ISSUE FOR CONSIDERATION
For an employer, staff welfare expense is normally an allowable business deduction under section 36 or 37 in computing his income under the head ‘Profits and Gains of Business or Profession’. However, the allowability of business deductions is restricted by the provisions of section 40A. Section 40A(9), inserted by the Finance Act, 1984 with retrospective effect from 1st April, 1980, provides that no deduction shall be allowed in respect of any sum paid by the assessee as an employer towards the setting up or formation of, or as contribution to, any fund, trust, company, AOP, BOI, society or other institution for any purpose. Exceptions are provided, for permitting deductions, for payment of contributions to specified funds being recognised provident fund, approved superannuation fund, approved gratuity fund and towards a pension scheme referred to in section 80CCD [i.e., sums paid for the purposes and to the extent provided by or under clauses (iv), (iva) or (v) of section 36(1)], or for payments required by or under any other law.
The issue has come up before the High Courts as to whether all contributions to funds, other than those specified, are hit by the embargo of section 40A(9) leading to disallowance of expenditure, or whether the provisions for disallowance apply only to funds which merely accumulate and do not spend such contributions on staff welfare. While the Kerala High Court has taken the view that in terms of section 40A(9) the payment of contributions would be disallowed where the contribution is to a fund other than the specified funds, the Bombay and Karnataka High Courts have taken a more liberal view, holding that the prohibition does not apply to contributions to genuine funds and the deduction would be allowed irrespective of section 40A.
ASPINWALL & CO.’S CASE
The issue had come up before the Kerala High Court in the case of
Aspinwall and Co. Ltd. vs. DCIT 295 ITR 533.
In this case, pertaining to assessment years 1990-91, 1991-92 and another year post assessment year 1980-81, the assessee had made a contribution to the Executive Staff Provident Fund, which was not a recognised provident fund, and claimed a deduction for such contribution. Such contribution had been allowed to it as a deduction u/s 37 for A.Y. 1979-80 by the Kerala High Court vide its decision reported in
194 ITR 739, and also for A.Y. 1977-78 by the Kerala High Court in a decision reported in
204 ITR 225 u/s 36(1)(iv), following its own earlier decision. The A.O. had disallowed such contribution.
The assessee contended before the Kerala High Court that in view of the decisions of the High Court in the earlier years in its own cases, it was entitled to get deduction for the amount paid to the unrecognised provident fund u/s 36(1)(iv) or (v), or in the alternative u/s 37. On behalf of the Revenue, it was contended that the earlier decisions of the Kerala High Court would not apply to the assessment years in question in view of the insertion of sub-section (9) to section 40A with retrospective effect from 1st April, 1980.
The Kerala High Court analysed the provisions of section 40A(9) to hold that after the insertion of sub-section (9), no deduction be allowed in respect of any sum paid by the assessee as an employer towards contribution to a provident fund, except where such amount was paid for the contribution to a recognised provident fund and for the purposes of and to the extent provided by or u/s 36(1)(iv). The High Court noted that section 37(1) was a general provision which stated that any expenditure, other than of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee, laid out or expended wholly and exclusively for the purposes of the business or profession, was to be allowed in computing the income chargeable under the head ‘profits and gains of business or profession’. According to the High Court, in view of the provisions of section 40A(9), no deduction could be allowed in respect of any sum paid towards contribution to a provident fund by taking recourse to the residuary section 37(1).
The Kerala High Court analysed the Explanatory Notes to the Finance Act, 1984 in relation to section 40A(9) to hold that the intention of the Legislature was to deny the deduction in respect of sums paid by the assessee as employer towards contribution to any fund, trust, company, etc., for any purposes, except to a recognised fund and that, too, within the limits laid down under the relevant provisions. Placing reliance on the decision of the Supreme Court in Shri Sajjan Mills Ltd. vs. CIT 156 ITR 585, where the Supreme Court had held that unless the conditions laid down in section 40A(7) were fulfilled, a deduction could not be allowed on general principles under any other provisions of the Act relating to computation of income under the head ‘profits and gains of business or profession’, the Kerala High Court held that section 40A had to be given effect to, notwithstanding anything contained in sections 30 to 39 of the Act, and
in view of that no deduction could be allowed in respect of any contribution towards an unrecognised provident fund.
The Kerala High Court noted that the deduction u/s 36(1)(iv) was subject to the prescribed limits, which limits had been laid down in Rules 75, 87 and 88 of the Income Tax Rules, 1962. Section 40A(9) referred to the purposes and the extent provided by or u/s 36(1)(iv), and therefore only such amounts, within the prescribed limits, could be allowed as a deduction.
The Kerala High Court, therefore, held that no deduction could be allowed u/s 37(1) in respect of contribution to the unrecognised provident fund, having regard to the provisions of section 40A(9).
This decision of the Kerala High Court was followed again by the Kerala High Court in the case of TCM Ltd. vs. CIT 196 Taxman 129 (Ker), where the issue related to the deduction for a contribution to an Employees’ Welfare Fund.
STATE BANK OF INDIA’S CASE
The issue came up again recently before the Bombay High Court in the case of
Pr. CIT vs. State Bank of India 420 ITR 376.
In this case, the assessee claimed expenditure of Rs. 50 lakhs incurred towards contribution to a fund created for the welfare of its retired employees. The A.O. disallowed such expenditure, invoking the provisions of section 40A(9).
The Tribunal allowed the assessee’s claim, observing that the assessee had made such contribution to a fund for the medical benefits specially envisaged for the retired employees of the bank. In the opinion of the Tribunal, section 40A(9) was inserted to discourage the practice of creation of bogus funds and not to disallow the general expenditure incurred for welfare of the employees. The Tribunal also noted that the A.O. had not doubted the bona fides of the assessee in creation of the fund, and that such fund was not controlled by the assessee. Proceeding on the basis that the A.O. and the Commissioner (Appeals) had not doubted the bona fides in creation of the trust and that the expenditure was incurred wholly and exclusively for the employees, the Tribunal allowed the assessee’s appeal and deleted the disallowance.
The Bombay High Court, on appeal by the Revenue, analysed the provisions of section 40A(9) to hold that the case of the assessee did not fall in any of the clauses of section 36(1) mentioned in section 40A(9), i.e., clauses (iv), (iva) or (v). It referred to the provisions of the Explanatory Memorandum and the Notes to the Finance Act, 1984 when section 40A(9) was introduced to hold that the purpose of inserting sub-section (9) in section 40A was not to discourage the general expenditure by an employer for the welfare activities of the employees. The Bombay High Court was of the view that the purpose of insertion of section 40A(9) was to restrict the claim of expenditure by the employers towards contribution to funds, trust, association of persons, etc., which were wholly discretionary and which did not impose any restriction or condition for expending such funds, which had possibility of misdirecting or misuse of such funds after the employer claimed benefit of deduction thereof. Basically, according to the Bombay High Court, the inserted provision was not meant to hit the allowance of the general expenditure by an employer for the welfare and the benefit of the employees.
The Court placed reliance on its earlier decisions in the cases of CIT vs. Bharat Petroleum Corporation Ltd. 252 ITR 43 where a donation to a club created for social, cultural and recreational activities of its members was allowed, by holding the expenditure to be on staff welfare activity; CIT vs. Indian Petrochemicals Corporation Ltd. 261 Taxman 251, where contributions to various clubs and facilities meant for use by staff and their family members were held allowable; and Pr. CIT vs. Indian Oil Corporation, ITA No. 1765 of 2016, where expenditure on setting up or providing grant-in-aid to Kendriya Vidyalaya Schools where children of staff of the assessee would receive education, was held to be allowable as a deduction.
The Bombay High Court in the case was not asked to examine or consider the ratio of the decision of the Kerala High Court in the case of Aspinwall Ltd. (Supra) and the said decision remains to be dissented with. In fact, the Court relied on another decision of the Kerala High Court in the case of PCIT vs. Travancore Cochin Chemicals Ltd. 243 ITR 284 to support its action to allow the deduction. It held that the contribution to a fund for the healthcare of retired employees was an allowable deduction and was not disallowable u/s 40A(9).
A similar view was also taken by the Karnataka High Court in the case of CIT vs. Motor Industries Co. Ltd. 226 Taxman 41, where the Court held that the contribution made by the assessee towards a benevolent fund created for the benefit of its employees was entitled to deduction, notwithstanding section 40A(9), though there was no compulsion under any other law for making such contribution. The Karnataka High Court relied on its earlier decision in the case of the same assessee, in ITA 3 of 2002 dated 2nd November, 2007. Such contribution was made pursuant to a Memorandum of Understanding embodying the terms of a settlement arrived at between the management and employees of the company.
OBSERVATIONS
It is interesting to note that both the Kerala as well as the Bombay High Courts relied on the same Explanatory Memorandum to the Finance Act, 1984 explaining the rationale behind introduction of sub-section (9) in section 40A, for arriving at diametrically opposite conclusions. The Explanatory Notes read as under:
‘(ix) Imposition of restrictions on contributions by employers to non-statutory funds.
16.1 Sums contributed by an employer to a recognised provident fund, an approved superannuation fund and an approved gratuity fund are deducted in computing his taxable profits. Expenditure actually incurred on the welfare of employees is also allowed as deduction. Instances have come to notice where certain employers have created irrevocable trusts, ostensibly for the welfare of employees, and transferred to such trusts substantial amounts by way of contribution. Some of these trusts have been set up as discretionary trusts with absolute discretion to the trustees to utilise the trust property in such manner as they may think fit for the benefit of the employees without any scheme or safeguards for the proper disbursement of these funds. Investment of trust funds has also been left to the complete discretion of the trustees. Such trusts are, therefore, intended to be used as a vehicle for tax avoidance by claiming deduction in respect of such contributions, which may even flow back to the employer in the form of deposits or investment in shares, etc.
16.2 With a view to discouraging creation of such trusts, funds, companies, association of persons, societies, etc., the Finance Act has provided that no deduction shall be allowed in the computation of taxable profits in respect of any sums paid by the assessee as an employer towards the setting up or formation of or as contribution to any fund, trust, company, association of persons, body of individuals, or society or any other institution for any purpose, except where such sum is paid or contributed (within the limits laid down under the relevant provisions) to a recognised provident fund or an approved gratuity fund or an approved superannuation fund or for the purposes of and to the extent required by or under any other law.
16.3 With a view to avoiding litigation regarding the allowability of claims for deduction in respect of contributions made in recent years to such trusts, etc., the amendment has been made retrospectively from 1st April, 1980. However, in order to avoid hardship in cases where such trusts, funds, etc., had, before 1st March, 1984, bona fide incurred expenditure (not being in the nature of capital expenditure) wholly and exclusively for the welfare of the employees of the assessee out of the sums contributed by him, such expenditure will be allowed as deduction in computing the taxable profits of the assessee in respect of the relevant accounting year in which such expenditure has been so incurred, as if such expenditure had been incurred by the assessee. The effect of the underlined words will be that the deduction under this provision would be subject to the other provisions of the Act, as for instance, section 40A(5), which would operate to the same extent as they would have operated had such expenditure been incurred by the assessee directly. Deduction under this provision will be allowed only if no deduction has been allowed to the assessee in an earlier year in respect of the sum contributed by him to such trust, fund, etc.’
The Kerala High Court interpreted the Memorandum to mean that the intention of the Legislature was to deny the deduction in respect of the sums paid by the assessee to all funds, trusts, AOPs, etc., other than those specified in section 36(1)(iv), (iva) and (v), while the Bombay High Court understood it to mean that the inserted provision applied only to trusts which were discretionary, with possibility of misdirection or misuse of such contributions, and not applicable to any genuine expenditure.
The intention of the Legislature behind the amendment may be gathered from paragraph 16.1 of the Explanatory Notes, where the types of cases of misuse sought to be plugged have been set out. The amendment is intended to apply in cases where the employer had discretion in utilisation of funds and in investment of funds without any safeguards, and which could be used as tools of tax avoidance by claiming deduction in respect of such contributions, which could flow back to the employer in the form of deposits or investment in shares, etc. It was certainly not intended to apply to genuine staff welfare trusts, where the amount of contributions was expended on staff welfare, where the contribution was really in the nature of staff welfare expenses. Clearly, the amendment was not targeted to curtail the allowance of staff welfare expenditure but only to curb misuse of claim for deduction of a payment disguised as staff welfare expenditure, of amounts not intended to be spent on staff welfare expenditure.
The Kerala High Court itself, in CIT vs. Travancore Cochin Chemicals Ltd. 243 ITR 284, while considering a payment towards proportionate share of expenses of assessee for running of a school wherein children of the assessee’s employees were studying, had held that such expenditure was expenditure for the smooth functioning of the business of the assessee and also expenditure wholly and exclusively for the welfare of the employees of the assessee and, thus, allowable.
In Sandur Manganese & Iron Ores Ltd. vs. CIT 349 ITR 386, the Supreme Court had occasion to examine the provisions of section 40A(9) and their applicability to payments made to schools claimed as welfare expenses towards providing education to its employees’ children. The Tribunal and High Court had concluded that those payments made by the assessee constituted ‘reimbursement’ to schools promoted by the assessee, and accordingly had upheld the disallowance. The Supreme Court on appeal observed that section 40A(9) of the Act was inserted as a measure for combating tax avoidance. Noting that the A.O. had observed that certain payments had been made to educational institutions other than those promoted by the assessee, in view of these facts, the Supreme Court further directed the ITAT to record a separate finding as to whether the claim for deduction was being made for payments to the school promoted by the assessee or to some other educational institutions / schools and thereafter apply section 40A(9). The action of the Court indicates that the expenditure where incurred for payments to funds, etc., not promoted by the assessee, were to be separately considered.
In Kennametal India Ltd. vs. CIT 350 ITR 209 (SC), the Tribunal had held that the amount paid by a company towards employees’ welfare trust had been reimbursed. The Supreme Court on appeal held that there was a difference between the reimbursement and contribution; the assessee could make a claim for deduction in case of the reimbursement, if the quantified amount was certified by the Chartered Accountant of the assessee. This decision supports the case for allowance of the expenditure on payment by way of reimbursement.
Having noted the above, it is possible for the Government to contend that the language of section 40A(9) is fairly clear and not ambiguous and may not permit the luxury of interpreting the provision by examining the intent behind the insertion of the provision. In simple words, it prohibits the allowance of all those payments specified therein, unless the same are covered by the provisions of section 36(1), clauses (iv), (iva) and (v). At the same time, it has to be appreciated that there is nothing in the language that provides for the disallowance of expenditure, including the reimbursement thereof, which is wholly and exclusively incurred for the purposes of the business. In cases where the contribution can be shown to be expenditure of such a nature, in our considered opinion, there can be no disallowance.
Again, the allowance of expenditure or payment would, to a large extent, depend upon the factual position relating to the contribution, its size, its objective and the composition of the recipient fund / trust. A distinction can be drawn between cases where:
1. the trusts are controlled by the employer, provisions of section 40A(9) may apply;
2. the contributions by the employer are of large amounts intended to remain invested by the trust and where the trustees have the discretion to invest the funds with the employer, the provisions of section 40A(9) may apply;
3. the contributions by the employer are to meet the annual staff welfare expenditure incurred by the trust, provisions of section 40A(9) may not apply;
4. the expenditure is in the nature of staff welfare or reimbursement thereof, the provisions of section 40A(9) should not apply.
The better view of the matter seems to be that the provisions relating to disallowance would not apply to genuine staff welfare expenditure or reimbursement thereof, even though routed through funds, trusts, AOPs, etc.
