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 phrase "high interest expenditure" in limited scrutiny instructions only applied to expenses related to new capital or fixed asset additions, which was not present in this case. CBDT Instruction No. 5 of 2016 mandating adherence to limited scrutiny conditions is binding on AOs, who cannot travel beyond specified parameters without converting to complete scrutiny with proper approval. Following HC precedents in Crystal Phosphates Ltd and Weilburger Coatings cases, ITAT directed deletion of the impugned addition. Appeal allowed.

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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 Instructions

The 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 Act

Section 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 Compliance

The 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 Facts

The 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.

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