BEFORE SHRI R.S. SYAL, AM AND SHRI C.M. GARG, JM

IN THE INCOME TAX APPELLATE TRIBUNAL DELHI BENCHES : D : NEW DELHI BEFORE SHRI R.S. SYAL, AM AND SHRI C.M. GARG, JM ITA No.844/Del/2013 Assessment Year : 2009-10 Jai Surgicals Ltd., C/o M/s Vinay Malik & Co., CA, 232, DDA Commercial Complex, Phase I, Jhandewalan Extension, New Delhi. Vs. ACIT, Circle-4(1), CR Building, IP Estate, New Delhi. PAN : AAACJ0771A (Appellant) (Respondent) Assessee By Department By : Shri Sanjay Jain, CA : Shri S.N. Bhatia, Sr.DR ORDER PER R.S. SYAL, AM: This appeal by the assessee emanates from the order passed by the CIT (A) on 20.11.2012 in relation to the assessment year 2009-10. 2. The only issue raised in this appeal through various grounds is against the confirmation of addition of ` 41,24,129/-. Briefly

stated, the facts of the case are that the assessee is engaged in the business of manufacture and export of surgical blades. Note no.6 to the Annual accounts, attached with the return of income, read as under:- On an observations by auditor, it was been noticed that the Central government approval of contract for sale, purchase of blades and scalpels and for getting job work done from M/s Razormed INC. (a partnership concern in which directors of the company are interested as partners) had expired on 01.04.2007 and the company continued to make transactions their under without renewal approval from Central Government. Subsequent to the closure of financial year the company has got necessary approval from Central Government for the period 06.04.2009 to 31.03.2012 offence relating to the period 01.04.2007 to 05.04.2009 has been compounded by the Company Law Board on an application made by the Company in this respect. 3. On the perusal of the Note, the Assessing Officer noticed that the assessee entered into transactions of payment of job work charges to a related party, viz., M/s Razormed Inc. during the financial year relevant to assessment year under consideration without obtaining prior approval of the Central Government in accordance with the provisions of section 297 of the Companies Act, 1956. On being called upon to explain as to why such job 2

work charges be not disallowed in accordance with the provisions of Explanation to section 37(1) of the Income-tax Act, 1961 (hereinafter also called the Act ), the assessee submitted that the post facto approval for the transactions with the related parties undertaken during the year, was obtained from the Company Law Board on payment of compounding charges for the condonation of delay and hence there was no violation of law. Not convinced with the assessee s submissions, the AO opined that the facts of post facto approval and the condonation of delay by the Ministry of Corporate Affairs were not relevant because on the day of payment of such expenditure, there was no prior approval to the job charges paid to M/s Razormed Inc., which triggered the Explanation to section 37(1) of the Act. This led to the addition of job work charges amounting to ` 41.24 lac and the further disallowance of compounding fee for condonation of delay amounting to ` 6,000/-. The ld. CIT(A) echoed the assessment order on this issue. The assessee is in appeal before us only on the disallowance of job work charges and not on the disallowance of compounding fee for condonation of delay. 3

4. We have heard the rival submissions and perused the relevant material on record. It is observed that the disallowance of ` 41.24 lac under consideration has been made in the light of the Explanation to section 37(1) of the Act, which came to be inserted by the Finance (No.2) Act, 1998 with retrospective effect from 01.04.1962. The disallowance has been made on the premise that as on the date of making the payment to the related party, the assessee did not have the approval from the Company Law Board in accordance with the section 297 of the Companies Act. Before we embark upon considering the applicability of Explanation to section 37(1) of the Act, it would be apposite to consider the relevant parts of section 297 of the Companies Act, 1956, as under:- 297. Board's sanction to be required for certain contracts in which particular directors are interested (1) Except with the consent of the Board of directors of a company, a director of the company or his relative, a firm in which such a director or relative is a partner, any other partner in such a firm, or a private company of which the director is a member or director, shall not enter into any contract with the company- (a) for the sale, purchase or supply of any goods, material or services; or 4

(b) after the commencement of this Act, for underwriting the subscription of any shares in, or debentures of, the company: Provided that in the case of a company having a paid-up share capital of not less than rupees one crore, no such contract shall be entered into except with the previous approval of the Central Government. (2) Nothing contained in clause (a) of sub-section (1) shall affect- (a) the purchase of goods and materials from the company, or the sale of goods and materials to the company, by any director, relative, firm, partner or private company as aforesaid for cash at prevailing market prices; or (b) any contract or contracts between the company on one side and any such director, relative, firm, partner or private company on the other for sale, purchase or -supply of any goods, materials and services in which either the company or the director, relative, firm, partner or private company, as the case may be, regularly trades or does business. Provided that such contract or contracts do not relate to goods and materials the value of which, or services the cost of which, exceeds five thousand rupees in the aggregate in any year comprised in the period of the contract or contracts; or (c) in the case of a banking or insurance company any transaction in the ordinary course of business of such company with any director, relative, firm, partner or private company as aforesaid. (3) Notwithstanding anything contained in sub-sections (1) and (2) a director, relative, firm, partner or private company as aforesaid may, in circumstances of urgent necessity, enter, without obtaining the consent of the Board, into any contract with the company for the sale, purchase or supply of any goods, materials or services even if the value of such goods or cost of such services exceeds five thousand rupees in the aggregate in any year comprised in the period of the contract; but in such a case, the consent of the Board shall be obtained at a meeting within three months of the date on which the contract was entered into. 5

(4) (5) If consent is not accorded to any contract under this section, anything done in pursuance of the contract shall be voidable at the option of the Board. (6). 5. Admittedly, the assessee s paid up share capital is more than ` 1 crore. As such, the case falls within the purview of the proviso to sub-section (1), which prescribes that no payment to related persons etc. can be made except with the previous approval of the Central Government. However, it is significant to note that subsection (1) of section 297 of the Companies Act requiring prior approval of the Board or the Central Government, as the case may be, in respect of certain contracts in which particular directors etc. are interested, is not invariably absolute. Such requirement gets waived in sub-section (2), if the aggregate of the value of goods or services etc. in a year does not exceed five thousand rupees. Sub-section (3) further waives pre-sanction in circumstances of urgent necessity even if the value of such goods or services exceeds five thousand rupees in the aggregate in any year. In such cases, the consent of the Board has to be obtained at a meeting within three months. Then comes sub-section (5) of 6

section 297, which is quite material. It provides that if the consent is not accorded to any contract under the section, then, anything done in pursuance of the contract shall be voidable at the option of the Board. Clause (i) of section 2 of the Indian Contract Act, 1872 states that : An agreement which is enforceable by law at the option of one or more of the parties thereto, but not at the option of the other or others, is a voidable contract. The essence of sub-section (5) is that when there is a violation of sub-section (1) of section 297 of the Companies Act, the contract does not automatically become void ab initio, but voidable at the option of the Board. The expression voidable at the option of the Board postulates that if the Board, despite no prior sanction, gives green signal and agrees to go ahead with the contract referred to in sub-section (1) of section 297 of the Companies Act, such contract would be valid. It is only when the Board exercises its option against validating the contract as per sub-section (1), that the contract becomes void ab initio. Turning to the facts of the instant case, it is observed that the Board has not objected to the contracts between the assessee and Razormed Inc., thus, making such contract for doing of job work as valid. Viewing from this 7

perspective, it becomes vivid that there is no violation of section 297 of the Companies Act inasmuch as the so-called violation as per sub-section (1) stood regularized by sub-section (5) of section 297 to the Companies Act, 1956, thereby making this transaction of payment of job charges in accordance with the provisions of the Companies Act. 6. Now we espouse the view point of the Revenue that the case of the assessee is caught within the mischief of the Explanation to section 37(1) of the Income-tax Act, 1961. At this juncture, it would be befitting to note the prescription of the Explanation to section 37(1), as under : - Explanation. For the removal of doubts, it is hereby declared that any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no deduction or allowance shall be made in respect of such expenditure. 7. A cursory look at the above Explanation to section 37(1) of the Act makes it palpable that any expenditure incurred by the assessee, for any purpose which is an offence or is prohibited by 8

law, shall not be deemed to have been incurred for the purpose of business and resultantly no deduction shall be allowed. 8. Reverting to the facts of the extant case, it is noticed that the authorities below have proceeded to make and uphold the disallowance in terms of Explanation to section 37(1) of the Act by observing that since the payment of job work expenses was made without prior approval from the Central Government, it amounted to payment in contravention of the Companies Act. Now the position which is obtaining in the present case is that the assessee made payment for getting the job work done from its related concern, which is otherwise neither an offence nor prohibited by law, but committed a breach by not obtaining the necessary approval from the Central Government in time. Thus, on one hand the payment is otherwise for a lawful purpose, but the legality of the transaction has been shadowed by not obtaining prior approval from the Central Government. The pertinent question which arises under the present circumstances is - Can it be said that the assessee incurred an expenditure for any purpose which is an offence or which is prohibited by law? 9

9. Before we deliberate upon this question, it is of paramount importance to note that we are dealing with a deeming provision. A deeming provision or a legal fiction as it is commonly called is one whose mandate does not exist but for such provision. Because of such provision alone, the given imaginary state of affairs is taken as reality despite it being at variance with the scope of the relevant provision of the enactment. It is trite that the scope of a deeming provision has to be restricted to what is expressly stated in such a provision. There can be no inference or intendment as regards such a provision. The Hon ble Supreme Court in CIT Vs. Amarchand N. Shroff (1963) 48 ITR 59 (SC) considered the ambit of a deeming provision and held that the fiction cannot be extended beyond the object for which it is enacted. In CIT Vs. Mother India Refrigeration Industries P.Ltd. (1985) 155 ITR 711 (SC) the same view was reiterated by holding that the legal fictions are created only for some definite purpose and these must be limited to that purpose and should not be extended beyond their legitimate field. The Hon ble Bombay High Court in CIT Vs. Ace Builders P. Ltd. (2006) 281 ITR 210 (Bom.) considered a case in which the assessee was a partner in a 10

firm which was dissolved in the year 1984 and the assessee was allotted a flat towards its credit in the capital account with the firm. The assessee showed the flat as capital asset in its books of account and depreciation was claimed and allowed from year to year. In the previous year relevant to the assessment year 1992-93 the assessee sold the flat and invested the net sale proceeds in a scheme eligible u/s.54e of the Act and accordingly declared Nil income under the head Capital gains. The Assessing Officer opined that since the block of building ceased to exist on account of sale of flat during the year, the written down value of the flat was liable to taken as cost of acquisition u/s.54e of the Act. He further held that since the assessee had availed depreciation on such asset which was otherwise long term capital asset, the deeming provision u/s.50 would apply and it would be treated as capital gain on the sale of short term capital asset and resultantly no benefit u/s.54e could be allowed. When the matter came up before the Hon ble Bombay High Court, it noted that sub-sections (1) and (2) of section 50 contain a deeming provision and such fiction is restricted only to the mode of computation of capital gain contained in sections 48 and 49 and hence it did not apply 11

to other provisions. Consequently the assessee was held to be eligible for exemption u/s.54e in respect of capital gain arising out of the capital asset on which depreciation was allowed. On an appraisal of the above judgments, the legal position which emerges is that whenever a legal fiction is created by way of a deeming provision, it is of paramount importance to go strictly by the express prescription of this provision. Such a deeming provision cannot be extended beyond what is expressly stated therein. 10. With this background, when we turn to the language of the Explanation to sec. 37(1), which is a deeming provision, it is amply borne out that it talks of disallowing any expenditure incurred by an assessee for any purpose which is either an offence or prohibited by law. So what is contemplated for disallowance is an expenditure incurred for any purpose which is either an offence or which is prohibited by law. When we consider the mandate of the Explanation in the light of the fact that it is a deeming provision, there remains no doubt whatsoever that the inquiry to determine the applicability or otherwise of the Explanation is restricted to ascertaining the purpose of the 12

expenditure. In simple words, the investigation should be carried out to see the object and consideration for the expenditure incurred. If the purpose of the expenditure is either an offence or is prohibited by law, then it would suffer disallowance. If, however, the purpose of the expenditure is neither to commit an offence nor is prohibited by any law, then there can be no question of disallowance. It means that the offence or prohibition under law should be judged with the purpose' of the expenditure on a standalone basis divorced from the fulfillment or otherwise of the procedural formalities attached with and necessary for the incurring of such expenditure. To put it in simple words, if the expenditure is otherwise lawful and neither amounts to offence nor is prohibited by law, but the procedural provisions attached for incurring it are not complied with, no doubt irregularity will creep in, but such irregularity would not make the expenditure itself as unlawful so as to be brought within the scope of the Explanation. At the cost of repetition, we state that the Explanation, being a deeming provision, is required to be strictly followed as per its express language and not beyond that. As its language talks of disallowing any expenditure for any purpose 13

which is an offence or which is prohibited by law, we cannot do violence to the language by expanding its scope to also bring within its sweep the cases where the purpose of expenditure is neither an offence nor is prohibited by law, but there is a breach of some procedural provision necessary for incurring such otherwise lawful expenditure. What, therefore, turns out is that it is the expenditure alone which should be tested on the touchstone of the mandate of Explanation to section 37(1) and nothing more than that. If the expenditure itself is for a valid and lawful purpose, then, there can be no question of any disallowance. The words for any purpose set in place by the legislature with the expenditure on the one hand and which is an offence or which is prohibited by law on the other, make it abundantly clear that if the purpose of expenditure, which is sought to be disallowed is not an offence or not prohibited by law, the same cannot be brought within the scope of Explanation to section 37(1) of the Act. If, on the other hand, the purpose of expenditure is an offence or is prohibited by law, the same cannot escape the clutches of the Explanation. The natural corollary which thus follows is that if the purpose of expenditure is not to 14

commit an offence or is otherwise not prohibited by law, then any breach of some procedural statutory provision necessary to be complied with before incurring such expenditure, would not per se convert the otherwise lawful purpose into an offence or prohibition under law so as to attract the wrath of the Explanation. A line of distinction needs to be drawn between the cases where the purpose of the expenditure incurred itself is unlawful on one hand and the cases where the purpose of expenditure is lawful but there is some lapse in complying with the procedural provisions for incurring such expenditure on the other. Whereas the disallowance will be called for in terms of the Explanation to section 37(1) in the first set of cases where the very purpose of the expenditure incurred is unlawful, the second set of cases will escape the mischief of the Explanation because the purpose of the expenditure is not unlawful. The crux of the matter is that the purpose of the expenditure incurred should be viewed in isolation unbothered by anything else for determining whether or not the Explanation is attracted. 11. At this stage, it will be relevant to note the judgment of the Hon ble Punjab & Haryana High Court in CIT vs. Dhanpat Rai & 15

Sons (2014) 98 DTR (P&H) 209. In that case, the assessee, a publisher of books claimed deduction of expenditure incurred on account of secret nature of commission paid to the educational institutions, teachers and individuals for promotion of sales of books and supply of specimen copies of books to teachers. The disallowance made of such secret commission by the AO was deleted by the CIT (A) as well as the Tribunal. However, the Hon ble High Court set aside the tribunal order and remitted the matter to the Tribunal for deciding the allowability of deduction of secret commission on the anvil of the Explanation added to section 37(1) by observing that any secret transaction/payment made to secure unfair advantage would necessarily be repugnant to law. The Hon ble High Court held that such expenditure, if allowed, is likely to encourage illegal payment, evasion of tax and unscrupulous practices. From the above judgment, it is patent that the expenditure in the nature of secret commission aimed at securing an unfair advantage is against the public policy. As such a purpose is an offence or prohibited by law, the same is hit by Explanation to section 37(1). 16

12. As against that and adverting to the facts of the instant case, we find that the expenditure which has been instantly disallowed is a sum of ` 41.24 lac on account of job work charges paid by the assessee to M/s Razormed Inc. It is not the case of the Revenue and naturally cannot be that the payment of job work charges is an offence or is prohibited by law. What the authorities below have taken into consideration while making the disallowance is that since there was no prior approval from the Central Government, the expenditure of job work charges became disallowable. We fail to understand as to how the payment of job work charges can by any stretch of imagination be construed as offence or prohibited by law simply because the necessary permission from the Central Government was obtained belatedly. It has been noticed above that the inquiry should stop on determining the immediate purpose of expenditure, which in the present case is job work done for the assessee. The first question to be asked is whether such payment of job charges is an offence? The answer is obviously in negative. The second question is whether such payment of job charges is prohibited by law? Again the answer is in negative because no law prohibits the 17

payment of job work charges in a manufacturing unit. When the language of the Explanation is crystal clear and does not encompass the incurring of expenses for a lawful purpose, such as the job charges, within its ambit, it is wholly impermissible to import a further requirement in the language of the Explanation to make the otherwise lawful purpose as unlawful for lack of the prior approval of the Central Government. As the purpose of incurring the expenditure of job charges is neither an offence nor is prohibited by law, we fail to comprehend as to how the otherwise lawful purpose would become contingent upon obtaining or not obtaining the prior approval of the Central Government. Since such expenditure in itself is neither an offence nor prohibited by any law and there is a valid and lawful quid pro quo for the same, we are disinclined to uphold the view canvassed in the impugned order. 13. Viewed from any angle, being the operation of sub-section (5) of section 297 of the Companies Act or the non-applicability of Explanation to section 37(1) of the Act, we cannot countenance the view canvassed by the ld. first appellate authority. It is ergo held that the ld. CIT(A) erred in sustaining the disallowance of ` 18

41.24 lac incurred on payment of job work charges. The impugned order is overturned on this issue and the disallowance is deleted. 14. In the result, the appeal is allowed. The order pronounced in the open court on 26.06.2014. Sd/- [C.M. GARG] JUDICIAL MEMBER Sd/- [R.S. SYAL] ACCOUNTANT MEMBER Dated, 26 th June, 2014. dk Copy forwarded to: 1. Appellant 2. Respondent 3. CIT 4. CIT (A) 5. DR, ITAT AR, ITAT, NEW DELHI.* 19