ITAT Rajkot Sets Aside Interest Disallowance Under Section 40(a)(ia) for NBFC Payments - Verification of Payee's Tax Compliance Required

Case Background and Parties Involved

In the matter of Servewell Household Appliance Vs ITO, the Income Tax Appellate Tribunal's Rajkot Bench delivered a significant ruling concerning the automatic disallowance of interest payments made to Non-Banking Financial Companies (NBFCs) under Section 40(a)(ia) of the Income Tax Act, 1961. The appellate authority granted relief to the assessee for the Assessment Year 2014-15, though for statistical purposes, and directed the matter back to the Assessing Officer for comprehensive re-examination.

The assessee operates a business involving the manufacture and distribution of household appliances and kitchen utilities. During the relevant financial year, the assessee had obtained vehicle financing from Daimler Financial Services India Pvt. Ltd., a registered NBFC, and was making regular Equated Monthly Installment (EMI) payments that comprised both principal and interest components.

Assessment Proceedings and Additions Made

The Assessing Officer initiated proceedings under Section 143(3) of the Income Tax Act, 1961 and passed an order dated 25.11.2016. During the assessment process, the AO made several adjustments to the returned income, resulting in an enhanced total income assessment.

The primary disallowance that formed the core of the appeal pertained to interest expenditure amounting to ₹3.86 lakh. The Assessing Officer invoked the provisions of Section 40(a)(ia) to disallow this amount, citing the assessee's failure to deduct tax at source on the interest payments made to the NBFC.

Additionally, the AO disallowed professional tax expenses of ₹46,025 under the provisions of Section 43B, on the grounds that such payment was not made within the statutory timeline prescribed under the Act. Furthermore, an addition of ₹1,416 was made on account of interest received on income tax refund, which the AO alleged had not been offered for taxation in the relevant year.

The total income was ultimately determined at ₹41,17,550 as against the returned income of ₹36,83,450, reflecting these three specific adjustments.

First Appellate Proceedings Before CIT(A)

Aggrieved by the assessment order, the assessee preferred an appeal before the Commissioner of Income Tax (Appeals). However, the appellate experience proved unsatisfactory for the assessee as the CIT(A), through an order dated 18.07.2024, upheld all the additions made by the Assessing Officer.

The appellate order passed by the CIT(A) was notably brief and did not contain detailed reasoning or analysis of the submissions made by the assessee. The order merely stated that the Assessing Officer's action contained no infirmity and that the disallowances were warranted. Consequently, the appeal was dismissed in its entirety without adequate adjudication of the specific contentions raised.

This non-speaking nature of the first appellate order became a significant factor in the subsequent proceedings before the Tribunal, as it reflected inadequate application of mind to the factual and legal submissions advanced by the assessee.

Grounds of Appeal Before ITAT

Dissatisfied with the CIT(A)'s order, the assessee approached the Income Tax Appellate Tribunal, Rajkot Bench, raising multiple grounds of appeal challenging the sustainability of the additions.

Primary Ground - Interest Disallowance Under Section 40(a)(ia)

The principal grievance related to the disallowance of ₹3.86 lakh representing interest paid to Daimler Financial Services India Pvt. Ltd. The assessee contended that this disallowance under Section 40(a)(ia) was legally unjustified and factually incorrect.

The assessee's representative argued that the payments constituted EMI installments on a legitimate vehicle loan obtained for business purposes. These installments naturally included an interest component along with principal repayment. Importantly, the assessee emphasized that the payee NBFC was a regularly assessed entity that filed returns of income and was compliant with its tax obligations.

The core submission was that when the payee has already offered the interest income to tax and paid appropriate taxes thereon, the disallowance under Section 40(a)(ia) in the hands of the payer becomes unsustainable and results in double taxation or penalization of legitimate business expenditure.

Additional Grounds

The second ground challenged the disallowance of ₹46,025 pertaining to professional tax under Section 43B, arguing that the CIT(A) had confirmed this disallowance without proper discussion or analysis in the appellate order.

The third ground contested the addition of ₹1,416 representing interest on income tax refund, though this ground was subsequently not pressed during the hearing before the Tribunal.

Contentions Advanced by the Assessee

The Authorized Representative appearing for the assessee presented comprehensive arguments supported by judicial precedents. The primary contention was that the legislative intent behind Section 40(a)(ia) was not to disallow legitimate business expenditure when the corresponding income had been duly taxed in the hands of the recipient.

Particular emphasis was placed on the second proviso to Section 40(a)(ia), which was characterized as a curative and remedial provision with retrospective effect. The assessee argued that this proviso was specifically inserted to address the unintended harsh consequences that arose from mechanical application of the disallowance provision.

The submission highlighted that when a payee has included the income in their return and discharged the appropriate tax liability, no justification exists for disallowing the corresponding expenditure in the hands of the payer. Such disallowance would result in the Revenue collecting tax on the same income twice—once from the recipient who has paid tax on it, and again by denying deduction to the payer.

Judicial Precedents Relied Upon

The assessee placed strong reliance on multiple judicial pronouncements that had examined similar factual matrices and legal questions:

  1. Santosh Kumar Kedia vs. ITO (IA No. 1905/Kol/2014) (Kolkata Tribunal) - This decision held that the second proviso to Section 40(a)(ia) is curative and retrospective in nature, and that legitimate business expenditure cannot be disallowed when the payee has discharged tax liability on the corresponding income.