Understanding the Controversy of Dis allowance – Section 40 Uncodified

By | January 5, 2015
We often talk about the various controversies under the Income tax Act, 1961, whether it is relating to transfer pricing, section 9 or any other important section. Every controversy leads to chaos in the industry which ultimately brings in various litigations. The main reason of every controversy is the ambiguity in the section, and because there are two views possible, hence assessee would always consider the view which is favorable to him and department will do the same, in their favor.

In this article, we will talk about one of the controversy which is now been disputed for a long time. This controversy relates to section 40(a)(ia) on which there has been various high court judgments and CBDT circulars but still, the law isn’t settled yet. Industries are following which has been laid by their jurisdictional High Courts or as per their interpretation of the law which make them prone to litigations. With all these, let us analyze the law in details and let us understand the whole controversy with the conclusion in the end.

The Rise of the Controversy

Section 40(a)(ia) relates to disallowance which states that:

[any interest, commission or brokerage, [rent, royalty,] fees for professional services or fees for technical services payable to a resident, or amounts payable to a contractor or sub-contractor, being resident, for carrying out any work (including supply of labour for carrying out any work)], on which tax is deductible at source under Chapter XVII-B and such tax has not been deducted or, after deduction, [has not been paid on or before the due date specified in sub-section (1) of section 139 :], shall not be allowed as deduction.

On a plain reading of this section and keeping the objective of this section in mind, we can understand that the legislative intent to disallow all such expenditure on which deduction is not made or after deduction has not been paid.

However, on 29.03.2012, the case of Merilyn Shipping & transports v. ACIT [2012] 20 taxmann.com 244 (Visakhapatnam) (SB), the special bench of ITAT took the view that section 40(a)(ia) will be applicable only on the expenditure which are outstanding at 31st March of every financial year. The observation of ITAT is as follows:

Held that section 40(a)(ia) cannot be invoked in respect of amounts actually paid within the previous year without deduction of TDS. Section 40(a)(ia) applies only to amounts outstanding as of 31st March of every year (Majority view). Section 40(a)(ia) would apply only to amounts outstanding as of 31st March of every year on which TDS not deducted and not to amounts paid during previous year without deduction of TDS for following reasons:

Legislature by consciously replacing words from ‘credited’ or ‘paid’ in Finance (No.2) Bill,2004 to ‘payable’ in Finance (No.2) Act, 2004 has made it clear that only outstanding amount or provision for expenses which are liable for TDS, are to be disallowed in event there is default in not following TDS provisions under Chapter XVII-B of Act.
CBDT’s Circular No.5 of 2005, dated 5th July, 2005 clarifies that intent of section 40(a)(ia) is to curb bogus payments by creating bogus liabilities.
Circular No.5/2005, dated 5-7-2005 – Extract – Further, with a view to augment compliance of TDS provisions in case of residents and curb bogus payments to them it has been provided that no deduction will be allowed in computation of income where tax is not deducted from payments of interest, commission or brokerage, fees for professional services or fees for technical services and payments to a contractor or sub-contractor for carrying out any work (including supply of labour for carrying out any work), on which tax is deductible at source under Chapter XVII-B and such tax has not been deducted or, after deduction, has not been paid during previous year, or in subsequent year before expiry of time prescribed under sub-section (1) of section 200.
This judgment of ITAT has created a chaos in the industry as it was the landmark judgment delivered by the honorable ITAT. According to the judgment, even if the assessee pays the whole of expenditure during the year without deduction, then also no disallowance will be attracted. This judgment was favorable to the assessee; hence, they started to take the benefit of this judgment in there pending cases too.

Since, it was against the view of the department, so it was natural that the department would appeal against the judgment in the Allahabad High Court. Also, department oppose this view in other states too which leads to litigation in other states too.

Distinguished view of other High Courts

On the same facts, on April 3, 2013, Calcutta High Court distinguishes his view from the view taken by the Vishakhapatnam ITAT, and held the following:
Comparison between the pre-amendment and post-amendment law is permissible for the purpose of ascertaining the mischief sought to be remedied or the object sought to be achieved by an amendment. But the same comparison between the draft and the enacted law is not permissible. Nor can the draft or the bill be used for the purpose of regulating the meaning and purport of the enacted law. It is the finally enacted law which is the will of the Legislature. The Tribunal inMerilyn Shipping & Transports (supra) fell into an error in not realizing this aspect of the matter. The Tribunal held ‘that where language is clear, the intention of the Legislature is to be gathered from the language used’. Having held so, it was not open to seek to interpret the section on the basis of any comparison between the draft and the section actually enacted nor was it open to speculate as to the effect of the so-called representation made by the professional bodies. The Tribunal held that ‘section 40(a)(ia) creates a legal fiction by virtue of which even the genuine and admissible expenses claimed by an assessee under the head’ ‘income from business and profession’, ‘if the assessee does not deduct TDS on such expenses, are disallowed’
As such, the Tribunal realized the meaning and purport of section 40(a)(ia) correctly when it held that in case of omission to deduct tax even the genuine and admissible expenses are to be disallowed. But it sought to remove the rigour of the law by holding that the disallowance shall be restricted to the money which is yet to be paid. What the Tribunal by majority did was to supply the casus ommisus which was not permissible and could only have been done by the Supreme Court in an appropriate case
There can be no denial that the provision in question is harsh. But that is no ground to read the same in a manner which was not intended by the Legislature. The law was deliberately made harsh to secure compliance of the provisions requiring deduction of tax at source. It is not the case of an inadvertent error

Since, at this stage, there were judgments of the High Court which have taken a different view from the Vishakhapatnam High Courts. Then, assessee who were taking the benefits of the judgment of Vishakhapatnam ITAT, were eagerly waiting for the Allahabad High Court to deliver so that they have something to defend themselves.

The Chaos

This waits finally ends on July 9, 2013, wide CIT vs M/s Vector shipping Services (P) Ltd 38 taxmann.com 77, where Allahabad High Court affirmed the order of Vishakhapatnam ITAT and this judgment was the boon for the assessee who had earlier taken the benefit from the Vishakhapatnam ITAT. After this judgment, the industry was in chaos and everyone was following according to their understanding of law and this was resulting in unnecessary litigations.

Since the industry was in chaos, there had to be something from the CBDT, therefore, on 16th December, 2013 wide circular number 10/DV/2013, clarifies the departmental view that disallowance under Section 40(a)(ia) would also cover amounts payable at any time during the year. It was clarified that the term ‘payable’ will include ‘amounts which are paid during the previous year’. It has also been clarified that where any High Court decides an issue contrary to the ‘departmental view’, such view shall not be operative in the area falling in the jurisdiction of the relevant High Court.

After this CBDT circular, department view was very much clear and since department circular are not binding on the assessee, it is now more prone to litigations.

The Supreme Court Route:
The law is very much unsettled, therefore, department filed a Special leave Petition (SLP) to Supreme Court against the judgment of honorable High Court in case of CIT vs M/s Vector shipping Services (P) Ltd 38 taxmann.com 77. On July 2, 2014, the Supreme Court rejected the SLP without stating any reason. This rejection was a setback for those, who were committed to seek the clarification from the Apex court on the subject. However, the main thing was to understand the impact of SLP dismissal. Dismissal of SLP in itself does not laid down any law and it cannot be understood that SC in any case supported the judgment of Allahabad High Court. However, since there is nothing from the Supreme Court then the High Court Judgments will prevail.

After the SC dismissal, there is no way out from the controversy. Even the Finance Act, 2014 didn’t resolve the dispute and had nothing in the Finance Act to resolve the issue and the unnecessary disputes, only the harshness has been reduced by restricting the disallowance up to 30%.

The Final Conclusion:

The chaos is still present; the ambiguity is still present even after the two years from the rise of the controversy. But the question is there that which view to be taken?

Since, there are contrary judgments of the High Court’s and if there are two view’s possible, then as per the Judgment of honorable Supreme Court in case of CIT vs Vegetable Products Ltd., 88 ITR 192, then Assessing officer should take the one favorable to the assessee. It means that in current era, where there are two views possible, whether disallowance is to be made only on outstanding at the yearend or on every amount paid or payable, the one which is more favorable to the assessee would have to be taken.

Therefore, the as per the ratio decidendi from the judgment of CIT vs Vegetable Products Ltd., 88 ITR 192 (SC), the judgment of Allahabad High Court in case of CIT vs M/s Vector shipping Services (P) Ltd 38 taxmann.com 77 will prevail.

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