CHANDRA POOJARI, ACCOUNTANT MEMBER 
AND DUVVURU R.L. REDDY, JUDICIAL MEMBER

R. Vijayaraghavan, Adv. for the Appellant. 
Siva Srinivas, JCIT, DR for the Respondent.

ORDER

Chandra Poojari, Accountant Member - These cross appeals are against the order of the ld. CIT(A)-17, Chennai dated 30.03.2016 passed u/s.143(3) of the Act for assessment year 2011-12.

First, let us take up Assessee 's appeal in ITA No.2487/Mds./2016 as under :—

2. The first issue in its appeal is with regard to sustenance of disallowance of scientific Research and Development expenses of Rs.4,19,14,375/- as not eligible for weighted deduction u/s.35(2AB) of the Act.

3. The facts of the case are that the assessee is a manufacturer of pharmaceuticals formulations and the assessment for assessment year 2011-12 was completed u/s.143(3) of the Act on 14.03.2014. During the assessment proceedings, the AO found that the AO has claimed weighted deduction u/s.35(2AB) of the Act on the R&D expenditure incurred ruing the assessment year under consideration. For the purpose of allowability of the claim, the assessee was asked to produce the approval of the expenditure by the Competent Authority as per the provisions of the section 35(2AB) of the Act. The assessee submitted Form No.3CL dated 22.12.2011 issued by the Competent Authority i.e. Department of Scientific and Industrial Research in which the following R& D expenditure has been approved for assessment year 2011-12.

The AO found that the assessee had claimed excess deduction of Rs.4,19,14,375/- and the AO had disallowed that amount on the ground that form 3CL given by the authority did not have the approval for the revenue expenditure, though it had approval for the capital expenditure. Based on the computation statement furnished by the assessee and Form No.3CL, the AO disallowed the amount of excess claim as follows:-

Against this, the assessee carried the appeal before the Ld.CIT(A).

3.1 On appeal, the Ld.CIT(A) observed that as per the provisions of the section 35(2AB), in-house R&D is permitted and the amount spent of in-house R&D is allowable subject to the approval by the prescribed authority. According to Ld.CIT(A), in assessee's case, out of the total R&D expenses of Rs.9.33,61,300/- claimed by assessee during the financial year 2010-11, the Competent Authority (DSIR) approved only 5,26,20,000/- and has not approved the balance of Rs.4,07,41,300/- (i.e. R&D capital expenses of 11,73,074/- and R&D revenue expenses of 3,95,68,226/-) claimed by the assessee.

3.2 The above deductions of R&D expenses are specially allowed benefits to the assessee and are subject to various terms and conditions. The assessees are required to obtain the approval of the R&D expenses every year from the DSIR. The DSIR examines the expenses and the nature of R&D and approves the R&D expenses for the purposes of sec.35(2AB) of the Act. In the instant case the DSIR has clearly approved the appellant's claim of R&D expenses to the extent of Rs.14,48,08,226/- only. In other words, the balance of Rs.4,19,14,375/-, which was not approved by the DSIR, is totally outside the purview of the provisions of sec.35(2AB) of the Act, for the purpose of weighted deduction. If the claim of the appellant that even if the claim of R&D expenses are not aproved by the DSIR in the concerned year, still the weighted deduction u/s.35(2AB) of the Act is to be allowed as long as the R&D facility is approved, is to be accepted, it will defeat the very purpose of the enactment of the provisions of sec.35(2AB) and the stipulations and the restrictions imposed therein. This will also render the requirement of assessees submitting the details expenses in R&D to the DSIR in the prescribed format and obtaining the necessary approvals for the same, totally irrelevant. This is not the intention of the legislature. The requirement of assessee furnishing the details of expenses of R&D to the DSIR and obtaining necessary approval, itself shows that the weighted deduction is available only on fulfilling these requirements. Therefore, if the conditions stipulated in the said statues are not fulfilled, the amounts will become ineligible for the weighted deduction, to be claimed against the business income of the year.

3.3 Thus, in view of the above reasons, the weighted deduction of 200% u/s.35(2AB) of the Income Tax Act is available only on approval by the DSIR and that too on the R&D expenses certified in the Form No.3CL. Any expenditure is not eligible for weighted deduction. However, the other R&D expenditure (i.e. which is not approved by the DSIR), which is revenue in nature, is allowable for normal deduction @ 100°k u/s.35(1) of the Act. No capital expenses incurred for R&D is allowable u/s.35 of the Income Tax Act.

3.4 According to Ld.CIT(A), the total R&D expenditure eligible for weighted deduction u/s.35(2AB) of the Act is Rs.5,26,20,000/- and the weighted deduction available to the appellant is Rs.10,52,40,000/-. The balance of R&D expenditure of Rs.4,07,41,300/- (i.e. R&D capital expenditure of Rs.11,73,074 and R&D revenue expenditure of Rs.3,95,68,226) which was not approved by the DSIR is not_eligible for weighted deduction u/s.35(2AB) of the Act. The unapproved R&D capital expenditure of Rs.11,73,074/- is not an allowable deduction under any of the provisions of the Act. However, the R&D revenue expenditure is eligible for normal (100%) deduction u/s.35(1) of the Act. Therefore, the Assessing Officer's disallowance of the weighted deduction to the extent of Rs.4,19,14,375/- is confirmed by the Ld.CIT(A) . Against this assessee is in appeal before us.

4. We have heard both the parties and perused the material on record. In this case, there is no dispute that the assessee incurred a sum of Rs.4,19,14,375/- for the purpose of R&D, which is capital in nature to the extent of Ld.CIT(A) agreed. However, since it is a capital expenditure, he disallowed the same. In our opinion, a part of expenditure incurred by the assessee towards unapproved R&D facilities was not entitled for deduction u/s.35(2B) of the Act and that itself cannot be a reason to disallow the same u/s.35(1)(iv) of the Act. 100% of the deduction on the capital expenditure incurred on the R&D activity was to be allowed. Once the Revenue authorities accepted that the expenditure was incurred towards R&D and it was disallowed u/s.35(2AB) of the Act on the reason of non-approval by the DSIR, then it should be considered u/s.35(1)(iv) of the Act, Being so, in our opinion, the Ld.CIT(A) is not justified in disallowing the same. For this purpose, we placed reliance in the judgement of Co-ordinate Bench of Hyderabad in the case of Dy. CIT v. Reliance Celulose Products Ltd. [2013] 36 CCH 269 wherein held that Merely because part of the expenditure incurred by the approved R&D facilities is not considered for weighted deduction u/s.35(2AB) of the Act would not render that expenditure is not towards R&D or not for the purposes of the business. Allowability of such expenditure u/s.35(1) or under other appropriate provisions will have to be considered.

4.1 In view of the judgements, we hold that unapproved R&D capital expenditure of Rs.11,73,074/- and revenue expenditure of Rs.3,95,68,226/- is not entitled for weighted deduction u/s.35(2AB) of the Act, However, unapproved R&D capital expenditure of Rs.11,73,074/- to be considered u/s.35(1)(iv) of the Act. If the assessee fulfills the condition in terms of explanation below the provisions 35(1) of the Act as held by the P&H High Court in the case of CIT v. FCS International Marketing (P.) Ltd. [2006] 283 ITR 32/155 Taxman 362. Accordingly, we hold that the matter is required to be referred by the AO to the prescribed authority and only on the basis of such order from the prescribed authority, as may be passed, that the AO has to make any disallowance. Accordingly, this issue is remitted to the file of AO for any further action as may be deemed fit in accordance with law, to make disallowance out of the R&D expenditure claimed by the assessee. This ground is partly allowed for statistical purposes.

5. The next ground of appeals is regarding the Assessing Officer's action of disallowance made u/s.14A of the Act r.w.r. 8D of the Income Tax Rules, relating to the expenses pertaining to the exempted income.

5.1 The facts of the issue are that the Assessing Officer in his order noticed that the appellant, during the financial year 2010-11 relevant to the A.Y. 2011-12, made substantial amounts of investments in purchase of shares/mutual funds, the income from which is exmpt from tax in the hands of the Assessee. However, the assessee has not segregated any expenditure pertaining to the earning of the said exempted income from the investments made in shares and mutual funds. Therefore, the AO invoked the provisions of the section 14A of the Act r.w.r. 8D of the Income Tax Rules ad worked out the expenses in earning the said exempted income from the firm by adopting the formula contained under the Rule 8D at 8,75,216/- and disallowed the same. Against this, the assessee carried the appeal before the Ld.CIT(A). On appeal, Ld.CIT(A) confirmed the action of the ld. Assessing Officer. Aggrieved by the order of lower authorities, the assessee is in appeal before us.

6. Before us, ld.A.R submitted that this should be restricted to the extet of exempted income as held by the jurisdictional High Court in the case of Redington (India) Ltd. v. Addl. CIT [2017] 77 taxmann.com 257 (Mad.) held that:-

'13. Reliance is also placed on a decision of the jurisdictional High Court in the case of Beach Minerals Company Pvt. Ltd. Vs. Assistant Commissioner of Income Tax in TCA No.681 of 2013, dated 2.12.2013. In that case, payments of interest by the assessee were sought to be disallowed invoking the provisions of s.14A on the premise that the same related to borrowings that had been invested and would yield exempt returns. The assessee contested the disallowance u/s 14A on multiple grounds. It was contended that there were sufficient reserves and surpluses available for the purpose of investments, and borrowed funds, for which the payment of interest had been incurred, had not been invested. The assessee sought to draw a nexus between the borrowed funds and the interest payments, highlighting the position that the quantum of available free funds was far in excess of the investments made. The Bench, in the light of the above submissions, remanded the issue to the file of the assessing officer to be considered de novo and after conducting a proper enquiry. Inter alia a direction was issued to the assessee to tender a proper explanation for the interest payments. The open remand was made in the facts and circumstances of that case and no conclusion was drawn by the Bench on the position of law involved. In fact, the substantial question of law raised in that case for the consideration of the Court was couched in general terms as follows

"Whether on the facts and in the circumstances of the case. the Income Tar Appellate Tribunal is right in law in confirming the disallowance under Section 11.1 of the income Tax Act, of an amount of Rs.55,00.000/- in relation to assessment year 2007- 2008?"

14. Nothing much turns on the use of the word 'includable' and the phrase 'under the act' in s. 14A and we are not persuaded to accept the emphasis laid or the interpretation of the same by the Revenue. An assessment in terms of the Income tax Act is specific to an assessment year and the related previous year. S.4 of the Act, which imposes the charge to tax reads thus:

Charge of income-tax
4. (1) Where any Central Act enacts that income —tax shall be charged for any assessment year at any rate or rates, income-tax at that rate or those rates shall be charged for that year in accordance with and subject to the provisions (including provisions for the levy of additional income-tax) of, this Act in respect of the total income of the previous year of every person:

Provided that where by virtue of any provision of this Act income-tax is to be charged in respect of the income of a period other than the previous year, income tax shall be charged accordingly.

Thus, where the statute indented that income shall be recognized for taxation in respect of any previous other than that immediately preceding the relevant assessment year, the provision shall expressly state so. The provisions of s.1O in Chapter III of the Act dealing with 'Incomes not included in total income' commences with the phrase 'In computing the total income of a previous year, any income falling within any of the following clauses shall not be included.

15. The exemption extended to dividend income would relate only to the previous year when the income was earned and none other and consequently the expenditure incurred in connection therewith should also be dealt with in the same previous year. Thus, by application of the matching concept, in a year where there is no exempt income, there cannot be a disallowance of expenditure in relation to such assumed income. (Madras Industrial Investment Corporation Ltd. Vs. CIT (225 ITR 802). The language of S.14A(1) should be read in the context and such that it advances the scheme of the Act rather than distort it.

16. In conclusion, we are of the view that the provisions of the section 14A r.w.Rule 8D of the Rules cannot be made applicable in a vacuum i.e. in the absence of exempt income. The questions of law are answered in favour of the assessee and against the department and the appeal allowed. No costs

Being so, we direct the Assessing Officer to disallow the expenditure u/s.14A to the extent of exempted income only. This ground of appeal of assessee is partly allowed.

7. The common ground in both the appeals is with regard to partly confirming the disallowance u/s.37(1) being gift of gold coins to doctors/medical practitioners.

7.1 The facts of the issue are that the AO disallowed sales promotion and other selling expenses of Rs.5,19,37,891/- u/s.37(1) of the Act. The AO found that the assessee incurred sales promotion expenses of Rs.3,18,49,500/- and other selling expenses of Rs.6,64,51,614/-. Out of these expenses, Rs.2,14,71,297/-(under 'sales promotion expenses ) and Rs.3,04,66,594/- ( under 'other selling expenses ) are by way of freebies and gifts to the doctors and medical practitioners, in the form of gold coins, laptos, LCD TVs. Refrigerators etc. The AO opined that as per Medical Council (professional Conduct, Etiquette and Ethics ) Regulations, 2002, these expenses are prohibited expenses and the AO invoked the provisions of the section 37(1) of the Act and disallowed the sales promotions expenses of Rs.2,14,71,297/- and other selling expenses of Rs.3,04,66,594/-, totaling to Rs.5,19,37,891/-. Agrrieved, the assessee carried the appeal before the Ld.CIT(A).

7.2 During the appellate proceedings, the assessee's counsel submitted before the Ld.CIT(A) that the appellant company, during appellate hearings, submitted that the company was engaged in the manufacturing of mainly "Zincovit", a healthcare supplement, but not a pharmaceutical product. In order to create awareness of the product and popularize it, the best persons were the medical practitioners only. The Company also claimed that the above sales promotions expenses and other selling expenses are mainly in the forms of refrigerators, LCD TVs, Laptops, gold coins etc, which are mainly intended to disseminate the information to the medical practitioners and from them to the ultimate consumers. Therefore, these expenses are essentially advertisement expenses for creating awareness and to promote sales. The appellant further claimed that it is neither engaged in the manufacturing of any pharmaceutical product nor prohibited by any law from incurring such expenses. Hence the appellant claimed that the above expenses, which are incurred wholly and exclusively for the purpose of business should be allowed as allowable expenses. The Ld.CIT(A) observed that One of the main submissions of the appellant is that it is not engaged in the manufacturing of any pharmaceutical product and hence the provisions of Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations 2002, have no application in its case and therefore, this claim is not acceptable. According to Ld.CIT(A), the aforesaid prohibition is not only relating to the manufacturing of any pharmaceutical products, but also includes all allied products. The appellant's product is a healthcare product and is covered by the second limb i.e. allied products. Further, the proviso to section 37(1) is relating the nature of the expenses which are paid to the doctors and medical practitioners. Any expenses paid by the manufacturers of any pharmaceutical products and allied products, to the doctors and medical practitioners, by way of freebies and gifts, are within the scope of the proviso. Therefore, this contention of the appellant stands rejected. Therefore, the Ld.CIT(A) confirmed the action of the ld. Assessing Officer and disallowance of expenditure incurred towards distribution of gold coins to the doctors and medical practitioners included in the above amount. Against the order of Ld.CIT(A), both the assessee and the Revenue is preferred appeal before us.

8. We have heard both the parties and perused the material on record. In our opinion, the Medical Council (professional Conduct, Etiquette and Ethics ) Regulations, 2002 prohibits the distribution of gift to the doctors and medical practitioners. Accordingly, this ground raised by the assessee is dismissed and the by the Revenue is allowed.

9. The next ground raised in Revenue's appeal is with regard to allowing the differential interests on borrowed funds diverted for non business purposes.

9.1 The brief facts of the case are that the assessee during the financial year 2010-11, advanced more than Rs. 28 crores by way of inter-corporate deposits to some of its group concerns and the interest charged on the loan is only @ 10%. However, the AO found that the assessee borrowed substantial amounts of interest bearing loans, where the rate of interest paid is 13.5% and the total amount of interest paid during the year was Rs.5.6 crores. Hence, the AO opined that there was diversion of interest bearing funds for advancing loans for lesser interest rates. Hence, the invoked the provisions of the section 36(1)(iii) of the Act and disallowed proportionate interest of 3.5%, being the difference in the interest paid @ 13.5 % and the interest received @ 10%, amounting to Rs.33,15,053/-. Aggrieved, the assessee carried the appeal before the Ld.CIT(A).

9.2 The assessee company, during appellate proceedings, submitted that the inter-corporate deposits were from its own interest- free funds. The appellant further explained that the inter-corporate deposits were a strategic investment to protect the interests of the assessee. Hence, the appellant stated that the Assessing Officer is not justified in disallowing proportionate interest u/s.36(1)(iii) of the Act. The Ld.CIT(A) observed that the assessee's explanation is that the inter-corporate deposits to the group concerns is a strategic investment and hence should not be considered for the purpose of determining the disallowance of proportionate interest u/s. u/s.36(1)(iii) of the Act, has little merits. Strategic investments means the investments in other concerns with which the assessee has close and immediate business transactions and the investments should directly benefit the assessee, by way reduction in the cost of' production or increase in the profitability etc. Also, the strategic investment means the investments which are required to be invested in order to protect the interests of the business, and if such investments are not made the business will suffer adversely. However, in the present case, the assessee has not proved any such inevitability/ requirement before making the above inter-corporate deposits. Therefore, the loans advanced by the appellant, by way of inter-corporate deposits, in the group concerns etc cannot be considered as strategic investment / business exigency.

9.3 According to Ld.CIT(A), as could be seen from the balance sheet of the financial year, the total accumulated capital as on 31.03.2011 was Rs.38.43 crores (share capital of Rs.1.37 crores and reserves and surplus of Rs.37.06 crores). In addition there is an interest free deferred tax reserve of Rs.6.70 crores. Thus there are interest free funds of about Rs.45 crores available with the company. Therefore the above inter- corporate deposits of Rs.28 crores can safely presumed to be out of the above interest free funds of Rs. 45 crores. Once the interest free funds are more than the amount of loans given, it is not possible to presume that there is a diversion of interest bearing funds. Under such circumstances, the assessee is free to decide its own rate of interest to be charged, the AO is not empowered to disallow any proportionate interest. Therefore, the Assessing Officer's action of invoking the provisions of section 36(1)(iii) of the Act and disallowing the proportionate interest @ 3.5% (being the difference between the rate of interest paid and the interest received) on account of the so called diversion of interest bearing funds for investing in inter-corporate deposits, is not justified. The disallowance made by the Assessing Officer is legally untenable and therefore deleted. Aggrieved with the order of Ld.CIT(A), the Revenue is in appeal before us.

10. We have heard both the parties and perused the material on record and gone through the case law cited by the ld.A.R. Ld.A.R submitted that the assessee is having Rs.45 crores interest free funds out of Rs.28 crores advanced by way of inter-corporate deposits to some of its group concerns. According to ld.A.R, there cannot be any disallowance for this purpose. He relied on the judgment of CIT v. Bharti Televenture Ltd. [2011] 331 ITR 502/200 Taxman 39/11 taxmann.com 356 (Delhi) and judgment of jurisdictional High Court in the case of CIT v. Hotel Savera [1999] 239 ITR 795/102 Taxman 247 (Mad.) and also relied in the case of Woolcombers of India Ltd. v. CIT [1982] 134 ITR 219/[1981] 7 Taxman 188 (Cal.) Ld.D.R submitted the assessee is having huge borrowing on which it has paid interest, as such disallowance is confirmed.

11. In this case, the Commissioner of Income-tax(Appeals) deleted the addition on the reason that the assessee is having accumulated own fund at Rs.38.43 crores as per the balance sheet dated 31.03.2011 and also interest free deferred Tax Reserve at Rs.6.70 crores, totally Rs.45 crores and the amount was advanced from its own funds. The assessee claimed deduction towards interest paid to various loans at Rs.5.60 crores. The Assessing Officer noticed that the assessee has diverted the funds of Rs.28 crores to its sister concern as advance free of interest. The Assessing Officer was of the opinion that the proposed interest on the amount invested like this is not for the purpose of business and the same was disallowed proportionately. As per provisions of section 36(1)(iii) of the Act, the interest on loans raised by the assessee for business purposes are available. Once the assessee claims any such interest as deduction in their books of account the onus always will be on the assessee to satisfy the Assessing Officer that whatever loans were raised by the assessee were for the purpose of business. If in the process of examination of genuineness of such deduction, if it transpires that the assessee has advanced certain funds to its group concern charging no interest, there would be a very heavy onus on the assessee to discharge before the Assessing Officer to the effect that in spite of outstanding loans on which the assessee is incurring liability to pay interest, there would be no justification to advance the loans to group concern for non-business purposes without charging any interest.

12. Entire money in a business entity comes in a common kitty. The monies received as share capital, as term loan, as working capital loan, as sale proceeds etc. do not have any different colour. Whatever are the receipts in the business, which have the colour of business receipts and have no separate identification? The only thing sufficient to disallow the interest paid on the borrowing to the extent the amount is lent to group concern without carrying any interest for non-business purposes would be that the assessee has some loans or other interest bearing debts to be repaid. In case the assessee had some surplus amount which, according to him, could not be repaid prematurely to any lender, still the same is either required to be circulated and utilised for the purpose of business or to be invested in a manner in which it generates income and not that it is diverted to group concern free of interest. This would result in not presenting true and correct picture of the accounts of the assessee as at the cost being incurred by the assessee, the sister concern would be enjoying the benefits thereof. It cannot possibly be held that the funds to the extent diverted to group concern or other persons free of interest were required by the assessee for the purpose of its business and loans to that extent were required to be raised. We do not subscribe to the theory of direct nexus of the funds between borrowings of the funds and diversion thereof for non-business purposes. Rather, there should be nexus of use of borrowed funds for the purpose of business to claim deduction under Section 36(1)(iii) of the Act. That being the position, there would be no escape from the finding that interest being paid by the assessee to the extent the amounts are diverted group concern on interest free basis are to be disallowed.

13. If the plea of the assessee is accepted that the interest free advances made to group concern for non-business purposes was out of his own funds in the form of capital introduced in business, that again will show a camouflage by the assessee as at the time of raising of loan, the assessee will show the figures of capital introduced by it as a margin for loans being raised and after the loans are raised, when substantial amount is diverted to group concern for non-business purposes without interest, a plea would be raised that the amount advanced was out of its capital, which in fact stood exhausted in setting up of the unit. Such a plea may be acceptable at a stage when no loans had been raised by the assessee at the time of disbursement of funds. This would depend on facts of each case.

14. The view that where the amount is advanced from a mixed account or share capital or sale proceeds or profits, it would not be deemed as diversion of borrowed capital or that the Revenue had not been able to establish nexus of the funds advanced to group concern with the borrowed funds is not correct. Once it is borne out from the record that the assessee had borrowed certain funds on which liability to pay tax is being incurred and on the other hand, certain amounts had been advanced to its group concern or others without carrying any interest and without any business purpose, the interest to the extent the advance had been made without carrying any interest is to be disallowed under Section 36(1)(iii) of the Act. Accordingly, we are of the opinion that the assessee used certain amounts to advance group concern as interest free and that portion of interest cannot be allowed while computing the business income of the assessee. Being so, we confirm the order of the AO and reverse the order of the Commissioner of Income-tax(Appeals) on this issue.

15. In the result, the appeal of assessee is partly allowed for statistical purposes. and the appeal of Revenue is allowed.