CIT vs. Rockman Cycle Industries (Punjab & Haryana High Court – Larger Bench)

AO can lift veil & determine legal effect but cannot ignore legal effect on ground of “substance”

The assessee borrowed money from a sister concern and paid interest therein @ 18% per annum. The funds were used to purchase shares from a sister concern which carried dividend @ 4%. The AO & CIT (A) followed McDowell 154 ITR 148 (SC) & disallowed the claim for interest u/s 57(iii) on the ground that no prudent person would borrow funds at 18% to make an investment which yielded 4% and that the transaction was “clear cut colourable dubious device”. This was reversed by the Tribunal on the ground that the transaction was bona fide and not sham. On appeal by the department, the High Court observed that while tax planning was permissible, the claim had to be supported on the principles of business expediency & referred the issue to the Larger Bench. HELD by the Larger Bench:

(i) U/s 57(iii), expenditure laid out or expended wholly or exclusively for the purpose of making or earning income is deductible. It is the purpose of the expenditure that is relevant but the purpose need not be fulfilled. Even if income is not earned, the expenditure will be deductible (R. P. Moody 115 ITR 519 (SC) followed);

(ii) The AO is entitled and bound to determine the true legal relation resulting from a transaction. If the parties have chosen to conceal by a device the legal relation, it is open to the taxing authorities to unravel the device and to determine the true character of the relationship. But the legal effect of a transaction cannot be displaced by probing into the “substance of the transaction” (B. M. Kharwar 72 ITR 603 (SC) followed);

(iii) In considering whether the expenditure is deductible, the AO must not look at the matter from his own view point but from that of a prudent businessman (S. A. Builders 288 ITR 1 (SC) followed);

(iv) While it is not unfair to borrow money from one concern and invest it in another concern for the purpose of profit or income, the assessee must act bona fide & show nexus between the advancing of funds and his business interest. The test is whether a reasonable person stepping into the shoes of the assessee and working solely in the interest of the assessee would have extended such interest free advances. The dominant purpose for making the investment must be to earn income & to ascertain the purpose the AO may lift the veil (Swapna Roy 233 CTR 10 (All) & Punjab Stainless 324 ITR 396 (Del) followed);

(v) Accordingly, the authorities can determine the true legal relation resulting from a transaction and if some device has been used by the assessee to conceal true nature of the transaction, it is the duty of the authority to unravel the device and determine its true character. However, the legal effect of the transaction cannot be displaced by probing into the “substance of the transaction”. The taxing authority must not look at the matter from its own view point but that of a prudent businessman. Each case will depend on its own facts. The exercise of jurisdiction cannot be stretched to hold a roving enquiry or deep probe.