2026 (2) TMI 360 - AT - Income Tax

Transfer pricing on preference share investment reaffirmed as loan; imputed interest benchmarked, and multiple tax disallowances addressed.

Transfer pricing adjustment: tribunal upheld recharacterisation of preference share investment as a loan where assessee failed to bifurcate ... TP Adjustment on Preference Share Investment - treating the assessee’s investment in preference share capital / share application money of its Associated Enterprise (“AE”) as a loan transaction and imputing notional interest thereon - arm’s length value of the interest to be received was determined applying LIBOR + 2% as the arm’s length interest rate and computed the interest - HELD THAT:- In the present case, in earlier years, the assessee converted outstanding loans of AE into preference shares, which has been characterized as loan transaction by the Revenue/Income-tax Authorities. During the year, the Dispute Resolution Panel specifically called upon the assessee to furnish a clear bifurcation of the preference share investment between that arising from conversion of earlier loans and that made by way of fresh cash subscription. Despite such opportunity, the assessee failed to produce cogent and verifiable material to substantiate its claim. In the absence of such bifurcation, the DRP was constrained to conclude that the preference shares outstanding during the year were traceable to earlier loan transactions. The inference drawn by the Revenue authorities that the transaction lacked commercial justification and was structured primarily to avoid interest liability cannot be said to be unreasonable. Where the assessee fails to discharge the burden of establishing the true nature and origin of the transaction, the Revenue is entitled to look beyond the form and examine its real substance. Transaction assumes the character of a sham arrangement, rendering the ratio of Aegis Ltd. [2019 (4) TMI 858 - BOMBAY HIGH COURT] inapplicable to the facts of the present case. Similarly, reliance placed on the decision in Tops Group Electronic Systems Ltd [2019 (2) TMI 2130 - BOMBAY HIGH COURT] is misplaced, as that case pertained to investment in equity shares and did not involve conversion of loans into preference share capital. The factual matrix in the present case is materially distinct. The other decisions cited on behalf of the assessee are likewise distinguishable on facts and do not advance the assessee’s case. We find no infirmity in the order of the Dispute Resolution Panel affirming the action of the Transfer Pricing Officer in re-characterising the preference share investment as a loan transaction and benchmarking the same accordingly. Disallowance u/s 14A - assessee suo-motu disallowed a sum as expenditure related to the exempted income - assessee submitted that no dissatisfaction had been recorded by the AO - HELD THAT:- Principal contention of the assessee that the Assessing Officer failed to record dissatisfaction with regard to the suo motu disallowance made u/s 14A cannot be accepted. On examination of the suo motu disallowance made by the assessee, we find that no rational or cogent basis was furnished for restricting the salary cost of the CFO, Deputy CFO, and Head of Treasury to 1%. The allocation appears to have been made purly on an ad hoc and arbitrary basis, unsupported by any evidence such as work allocation or time spent on investment-related activities. Similarly, no basis was explained for estimating 5% of the salary of certain employees, nor were the names or roles of such employees identified. Further, no justification was provided for allocating overheads at 10% of the salary so apportioned. In the absence of any rational or scientific basis, the estimation adopted by the assessee cannot be accepted as reasonable. Plea of consistency - It is well settled that the principle of res judicata has no application to income-tax proceedings and each assessment year is a separate and independent unit. The quantum of investments and the extent of investment activity may vary from year to year. Therefore, the acceptance of a particular method of disallowance in earlier years does not preclude examination of the claim on its own merits in the year under consideration. Disallowance of interest expenditure under Rule 8D(2)(ii) - As we find merit in the assessee’s contention. The Hon’ble Bombay High Court in CIT v. Reliance Utilities and Power Ltd [2009 (1) TMI 4 - BOMBAY HIGH COURT] has held that where an assessee possesses sufficient interest-free funds exceeding the value of investments, a presumption arises that such investments were made out of own funds, and no disallowance of interest is warranted. In the present case, the assessee has demonstrated availability of interest-free funds far in excess of the investments made. Accordingly, no disallowance under Rule 8D(2)(ii) can be sustained. Disallowance of administrative expenditure under Rule 8D(2)(iii) - Special Bench of the Tribunal in ACIT v. Vireet Investment Pvt. Ltd. [2017 (6) TMI 1124 - ITAT DELHI] has held that, for the purpose of computing disallowance under Rule 8D(2)(iii), only those investments which have actually yielded exempt income during the relevant previous year are to be considered. We direct the AO to recompute the disallowance under Rule 8D(2)(iii) in accordance with law. Admissibility of the additional ground - Disallowance of deduction u/s 80IA - transfer of steam from the 80-IA eligible undertaking - The subsequent attempt to ascribe a notional market value to such transfer, after having consistently treated it at cost, cannot be regarded as a bona fide plea raised in the interest of correct legal adjudication. The captive power plant generate electricity where turbine is rotated by force of steam and thus generation of steam is prime requirement of electricity generation and it is not the case the assessee is separately generating steam, for use as a power source so as to mark the cost of steam separately. In our opinion it seems that the assessee has done this bifurcation of cost so that it can create more profit in generation of electricity. So there is no bonafide intention on the part of the assessee in raising the additional ground. The assessee itself has considered the transfer of the steam from its captive power plant to another unit at cost and now want to transfer the same at the fair market value which was neither determined at the stage of filing return of income or at the stage of the assessment proceedings. We are not satisfied that the assessee has discharged the burden cast upon it to justify admission of the additional ground. The discretion vested in this Tribunal, when exercised in accordance with settled principles of law, does not warrant admission of additional ground. Accordingly, the additional ground raised by the assessee is held to be devoid of bona fides and unsupported by good and sufficient reasons for its non-raising before the lower authorities. The same is, therefore, declined admission. Disallowance of deduction claimed u/s 80-IA in respect of its captive power plants - Whether the assessee was justified in bifurcating the cost of the captive power plant between electricity and steam, and in attributing a separate cost to steam so as to compute profits from generation of electricity - HELD THAT:- The reference of ‘power’ in budget speech was in relation with electrical power only. Nevertheless, since the issue before us is confined to cost attribution and not eligibility of steam per se, we refrain from expressing any final opinion on that aspect. We hold that the AO was justified in attributing the entire cost of the captive power plant to generation of electricity and in rejecting the artificial bifurcation adopted by the assessee. Once the correct cost is taken into account, the eligible undertaking results in a loss and no deduction under section 80-IA is admissible. Disallowance of interest claim u/s 36(1)(iii) - as contended that the overseas subsidiary was engaged in the same line of business as the assessee and that the investment had been made as a measure of commercial expediency and for furtherance of the assessee’s own business interests - HELD THAT:- The deduction under section 36(1)(iii) is embedded in the statutory scheme governing computation of business income and, therefore, can be allowed only against income assessable under the head “Profits and gains of business or profession”. It cannot be extended to income which is assessable under other heads. The statute itself clarifies that interest on capital borrowed for acquisition of a capital asset is to be capitalised up to the point when the asset is first put to use, and only thereafter does it assume the character of revenue expenditure allowable in accordance with the provisions applicable to business income. In our considered view, permitting deduction of interest expenditure against business income, when the corresponding investment yields income assessable under entirely different heads, would be contrary to the fundamental scheme and principles governing computation of income under the Act. The borrowed capital in the present case has not resulted in the acquisition of any business asset employed in the assessee’s business operations, but has merely facilitated acquisition of controlling interest in subsidiary companies. Consequently, the nexus required for allowance of deduction under section 36(1)(iii) is absent. Accordingly, we hold that the interest expenditure claimed by the assessee under section 36(1)(iii) of the Act is not allowable on the facts of the present case. The judicial precedents relied upon by the assessee are distinguishable and do not advance its case. Alternative plea of the assessee for allowance of the interest expenditure against dividend income under section 57(iii) - We find that the issue stands squarely covered by the judgment of R. Amritaben Shah [1999 (4) TMI 73 - BOMBAY HIGH COURT] wherein it has been categorically held that interest incurred on borrowed funds utilised for acquiring controlling interest in a company is not allowable as a deduction under section 57(iii), as such expenditure is not incurred wholly and exclusively for the purpose of earning dividend income. Disallowance of Provision for Post-Retirement Medical Benefits u/s 43B - assessee has been extending post-retirement medical benefits to its retired employees and their dependent family members in terms of a long-standing policy - HELD THAT:- We restore the matter back to the file of the Assessing Officer. AO shall examine the actuarial valuation report and determine, in accordance with law, whether the provision for post-retirement medical benefits represents an ascertained liability allowable as deduction. Disallowance of In-house Scientific Research and Development Expenditure u/s 35(2AB) - In the present case, the detailed item-wise justification for the disputed expenditure has been furnished by the assessee for the first time before the Tribunal. Verification of such claims would necessarily require examination of underlying bills, vouchers, agreements, and the nexus of each item of expenditure with inhouse scientific research activities. Such an exercise is essentially factual in nature and cannot be undertaken for the first time at the appellate stage. We consider it appropriate to restore the matter to the file of the AO. AO shall examine, de novo, the eligibility of the disputed expenditure for weighted deduction u/s 35(2AB). Grant of foreign tax credit in respect of tax withheld in a foreign jurisdiction - The restriction enunciated by the Hon’ble Supreme Court in Goetze (India) Ltd [2006 (3) TMI 75 - SUPREME COURT] operates only at the stage of assessment and does not impinge upon the powers of appellate authorities or the obligation of the AO to faithfully implement directions issued by the Dispute Resolution Panel. Once a direction has been issued by the DRP and the AO has failed to give effect thereto, the appropriate statutory remedy available to the assessee is to seek rectification of the assessment order under the relevant provisions of the Act. The assessee has not availed of such remedy thus far. Having regard to the above, and without entering into the merits of the claim at this stage, we consider it appropriate to direct the AO to examine and dispose of any rectification application that may be filed by the assessee for grant of foreign tax credit, strictly in accordance with law and in conformity with the directions already issued by the DRP. Issues: (i) Whether investment in preference shares should be re-characterised as a loan for transfer pricing and notional interest benchmarked; (ii) Whether disallowance under section 14A read with Rule 8D was correctly computed and applied; (iii) Whether deduction under section 80-IA in respect of captive power plants (allocation between electricity and steam) was correctly denied; (iv) Whether interest on borrowings used to acquire controlling interest in foreign subsidiaries is allowable under section 36(1)(iii) or otherwise; (v) Whether the provision for post-retirement medical benefits is allowable as an accrued (actuarial) liability; (vi) Whether expenditure claimed under section 35(2AB) for in-house R&D that auditors excluded is allowable; (vii) Whether foreign tax credit claimed during assessment proceedings should be granted in accordance with DRP directions.Issue (i): Re-characterisation of preference share investment as loan for transfer pricing.Analysis: The transaction was examined on surrounding commercial facts (loss-making AE, disparity in face value, history of loan conversions, lack of share-wise identification, absence of cogent evidence to trace fresh subscriptions separately, borrowing profile and absence of demonstrable arm's length return). The authorities applied substance-over-form and arm's-length tests and the transfer pricing officer benchmarked notional interest at LIBOR+2%.Conclusion: Re-characterisation sustained; adjustment of notional interest benchmarked at LIBOR+2% upheld against the assessee.Issue (ii): Validity and computation of disallowance under section 14A read with Rule 8D.Analysis: The Assessing Officer recorded objective dissatisfaction with the assessee's suo-motu apportionment and applied Rule 8D. The Tribunal accepted that AO had recorded reasons but examined components separately: (a) Rule 8D(2)(ii) (interest portion) was not sustainable because assessee demonstrated availability of sufficient interest-free own funds; (b) Rule 8D(2)(iii) (administrative overheads) required recomputation following precedents limiting scope to investments that actually yielded exempt income and other applicable principles.Conclusion: Disallowance under section 14A partly set aside as to interest component; administrative expenditure disallowance to be recomputed by AO. Ground partly allowed for statistical purposes.Issue (iii): Allowability of deduction under section 80-IA for captive power plants (cost allocation between electricity and steam).Analysis: The dispute centred on the assessee's bifurcation of costs between electricity and residual steam, and treatment of steam at cost. The Tribunal found no cogent technical or contemporaneous evidence verifying the scientific basis of cost allocation; noted that steam was generated as an intermediate medium for electricity and the claimed value for steam exceeded electricity receipts, indicating artificial bifurcation. Transfer pricing record showed no adjustment on domestic power transactions, but the AO's disallowance rested on cost allocation, not market value.Conclusion: The artificial bifurcation rejected; entire cost attributable to electricity leads to no eligible profit and deduction under section 80-IA denied. Ground dismissed.Issue (iv): Deductibility of interest on borrowings used to acquire controlling interest in foreign subsidiaries under section 36(1)(iii) or section 57(iii).Analysis: The Tribunal examined whether the borrowing created an asset directly employed in the assessee's business such that interest could be allowed under the business income code. The investments produced income assessable under other heads (dividend/other sources) and the assessee did not offer that income as business income. The statutory scheme segregates deductions by heads; precedents on section 36(1)(iii) were considered but distinguished on facts. Alternative claim under section 57(iii) was declined following binding precedent that interest for acquiring controlling stake is not wholly and exclusively for earning dividend income; applicability of section 115BBD also noted.Conclusion: Interest disallowance sustained; ground dismissed.Issue (v): Allowability of provision for post-retirement medical benefits as accrued liability.Analysis: The Tribunal held that such provisions do not fall within section 43B clauses relied upon by the AO, but their allowability depends on whether the liability is an ascertained obligation supported by a reliable actuarial valuation. The actuarial report was not placed before the AO; prior tribunal directions required AO verification of valuation.Conclusion: Matter remitted to AO to examine actuarial valuation and determine allowability; ground allowed for statistical purposes.Issue (vi): Allowability of disputed in-house R&D expenditure for section 35(2AB) where auditors excluded amounts.Analysis: The assessee produced item-wise explanations at appellate stage but the auditor certificates identified specific items as not qualifying. Admission of those items requires factual verification (bills, allocation, nexus). The Tribunal found these factual inquiries inappropriate to decide first time on appeal and directed de novo examination by AO with opportunity to assessee to produce evidence.Conclusion: Matter remitted to AO for fresh examination of disputed Rs.4,24,13,526/-; ground allowed for statistical purposes.Issue (vii): Claim for foreign tax credit not made in return but directed by DRP.Analysis: DRP issued directions to verify and allow credit if corresponding income was offered to tax in India; AO failed to implement direction in final order. The appropriate remedy is rectification by AO; appellate authority directed AO to examine any rectification application in accordance with law.Conclusion: Direction to AO to consider rectification application and grant foreign tax credit in accordance with DRP directions; ground allowed for statistical purposes.Final Conclusion: The appeal is partly allowed: the transfer pricing re-characterisation and certain additions/deductions were sustained against the assessee, interest disallowance was sustained, while Rule 8D interest component was deleted and multiple factual issues (administrative disallowance under Rule 8D(2)(iii), post-retirement medical provision, disputed R&D expenditure, and foreign tax credit) were remitted or directed for recomputation/rectification for further action by the Assessing Officer.Ratio Decidendi: Where an assessee fails to substantiate the legal form and origin of relatedparty funding, revenue may look to substance over form and re-characterise transactions for transferpricing; invocation of Rule 8D requires objective, recorded dissatisfaction by the Assessing Officer and disallowance under Rule 8D(2)(ii) is negated where sufficient interestfree funds are shown; provisions or accruals claimed under mercantile accounting require an ascertained liability supported by reliable actuarial/technical evidence to be allowable.