Bombay H.C : Whether a subsidiary company is a ‘related person’ within meaning of clause (b) of section 40A(2)

High Court Of Bombay

CIT, Panaji-Goa vs. V.S. Dempo & Co. (P.) Ltd.

Assessment Year : 1985-86

Section : 40A(2)

D.G. Karnik & F.M. Reis, JJ.

Tax Appeal No. 22 Of 2005

October 19, 2010

JUDGMENT

D.G. Karnik, J. – This appeal is directed against an order dated 2-12-2004 of the Income-tax Appellate Tribunal, Panaji Bench, Panaji (for short “ITAT”) confirming the decision of the Commissioner of Income-tax (Appeals) [for short CIT (Appeals)] on the point of addition of income under section 40A(2) of the Income-tax Act (for short the Act).

2. The assessee is a company, incorporated and registered under the Companies Act, 1956. The assessee is engaged in the business of extraction and export of iron ore. During the assessment year 1985-86, the assessee purchased iron ore worth Rs. 8,66,75,390 from its subsidiary M/s. Dempo Mining Corporation (P.) Ltd. The iron ore purchased included high grade lumpy ore and high grade iron ore powder. The rate at which the assessee purchased from its subsidiary was Rs. 85 per DLT for high grade iron ore powder and Rs. 80 per DLT for the high grade lumpy iron ore. The Assessing Officer held that the prevailing rates of sale/purchase of the same grade of iron ore in the State of Goa were lower than the rate at which the assessee had purchased the ore from its subsidiary. The Assessing Officer noted that M/s. Orient Goa Pvt. Ltd., had purchased high grade iron ore at Rs. 62.30 and high grade lumpy ore at Rs. 59.64 per DLT. On this basis, the Assessing Officer concluded that the rate at which the assessee had purchased the ore from its subsidiary were higher than the market rate and, therefore, the provisions of section 40A(2) of the Act were attracted. After making calculations, the Assessing Officer disallowed the expenditure to the extent of Rs. 49,30,488, under section 40A(2) of the Act. Aggrieved by the assessment order, the assessee filed an appeal before the CIT (Appeals) at Belgaum. The appeal was filed against the disallowance of the expenditure to the extent of Rs. 49,30,488 under section 40A(2) of the Act, as also on some other points. We, however, are not concerned with the other points involved in the appeal before the CIT (Appeals). As regards the addition of Rs. 49,30,488 under section 40A(2) of the Act, the CIT (Appeals) held that the rates at which the iron ore was purchased by the assessee from its subsidiary were determined under a contract. He further accepted the argument that the assessee was assured a huge quantity of ore and quality of ore and in view of the fact that the assessee was assured of the quantity as well as the quality, the assessee was justified in paying the rate higher than the rate at which the ore was available during the relevant time on non-contractual basis. The CIT (Appeals) further held that the assessee was a company as well as the seller of the goods was a company and, therefore, the rate of tax applicable to both of them was identical, namely the highest rate of tax. Therefore, by buying ore at rate higher than the market rate, there was no reduction in the amount of tax payable. This was, therefore, not a case of tax evasion. CIT (Appeals), accordingly, held that the Assessing Officer was not justified in adding Rs. 49,30,488 in the taxable income of the assessee. Aggrieved by the decision of the CIT (Appeals), the Revenue filed an appeal before the ITAT. The ITAT also accepted the contention of the assessee that the rate of purchase of the iron ore was fixed taking into consideration that the assessee was assured supply of huge quantity of ore of uniform quality. It also held that both the companies were paying taxes at the same rate and, therefore, there was no case of evasion of tax. The ITAT, therefore, confirmed the order of the CIT (Appeals) setting aside the order of the Assessing Officer adding to the income of the assessee Rs. 49,30,488 under section 40A(2) of the Act. On an appeal to this Court, the appeal has been admitted by this Court by an order dated 29-8-2005 on the following substantial question of law :

“Whether on the facts and in the circumstances of the case, the ITAT has gone wrong in law by holding that rate of ore at Rs. 85 per DLT and at Rs. 80 per DLT respectively, purchased from its subsidiary M/s. Dempo Mining Corporation (P.) Ltd., is contrary to evidence relied on by Assessing Officer proving the fair market rate at the relevant time and therefore against the provision of section 40A(2)?”

3. After hearing the Counsel for the parties, we have reframed the question as follows :

“Whether in the facts and circumstances of the case, the ITAT was right in confirming the order of CIT (Appeals) setting aside the order of the Assessing Officer adding Rs. 49,30,488 under section 40A(2) of the Income-tax Act ?”

4. Clause (a) of sub-section (2) of section 40A of the Income-tax provides that where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in clause (b) of the sub-section and the Assessing Officer is of the opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as a deduction. Clause (b) of sub-section (2) of section 40A of the Income-tax mentions the class of persons in respect of whom clause (a) is attracted. Learned Counsel for the respondent submits that M/s. Dempo Mining Corporation Pvt. Ltd., (hereinafter referred to as “the subsidiary company”) from which the assessee purchased the iron ore is not one of the persons mentioned in clause (b) of sub-section (2) of section 40A and, therefore, sub-section 2(a) was not attracted. In the alternative he submitted that the finding recorded by the CIT (Appeals) as well as the ITAT that the assessee had paid a little higher than the usual rate taking into consideration the fact that the assessee was assured a huge quantity of supply, as well as the quality of supply that it cannot be said that the rate was unjustified, was a finding of fact. In the absence of any perversity, the finding of fact recorded by the CIT (Appeals) and confirmed by the ITAT cannot be interfered with in an appeal under section 260-A of the Act. He further submitted that both the assessee, as well as the subsidiary were registered were companies under the Companies Act, 1956 liable to pay the Income-tax at the same rate. Therefore, there was no question of diversion of any funds. He invited our attention to the CBDT Circular No. 6-P dated 6-7-1968, which states that no disallowance is to be made under section 40A(2) in respect of the payments made to the relatives and sister concerns where there is no attempt to evade tax. He submitted that the CIT (Appeals) as well as the ITAT have also recorded a finding of fact that there was no attempt of evasion of tax and, therefore, in view of the CBDT circular dated 6-7-1968, section 40A(2) was not attracted and should not have been applied by the Assessing Officer. The circular is binding on the department and on this ground also the appeal should be dismissed.

5. The CIT (Appeals), on appreciation of the material available before him, has come to the conclusion that the assessee, as an exporter, was exporting huge quantity of iron ore. It was assured of supply of huge quantity of iron ore as well as quality of iron ore by a reason of the fact that it had entered into a contract with its subsidiary. He has also held that both the assessee and its subsidiary were companies paying tax at the same rate and, therefore, there was no question of tax evasion. These findings are not open for challenge in this appeal.

6. In our view, in a business of export consistency of supply as well as quality of supply is important. In order to assure a consistent supply of material of the same quality the purchaser of a commodity may pay to a seller bound under a contract a little higher than the current rate. Furthermore, in case of yearly contracts by agreeing to buy goods at a specified rate the exporter is insulated from vagaries of any seasonal rise in the market rate. Therefore, unless the rate agreed is so very much excessive or unreasonable as to doubt the objective behind the agreement, it cannot be said that the rate, a little higher than the seasonal market rate is unjustified or amounts to diversion of profit. In this connection, the fact that the assessee as well as its subsidiary which is the seller are in the same tax bracket and pay same rate of tax is a fact which assumes importance. Admittedly, it is not a case of tax evasion inasmuch as if the rate would have been less, the assessee’s profit would have been more, but the profits of the seller would have been less and both being taxable at the same rate, there would be no difference in the aggregate tax payable by the assessee and its subsidiary.

7. A decision of a Division Bench of this Court in CIT v. Indo Saudi Services (Travel) (P.) Ltd. [2009] 310 ITR 306  is a case in point. Therein the assessee was a general sales agent of Saudi Arabian Airlines. The assessee earned commission at 12 per cent from Saudi Arabian Airlines. The assessee had appointed several agents, including its sister concern as sub-agents and was paying commission to each such sub-agent. While the assessee was paying a commission of 9 per cent to all its agents, it was paying additional ½ per cent to its sister concern which was also acting as a sub-agent. The Assessing Officer disallowed the ½ per cent commission paid to the assessee’s sister concern under section 40A(2) of the Income-tax Act. The order was confirmed by the CIT (Appeals) as well as by the ITAT. On an appeal at the instance of the assessee, this Court noted that the sister concern to which the assessee was paying extra ½ per cent commission was also assessed to tax and was paying tax. Relying upon the Circular No. 6-P, dated 6-7-1968 of the CBDT, it is held that no disallowance should be made under section 40A(2) of the Income-tax Act in respect of the payments made to the relatives and sister concerns where there is no attempt to evade tax. This Court while allowing the appeal, set aside the addition made under section 40A(2) of the Act. In our view, in the facts and circumstances of the case, the ratio of decision of this Court in Indo Saudi Services (Travel) (P.) Ltd.’s case (supra ) squarely applies to the facts of the case at hand.

8. Ms. Dessai, learned Counsel appearing for the Revenue, invited our attention to another decision of a Division Bench of this Court in CIT v. Shatrunjay Diamonds [2003] 261 ITR 258 1, and to the observations made in paragraphs 10 and 11 of the decision. She submitted that once it was held that the payment was made to a related person mentioned in clause (b) of section 40A(2) of the Act, the burden shifted on the assessee and it was the duty of the assessee to discharge the burden by leading proper evidence that the provisions of section 40A(2) were not attracted to the assessee’s case. The basic requirement for the applicability of section 40A(2) of the Act is that the payment must be made to a related person i.e. to a person referred to in clause (b), of sub-section (2) of section 40A of the Act. In the facts and circumstances of the case, we are of the view that the payment in the case at hand was not made to a person mentioned in clause (b) of section 40A(2) of the Act for the reasons indicated below.

9. Clause (a ) of sub-section (2) of section 40A of the Act provides that where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in clause (b) of the sub-section and the Assessing Officer is of the opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom, so much of the expenditure as it so considered by him to be excessive or unreasonable, shall not be allowed as a deduction. The object of section 40A(2) is to prevent diversion of income. An assessee who has large income and is liable to pay tax at the highest rate prescribed under the Act often seeks to transfer a part of his income to a related person who is not liable to pay tax at all or liable to pay tax at a rate lower than the rate at which the assessee pays the tax. In order to curb such tendency of diversion of income and thereby reducing the tax liability by illegitimate means, section 40-A was added to the Act by an amendment made by the Finance Act, 1968. Clause (b) of section 40A(2) gives the list of related persons. It is only where the payment is made by the assessee to the related persons mentioned in clause (b) of section 40A(2) of the Act that the Assessing Officer gets jurisdiction to disallow the expenditure or a part of the expenditure which he considers excessive or unreasonable. Clause (b) of section 40A(2) reads as under :

“40A(2)(b) The persons referred to in clause (a) are the following, namely:—

(i) where the assessee is an individual    any relative of the assessee;

(ii) where the assessee is a company, firm, association of persons or Hindu un- divided family    any director of the company, partner of the firm, or member of the association or family, or any relative of such director, partner or member;

(iii) any individual who has a substantial interest in the business or profession of the assessee, or any relative of such individual;

(iv) a company, firm, association of persons or Hindu undivided family having a substantial interest in the business or profession of the assessee or any director, partner or member of such company, firm, association or family, or any relative of such director, partner or member;

(v ) a company, firm, association of persons or Hindu undivided family of which a director, partner or member, as the case may be, has a substantial interest in the business or profession of the assessee; or any director, partner or member of such company, firm, association or family or any relative of such director, partner or member;

(vi)any person who carries on a business or profession,—

(A)where the assessee being an individual, or any relative of such assessee, has a substantial interest in the business or profession of that person; or

(B)where the assessee being a company, firm, association of persons or Hindu undivided family, or any director of such company, partner of such firm or member of the association or family, or any relative of such director, partner, or member, has a substantial interest in the business or profession of that person.

Explanation.—For the purposes of this sub-section, a person shall be deemed to have a substantial interest in a business or profession, if,—

(a )in a case where the business or profession is carried on by a company, such person is, at any time during the previous year, the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profit) carrying not less than twenty per cent of the voting power; and

(b )in any other case, such person is, at any time during the previous year, beneficially entitled to not less than twenty per cent of the profits of such business or profession.”

10. Learned Counsel for the appellant submitted that the present case falls under sub-clause (ii) or sub-clause (iv) of clause (b) of section 40A(2). Sub-clause (ii) provides that where the assessee is a company, firm, association of persons or Hindu undivided family, any director of the company, partner of the firm, or member of the association or family, or any relative of such director, partner or member would be a related person. In the present case, the assessee is a company and the seller is its subsidiary company. The seller i.e., the subsidiary company does not fall in any of the capacities mentioned under sub-clause (ii) of clause (b). Only a director of the company, partner of the firm, or member of the association or family or any relative of such director, partner or member is a related person, under sub-clause (ii) of clause (b) of sub-section (2). Another company, even if it is a subsidiary of the assessee is not a related person within the meaning of sub-clause (ii) of clause (b) of section 40A(2). Sub-clause (iv) of clause (b) of section 40A(2) provides that in case of a company, firm, association of persons or Hindu undivided family having a substantial interest in the business or profession of the assessee or any director, partner or member of such company, firm, association or family, or any relative of such director, partner or member is a related person. Again a subsidiary company does not fall in any of the class of persons mentioned in sub-clause (iv) of clause (b) of section 40A(2). In law, a holding company is a member of subsidiary company and holds more than 50 per cent equity share capital of the subsidiary company (except in cases where it controls the composition of the board of directors without holding majority of the shares). While the holding company is a member of its subsidiary company, the subsidiary company is not a member of the holding company. As, the subsidiary company was not a member of the assessee sub-clause (iv) of clause (b) of section 40A(2) of the Act is also not attracted in the present case.

11. In Shatrunjay Diamonds’s case (supra) the Division Bench of this Court held that the burden of proving that the case does not fall under section 40A(2)(b) would shift on the assessee if the supplier of the goods is a related person as mentioned under clause (b). In the present case, as we have held that the subsidiary company is not a related person of the assessee within the meaning of clause (b) of section 40A(2) of the Act, the decision has no application to the facts of the present case.

12. For these reasons, there is no merit in the appeal which is hereby dismissed.

[Citation : 336 ITR 209]

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