition of Rs.11,95,367/- on an ad hoc basis for fall in gross profit margin inclusive of undervaluation of work-in-progress (WIP) stock of Rs.3,20,983/-, which was not separately added.The assessee explained the fall in gross profit was due to a strike in the textile industry reducing receipts of grey cloth, increased consumption of electricity, coal and lignite due to inferior quality inputs, increased repairs and maintenance expenses due to older machinery, and non-receipt of electricity rebates. The assessee argued these were ordinary business expenses incurred out of commercial prudence and did not indicate concealment of income.Regarding work-in-progress, the assessee contended that since the company did job work on grey cloth owned by others, no WIP should be shown or added.The Commissioner of Income Tax (Appeals), relying on the Supreme Court's decision in British Paints India Ltd. (188 ITR 44), held that WIP must be disclosed even in job work cases because costs such as chemicals, power, fuel, and labor are incurred on the fabric lying in process, and these costs have been debited to the Profit & Loss account without corresponding revenue recognition. Therefore, the addition on account of WIP was sustained.However, the Commissioner of Income Tax (Appeals) accepted the assessee's explanation for the fall in gross profit to some extent and restricted the addition to Rs.6,00,000/- (approximately 50% of the Assessing Officer's addition), which included the WIP addition of Rs.3,20,983/-.The Revenue contended that the Assessing Officer had already considered and accepted explanations to the extent of Rs.29,87,628/- and that the residual addition of Rs.11,95,367/- was justified and should be restored. The Revenue pointed out that the assessee's production was low compared to installed capacity, and the reasons given for the fall in gross profit were insufficient.After considering the submissions and the orders below, the Tribunal found that the Commissioner of Income Tax (Appeals) had carefully balanced the explanations and objections and that restricting the addition to Rs.6,00,000/- including WIP was just and reasonable. The Tribunal upheld the Commissioner's order, dismissing the Revenue's appeal and the relevant ground of the assessee's appeal.Significant HoldingsOn the disallowance of interest under section 40A(2)(b), the Tribunal emphasized the settled legal principle that disallowance applies only if the expenditure is excessive and unreasonable, quoting the Supreme Court's decision in Upper India Publishing House Pvt. Ltd. The Tribunal held:'It is a well-settled law that section 40A(2)(b) cannot have any application, unless it is first held that expenditure was excessive and unreasonable as held by the Hon'ble Supreme Court in the case of Upper India Publishing House Pvt. Ltd.'Applying this, the Tribunal found the interest rates of 18% (AY 2004-05) and 18% (revised for AY 2005-06) on unsecured loans from directors and relatives to be reasonable in the prevailing market context, deleting or reducing the disallowances accordingly.Regarding the valuation of work-in-progress in job work cases, the Tribunal relied on the Supreme Court's ruling in British Paints India Ltd., which mandates disclosure of WIP since costs are incurred and debited without revenue recognition, stating:'The assessee is mandatorily required to disclose the work-in-progress because on the fabric lying on machine it has incurred cost and colour chemicals, electricity, power and fuel, labour charges and various other expenses which have already been debited to Profit & Loss A/c. for which no revenue has been recognized.'On the fall in gross profit margin, the Tribunal accepted the Commissioner of Income Tax (Appeals)'s approach of partial acceptance of the assessee's explanations and restricting the addition to Rs.6,00,000/-, balancing the competing contentions of the parties.In conclusion, the Tribunal dismissed the Revenue's appeal for AY 2004-05, partly allowed the assessee's appeals for both AY 2004-05 and AY 2005-06, deleting or reducing the disallowances under section 40A(2)(b) and upholding the restricted addition on account of fall in gross profit and WIP valuation.