Income-tax To Be Levied On Real Income And Not Notional Income

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During the assessment, the Assessing Officer (AO) observed that the assessee* had no business activity or any revenue and had still claimed deduction of certain expenses.

India Tax

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BRIEF FACTS OF THE CASE

During the assessment, the Assessing Officer (AO) observed that the assessee* had no business activity or any revenue and had still claimed deduction of certain expenses. AO also observed that the assessee has not charged any interest on funds lent to the directors and had also gifted a property to a charitable trust.
Consequently, the AO passed an order for the below:
- Disallowed indirect expenses (audit fees, rent, professional fees, etc.) amounting to Rs. 3.01 Lakhs.
- Computed notional interest @ 18% (approx. Rs. 29.93 Lakhs) on interestfree advances given to a Director.
- Made a protective addition regarding a gift of property.
The CIT(A) deleted the additions, leading the Revenue to appeal before the Mumbai ITAT.

REVENUE'S CONTENTIONS:

Regarding Expenses: The Revenue argued that since the Taxpayer had nil revenue for many years and no business activity, it was merely a paper company. Therefore, expenses claimed were not for business purposes and should be disallowed.
Regarding Notional Interest: The Revenue contended that the Taxpayer advanced significant amounts (Rs. 1.66 Crores) to a director holding 99.98% shares without charging interest.
The AO argued that since the company incurred expenses but charged no interest on these advances, notional interest @ 18% should be added to the income.

TAXPAYER'S CONTENTIONS:

Regarding Expenses: The Taxpayer submitted that expenses such as statutory audit fees, ROC filing fees, and registered office rent were essential to maintain the corporate identity of the company.
It was argued that the lack of immediate revenue does not preclude the allowance of expenditure incurred wholly and exclusively for business purposes u/s 37(1).
Regarding Notional Interest: The Taxpayer argued that the advances were funded out of interest-free share capital and reserves, not borrowed funds.
Reliance was placed on the principle of real income, arguing that the Income Tax Act does not authorize the taxation of hypothetical or notional income.
The Taxpayer asserted that commercial expediency is the prerogative of the businessman, and the AO cannot sit in the armchair of the assessee to dictate interest charges

ITAT'S OBSERVATIONS:

On Expenses: The Tribunal upheld the CIT(A)'s view that statutory expenses are mandatory to maintain the corporate existence. Even in the absence of revenue, these expenses are allowable u/s 37(1) as they are incurred for the purpose of business. It was argued that the lack of immediate revenue cannot be the basis for disallowance of expenditure incurred wholly and exclusively for business purposes u/s 37(1).
On Notional Interest: The ITAT observed that the advances were given out of share capital and free reserves and no interest-bearing funds were utilized.
The Tribunal ruled that only "real income" can be taxed. Where an assessee, in its commercial wisdom, advances interest-free funds to a director out of its own surplus, there is no basis to determine and tax notional interest.
The Tribunal relied on the Supreme Court ruling in Shoorji Vallabhdas and the Gauhati High Court decision in Highway Construction Co. Pvt. Ltd. to confirm that tax cannot be levied on hypothetical income.
On Protective Addition: The protective addition was set aside as the assessee had already suo-moto disallowed the amount in the subsequent assessment year (substantive addition), which was accepted.

AURTUS COMMENTS

This ruling reinforces that income tax is a levy on real income, not notional income, unless otherwise mentioned.
The judgment provides relief to companies which are not actively engaged in any business and still have to carry certain expenses. It clarifies that the maintenance of corporate identity is in itself a business activity, and the costs associated with statutory expenses are deductible business expenditure, regardless of the revenue.
The decision reiterates the importance of the source of funds. The fact that the advances were funded by share capital and free reserves (interest-free sources) was one of the important factor in deleting the notional interest addition.

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