AO failed to verify expenses properly, CIT revision order under section 263 upheld for fresh assessment

ITAT Delhi upheld CIT's revision order u/s 263 directing AO to conduct fresh assessment after disallowing all P&L expenses except those required for maintaining corporate identity like statutory auditor fees and registrar fees. The tribunal found AO failed to properly enquire or verify the expenses claimed, making the assessment order erroneous and prejudicial to revenue interests under Explanation 2(a) to section 263. Following precedent in Rajpal Singhal case, ITAT dismissed assessee's appeal, confirming CIT's jurisdiction to set aside the defective assessment order.

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The core legal questions considered in this appeal revolve around the exercise of revisionary power under section 263 of the Income Tax Act, 1961 (the 'Act'), specifically:

1. Whether the order of the Assessing Officer (AO) accepting the returned income without making necessary inquiries or verifications was erroneous and prejudicial to the interests of the Revenue.

2. Whether the Principal Commissioner of Income Tax (PCIT) acted beyond the scope of the show-cause notice issued under section 263, thereby violating the principles of natural justice.

3. Whether the assessee was engaged in any business activity during the relevant assessment year, justifying the claimed expenses.

4. Whether the PCIT's direction to disallow certain expenses and to assess income under section 22 in respect of six flats owned by the assessee was legally sustainable.

5. Whether the limited time given to the assessee to respond to the show-cause notice under section 263 violated the principles of natural justice.

Issue 1: Whether the AO's assessment order was erroneous and prejudicial to the interests of the Revenue under section 263 of the Act

The relevant legal framework is section 263 of the Income Tax Act, which empowers the PCIT to revise any order passed by the AO if it is found to be erroneous and prejudicial to the interests of the Revenue. Explanation 2 to subsection (1) of section 263 clarifies that an order passed without making inquiries or verification which should have been made shall be deemed erroneous and prejudicial.

The Court examined the facts that the AO accepted the returned income of nil without conducting adequate inquiries, despite the assessee admitting no business activity during the year and the absence of employees. The AO had raised queries regarding justification of expenses and investment in six flats, but the assessee failed to provide satisfactory explanations or documentary evidence.

The PCIT found that the AO's acceptance of all claimed expenses totaling Rs. 50,18,444/- without verification was erroneous and prejudicial. The AO did not ascertain the business nexus of the expenses or verify the use of the flats for business purposes, which was necessary before allowing deductions.

In applying the law to facts, the Court noted the absence of any sales or service revenue during the year in the financial statements, and the assessee's failure to establish business operations or provide evidence of rendering services as per the agreement. This indicated no business activity was carried out, making the claimed expenses inadmissible under section 37.

The Court referred to the Supreme Court's ruling in Malabar Industrial Co. Ltd., which held that an order is erroneous and prejudicial when the AO fails to make necessary inquiries, resulting in loss of lawful revenue. The Court also relied on the recent Supreme Court decision in Paville Project Pvt. Ltd., which upheld the Commissioner's power to revise an erroneous and prejudicial order under section 263.

Competing arguments by the assessee that the PCIT acted beyond the scope of the show-cause notice and that the assessee was engaged in business were rejected. The Court held that the revisionary power under section 263 is not confined to the terms of the show-cause notice and that the assessee failed to prove business activity.

Conclusion: The Court upheld the PCIT's finding that the AO's order was erroneous and prejudicial to the interests of the Revenue, justifying revision under section 263.

Issue 2: Whether the PCIT violated principles of natural justice by giving only limited time to respond and by traveling beyond the show-cause notice

The assessee contended that the show-cause notice dated 27.03.2023 was issued late at night and allowed only about two days to respond, which was insufficient and violated natural justice. Further, the PCIT's order disallowed expenses and directed income assessment under section 22 for six flats, which the assessee argued was beyond the scope of the show-cause notice.

The Court examined the reply submitted by the assessee on 29.03.2023 and found no request for extension or grievance regarding the limited time. The Court reasoned that the proceedings were time-barred by 31.03.2023, necessitating prompt response. Hence, no violation of natural justice occurred.

Regarding the PCIT's scope of inquiry, the Court relied on the Supreme Court's decision in Amitabh Bachchan, which clarified that the Commissioner's power under section 263 is not restricted to the terms of the show-cause notice and may extend beyond it. Therefore, the PCIT's directions were within jurisdiction.

Conclusion: The Court held that there was no breach of natural justice in the limited time given for reply and that the PCIT did not exceed jurisdiction by addressing issues beyond the show-cause notice.

Issue 3: Whether the assessee was engaged in business activity during the relevant year to justify claimed expenses

The assessee claimed to be engaged in consulting services related to sale, repair, and maintenance of earthmover tyres, relying on a 2016 agreement for sale and repair services. However, the financial statements for the relevant year showed no sales or service income, and the assessee admitted having no employees during the year.

The Court noted the absence of any documentary evidence such as service requisitions or proof of repairs undertaken during the year. The entire revenue of Rs. 75.50 lakhs shown in the previous year was on repair and maintenance, not sales. The assessee's claim that it was servicing tyres sold in earlier years was unsubstantiated.

The Court concluded that the assessee did not carry on any business activity during the year, rendering the claimed expenses inadmissible as they were not incurred wholly and exclusively for business purposes under section 37.

Conclusion: The Court upheld the PCIT's finding that no business activity was carried out by the assessee during the relevant year.

Issue 4: Legality of PCIT's direction to disallow expenses and assess income under section 22 for six flats

The PCIT directed the AO to disallow expenses of Rs. 50,18,444/- except those necessary to maintain the corporate identity (e.g., statutory auditor fees) and to compute income from six flats owned by the assessee under section 22 (income from house property), after giving the assessee an opportunity to be heard.

The Court observed that the assessee failed to justify the business nexus of the flats or provide details of their occupancy or use for business purposes. The AO had not made inquiries regarding the flats' use before allowing deductions for building maintenance and rent expenses.

The Court found the PCIT's directions consistent with the legal provisions, as income from property not used for business is taxable under section 22, and expenses unrelated to business cannot be allowed as deductions.

Conclusion: The Court upheld the PCIT's directions to disallow non-business expenses and assess income under section 22 in respect of the flats.

Issue 5: Whether the PCIT's exercise of revisionary jurisdiction was justified in light of precedents

The Court referred to the Coordinate Bench's decision in Rajpal Singhal, where similar facts led to the conclusion that the AO's acceptance of returned income without verification was erroneous and prejudicial, justifying revision under section 263.

The Court also reiterated the principles from Malabar Industrial Co. Ltd. and Paville Project Pvt. Ltd. that revision under section 263 requires satisfaction of twin conditions: erroneous order and prejudice to Revenue's interests. The Court found these conditions fulfilled on the facts.

Conclusion: The Court affirmed the PCIT's valid exercise of revisionary jurisdiction under section 263.

Significant holdings include:

"An order passed without making inquiries or verification which should have been made shall be deemed to be erroneous in so far as it is prejudicial to the interests of the Revenue." (Explanation 2(a), section 263)

"There is nothing in section 263 of the Act to make the Commissioner confine himself to the terms of show-cause notice, and further that power of revision under section 263 of the Act is not contingent on giving of a show-cause notice." (Supreme Court in Amitabh Bachchan)

"If due to an erroneous order of the Income Tax Officer, the Revenue is losing tax lawfully payable by a person, it will certainly be prejudicial to the interests of the Revenue." (Supreme Court in Malabar Industrial Co. Ltd.)

"Where the order passed by the Assessing Officer is erroneous and prejudicial to the interest of the Revenue, the Commissioner has jurisdiction under section 263 to revise the order." (Supreme Court in Paville Project Pvt. Ltd.)

The Court concluded that the AO's order accepting returned income without proper inquiry was erroneous and prejudicial, justifying revision under section 263. The PCIT did not violate principles of natural justice, nor did she exceed jurisdiction. The assessee failed to establish business activity, rendering claimed expenses inadmissible. Directions to disallow expenses and assess income from flats under section 22 were legally sound. The appeal was dismissed, affirming the PCIT's order.

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