Whether when assessee has deducted tax at source on payments made to related party, and there is no attempt to evade taxes, even then AO can disallow such payments questioning necessity of availing services from sister concern - NO, rules ITAT

THE questions before the Bench are - Whether when the assessee has deducted tax at source on payments made to its related party, and there is no attempt to evade taxes, even then AO can disallow such payments questioning the necessity of availing services from sister concern and Whether disallowance u/s 40A(2) can be made even if the expenditure is not found to be excessive or unreasonable. NO is the Tribunal's answer.

Facts of the Case

The assessee company is in the business of manufacturing and selling diamonds and CBN grinding wheels, tools, machinery and accessories. The assessee company was a joint venture between M/s Wendt GMBH of Germany and M/s Carborundum Universal (CUMI), with each holding 40 per cent of the assessee’s equity capital and the balance being held by the public. The assessee was part of Murugappa group, headquartered in Chennai. Under an agreement with its AE, the assessee had made a payment to CUMI, as service fees at the rate of 1.5 per cent on value of the products manufactured and sold by the assessee, for services rendered towards administration, financial, legal and taxation matters which included funds management, investments, foreign exchange management and bank loans. Tax was duly deducted at source on these payments.

On scrutiny of the assessee’s income tax return, the AO observed that the assessee had paid service fees to its associate person, while being under the same control and management, which made CUMI a person covered under section 40A(2)(b). The assessee’s explanation for justification of expenditure was found to be general in nature, which did not specify any services which needed specific expertise. The AO noted that the assessee’s agreement with CUMI was brief and basic and did not indicate that it had been prepared by an expert. The assessee company already had a team of professionals looking after financial matters, and the agreement / reports did not reflect any benefit to the assessee’s business. The AO therefore held that the service payment was superfluous expenditure and had no correlation with the business of the assessee whatsoever. The AO disallowed the entire amount and made an addition to the assessee’s income. The AO also disallowed the commission on sales paid to CUMI, for similar reasons.

In appeal, the CIT(A) referred to the CBDT circular, to hold that no disallowance was to be made under section 40A(2) in respect of payments to relatives and sister concerns where there was no attempt to evade tax. The CIT(A) followed the decision of the Karnataka High Court, wherein it was held that so long as there was no intention to evade tax and so long as the expenditure was not shocking, the expenditure was to be accepted. The CIT(A) noted that the assessee had deducted appropriate taxes at source before remitting the amount to CUMI, which was a tax paying entity having positive income. Thus there was no attempt by the assessee to evade tax whereby there could be no disallowance under section 40A(2). The disallowance of service fee and also sales commission paid to CUMI was therefore deleted.

In appeal before the Tribunal, the Revenue side contended that the assessee had failed to prove that CUMI had rendered any services to the assessee. The assessee’s explanation was too general and did not justify the payment of sales commission. Also, CUMI being the associate enterprise of the assessee, fell within the ambit of section 40A(2) whereby it was incumbent on the AO to examine the justifiability of the payments made to it by the assessee.

The assessee submitted that all the details and necessary evidences relating to the services rendered by its associate enterprise CUMI had been furnished before the authorities, which the CIT(A) had considered in detail. Also disallowance under section 40A(2) could only be made where the payment was found to be excessive or unreasonable.

Having heard the parties, the Tribunal held that,

++ undisputedly, the assessee and CUMI were associate persons, whereby the AO had sought to examine the reasonableness of the payment made by the assessee to CUMI;

++ the Gujarat High Court had held that under the provisions of section 40A(2), the AO, being of the opinion that such expenditure was excessive or unreasonable, in relation to any one of the three specified requirements, independent and alternative to each other, could disallow as a deduction so much of the expenditure as considered to be excessive or unreasonable. Applying this decision to the payment in question, the assessee had furnished all evidences relating to the various services rendered, which had been rightly considered by the CIT(A), after taking note of the CBDT circular, that was binding on the Revenue authorities, to hold that the disallowance was not justified;

++ the Karnataka High Court had also held that so long as there was no intention to evade tax and so long as the commission was not shocking, the payment had to be accepted, particularly in the light of the wordings of section 40A(2). Also, it was not the quantum alone that governed such cases but the fair market value of the goods, services and legitimate needs of the business of the assessee had to be the guiding factor in terms of section 40A(2). The CIT(A) had taken into consideration the judicial precedents and also the fact that CUMI was a tax paying entity with positive income before deleting the disallowance. There was thus no reason to take any contra view.