Facts of the Case

The assessee, Khyati Chemicals Private Limited, engaged in the manufacture of chemicals, filed its return of income for Assessment Year 2018-19 declaring total income of ₹17,84,76,810. The assessment under Section 143(3) resulted in three disallowances: excess remuneration of ₹2,40,00,000 paid to two whole-time directors under Section 40A(2)(b); disallowance of ₹9,23,994 towards spray dryer expenses treated as capital in nature; and disallowance of ₹3,29,520 towards computer software expenses treated as capital expenditure.

The CIT(A), NFAC deleted the disallowance under Section 40A(2)(b) holding the remuneration reasonable, but upheld the capital nature of spray dryer and software expenses while allowing depreciation. Aggrieved, the Revenue filed an appeal and the assessee filed a cross objection before the Tribunal.

Issues Involved

Whether the CIT(A) was justified in deleting disallowance under Section 40A(2)(b) relating to excessive remuneration paid to directors, whether such remuneration constituted dividend substitution and tax avoidance, and whether the CIT(A) was correct in treating spray dryer and computer software expenditure as capital in nature.

Petitioner’s Arguments

The Revenue contended that the assessee paid excessive remuneration of ₹5.40 crore to its two directors despite availability of accumulated profits exceeding ₹64 crore and without declaring dividends. It was argued that similarly qualified senior executives in the assessee company were paid significantly lower salaries, establishing that the director remuneration was unreasonable having regard to fair market value. The Revenue submitted that the arrangement was a clear device to avoid dividend distribution tax and corporate tax, squarely attracting Section 40A(2)(b).

The Revenue further contended that the CIT(A) ignored detailed findings of the Assessing Officer demonstrating tax avoidance and erred in deleting the disallowance.

Respondent’s Arguments

The assessee supported the order of the CIT(A) and contended that the directors were highly qualified, experienced and devoted full-time to the business. It was argued that remuneration was commensurate with services rendered and that there was no revenue loss to the Government. Through cross objections, the assessee also challenged the capitalisation of spray dryer and computer software expenditure, contending that both were revenue in nature.

Court Order / Findings

The ITAT Ahmedabad held that the Assessing Officer had carried out a detailed comparative and functional analysis demonstrating that remuneration paid to the two directors was grossly excessive when compared with salaries paid to similarly or more qualified senior executives within the same organisation. The Tribunal noted that despite substantial accumulated profits, the assessee did not declare dividends and instead distributed profits in the form of inflated director remuneration, resulting in clear tax avoidance.

The Tribunal found the reasoning of the CIT(A) to be contrary to facts and unsupported by record, particularly the observation that there was no loss of revenue. The Tribunal held that the provisions of Section 40A(2)(b) were rightly invoked and restored the disallowance of ₹2,40,00,000 made by the Assessing Officer.

On the assessee’s cross objections, the Tribunal held that no material was produced to controvert the findings of the CIT(A) regarding spray dryer and computer software expenditure. Accordingly, the capital nature of these expenditures and allowance of depreciation thereon was upheld.

Important Clarification

The Tribunal clarified that Section 40A(2)(b) is intended to prevent tax avoidance through diversion of profits to related parties under the guise of remuneration. Where facts demonstrate dividend substitution and unreasonable payments beyond fair market value, disallowance is warranted irrespective of the assessee’s claim of business expediency.

Final Outcome

The Revenue’s appeal was allowed. The disallowance of ₹2,40,00,000 under Section 40A(2)(b) was restored. The cross objection filed by the assessee was dismissed in entirety.

 Link to download order https://www.mytaxexpert.co.in/uploads/1769063641_DEPUTYCOMMISSIONEROFINCOMETAXCIRCLE211AHMEDABADAHMEDABAD.pdf

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