2025 (7) TMI 293 - AT - Income Tax

AO exceeded limited scrutiny parameters making addition under section 36(1)(iii) without proper justification for inadmissible interest

ITAT Delhi held that AO exceeded limited scrutiny parameters by making addition u/s 36(1)(iii) for inadmissible interest without proper justification. The ... Scope of limited scrutiny - allegation of Violation of limited scrutiny instruction - Addition on account inadmissible interest u/s 36(1)(iii) DR argued that item ‘c’ extracted by the ld AO on first page of this order qua reasons of limited scrutiny refers to reason “high interest expenditure against new capital added in work in progress or addition made to the fixed asset.” It was argued that the impugned reason covered AO’s action of enquiring and making addition u/s 36(1)(iii) of the Act - HELD THAT:- The justification given by the ld DR has been found to be far from satisfactory and highly unconvincing. It is trite law that words and phrases used in judicial proceedings cannot be understood in isolation and have to be understood in complete contextual environment. We have noted that the ld DR basically is pressing on the word “high interest expenditure” so as to justify the addition of the ld AO. The same is not correct because the phrase “high interest expenditure” is to be understood only in the light of expenses qua new capital added or any additions to fixed assets. No such factual fact is found to be existing in the controversy of addition u/s 36(1)(iii) of the Act raised by the ld AO. We, therefore, cannot subscribe to the reasoning put forth by the revenue. Whether the instructions of CBDT are binding upon assessing authorities or not? - Instruction No. 5 of 2016 dated 14.07.2016 of CBDT mandating adherence to only limited scrutiny condition by the ld AOs of the department is mandatory and binding. The impugned instruction postulates that an AO may travel beyond the reasons given in the limited scrutiny parameters, provided he obtains necessary approval from his Pr. Commissioner and proceeds to convert the case into a complete scrutiny case. We have also noted that there exists a catena of cases stipulating that an AO is to restrict his enquiry and consequent addition only to the issues for which a case was selected for limited scrutiny assessment and cannot travel beyond. Such view has, interalia, been held in the case of Crystal Phosphates Ltd[2023 (4) TMI 817 - PUNJAB AND HARYANA HIGH COURT] and Weilburger Coatings (India) (P.) Ltd. [2023 (10) TMI 921 - CALCUTTA HIGH COURT] We have noted that it is an evident fact on record that the ld AO has travelled beyond the limited scrutiny parameters for which the case was selected by making the impugned addition u/s 36(1)(iii) of the Act. We have noted that in respectful compliance to the decision of the Hon’ble High Courts discussed supra the said addition was not legally permissible. Accordingly, we direct the ld AO to delete the impugned addition u/s 36(1)(iii) - Assessee appeal allowed. The primary legal issue considered by the Appellate Tribunal (AT) was whether the Assessing Officer (AO) exceeded his authority by making an addition of Rs. 3,83,08,176/- under section 36(1)(iii) of the Income Tax Act, 1961 (the Act) in a limited scrutiny assessment, and whether such addition was legally sustainable.More specifically, the core legal questions were:Whether the AO was empowered to make an addition under section 36(1)(iii) of the Act relating to inadmissible interest expenses in a limited scrutiny assessment when the issue was not part of the limited scrutiny reasons.Whether the instructions issued by the Central Board of Direct Taxes (CBDT), particularly Instruction No. 5/2016 dated 14.07.2016, mandating adherence to the scope of limited scrutiny, are binding on the AO.The correctness of the AO's factual and legal conclusion that the interest expenditure disallowed under section 36(1)(iii) related to borrowed funds used for investments in short-term deposits unconnected to the business.Issue-wise detailed analysis:1. Authority of AO in Limited Scrutiny Assessments and Applicability of CBDT InstructionsThe legal framework governing limited scrutiny assessments is encapsulated in the CBDT Instruction No. 5/2016 dated 14.07.2016, which restricts the AO to examine only those issues for which the case was selected for limited scrutiny. The AO may not expand the scope of inquiry beyond the specified reasons without obtaining prior approval from the Principal Commissioner of Income Tax (PCIT) and converting the case into a full scrutiny assessment.Precedents cited include decisions of the Hon'ble Punjab and Haryana High Court and Calcutta High Court which have held that the AO cannot travel beyond the limited scrutiny parameters without requisite approvals. The Hon'ble Jurisdictional High Court in Best Plastics Pvt. Ltd. held that CBDT instructions are binding on assessing authorities. Additionally, a CBDT circular dated 30.11.2017 was referenced, emphasizing strict compliance with limited scrutiny instructions and highlighting consequences of non-compliance, including suspicion of mala fide intent and suspension of officers.The Court examined the reasons recorded for limited scrutiny in the present case, which included high interest expenditure against new capital additions or fixed assets, but found no factual basis that the disputed interest expenditure related to such capital additions. The phrase 'high interest expenditure' was held to be contextual and limited to interest on borrowed funds used for new capital or fixed assets, which was not the case here.Accordingly, the Court concluded that the AO had exceeded his jurisdiction by making the addition under section 36(1)(iii) without the issue being part of the limited scrutiny reasons and without requisite approvals, thereby violating the CBDT instructions.Competing arguments by the Revenue that item 'c' in the limited scrutiny reasons covered the AO's action were rejected on the ground that the factual matrix did not support such an interpretation.2. Merits of the Addition under Section 36(1)(iii) of the ActSection 36(1)(iii) allows deduction of interest on borrowed capital only if such borrowed funds are used for the purposes of business or profession. The AO disallowed interest expenses on the ground that borrowed funds were invested in short-term deposits unrelated to the business, thus rendering the interest inadmissible.The CIT(A) deleted the addition after examining the facts and concluded that the interest expenditure was allowable. The Revenue challenged this deletion.The Tribunal noted that since the AO's addition was not legally permissible due to jurisdictional overreach, it was unnecessary to delve deeply into the merits of the addition. However, it was noted that the CIT(A) had examined the facts and granted relief accordingly, which was not interfered with.3. Binding Nature of CBDT Instructions and Procedural ComplianceThe Court emphasized that CBDT instructions are binding on assessing authorities. The scheme of assessment under section 143 of the Act is a complete code, and procedural safeguards, including adherence to limited scrutiny parameters, must be strictly followed.The Court rejected the Revenue's contention that non-compliance with limited scrutiny instructions amounted only to procedural irregularity, holding that the scheme under section 143 is substantive and procedural both, and non-compliance affects the validity of the assessment order.Conclusions and Application of Law to FactsThe Tribunal concluded that the AO's action in making the addition under section 36(1)(iii) was beyond the scope of limited scrutiny and contrary to binding CBDT instructions. Since the AO did not obtain approval to convert the case into a full scrutiny assessment, the addition was not legally sustainable.The CIT(A)'s deletion of the addition was upheld, and the Revenue's appeal was dismissed.Significant holdings include the following verbatim excerpt from the judgment:'Learned Tribunal rightly allowed the assessee's appeal on the said issue. This Court had an occasion to consider a somewhat similar issue... The Revenue cannot rely upon the said decision as the scheme of assessment as provided under Section 143 of the Act is a complete code by itself... Therefore, the question of part of the provision being procedural is an incorrect interpretation of the scheme provided under Section 143 of the Act... The CIT(A) has examined the merits of the matter and after taking note of the facts granted relief to the assessee to the extent indicated therein. Thus, for the above reasons, we find that the revenue has not made out any case for interference of the order passed by the Tribunal.'Core principles established:Assessing Officers are bound by the scope of limited scrutiny as specified in CBDT instructions and cannot expand their inquiry without proper approval.CBDT instructions issued under the Income Tax Act are binding on assessing authorities.The scheme of assessment under section 143 is a complete code, and non-compliance with procedural mandates can invalidate an assessment action.Interest on borrowed capital is allowable only if the borrowed funds are utilized for business purposes; however, if the AO's jurisdiction is lacking, the addition cannot be sustained.Final determinations:The addition of Rs. 3,83,08,176/- under section 36(1)(iii) of the Act was not legally permissible as it was made beyond the scope of limited scrutiny without requisite approval.The CBDT Instruction No. 5/2016 dated 14.07.2016 is binding on the AO, and strict adherence is mandatory.The CIT(A)'s order deleting the addition is upheld, and the Revenue's appeal is dismissed.