“interest” in 80 HHC connotes “net interest” and not “gross interest” 

RS Sharma Tax Expert 

Much awaited High Court ruling has finally settled interpretation of Section 80 HHC of Income Tax Act  issue and in particular sub-section (1) read with sub-section (3) and clause (baa) of the Explanation below sub-section (4C) thereto  vide a recent landmark ruling  AIT-2007-30-HC  holding that where surplus funds are parked with the bank and interest is earned thereon it can only be categorised as income from other sources. Interest earned on fixed deposits for the purposes of availing credit facilities from the bank, does not have an immediate nexus with the export business and therefore has to necessarily be treated as income from other sources and not business income.               

Revenue has lost the bunch of appeal against Lalsons and several other parties and the High Court has upheld Tribunal’s Special Bench ruling in Lalsons Enterprises holding that the AO is required to deduct from the profits of the business computed under the head “profits and gains of business or profession” the following sums in order to arrive at the “profits of the business” for the purposes of Section 80HHC (3):
(a) 90% of any sum referred to in clauses (iiia), (iiib) and (iiic) of Section 28 i.e. export incentives;
(b) 90% of any receipts by way of brokerage, commission, interest, rent, charges
or any other receipt of a similar nature included in such profits; and
(c) profits of any branch, office, warehouse or any other establishment of the
assessee situate outside India
 

The following Observations of the High Court will be of interest to netizens:

de hors Section 80HHC, the approach generally is that where the statutory provision talks of “income derived from” the business activity in question, the nexus theory should be applied in order to determine whether a particular item of income is business income or not.(Para 12)

Where surplus funds are parked with the bank and interest is earned thereon it can only be categorised as income from other sources. This receipt merits separate treatment under Section 56 of the Act which is outside the ring of profit and gains from business and profession. It goes entirely out of the reckoning for the purposes of Section 80HHC. To give effect to this position, the AO while computing profits of the export business will have to remove from the debit side of the Profit and Loss account the corresponding interest expenditure that has been “laid out” to earn such income from other sources. Otherwise this will depress the profits by an amount which is out of the reckoning of Section 80HHC, a consequence not intended to be brought about.(Para 19)

Interest earned on fixed deposits for the purposes of availing credit facilities from the bank, does not have an immediate nexus with the export business and therefore has to necessarily be treated as income from other sources and not business income.(Para 20)

However, we must add a caveat here. This holding of ours will apply only where there is a specific finding by the AO that interest income is not business income. However, if in a given case the AO has held that the interest income is business income, and this has not been challenged by the Department thereafter, then that question ought not to be permitted to be reopened and the only question then will be if netting should be allowed(Para 21)

The legislative intent in using the word “interest” in clause (baa) to the explanation in section 80HHC is indicative of “net interest, i.e. gross interest less the expenditure incurred by the assessee in earning such interest.”(Para 24.5)

The underlying principle of netting appears to logically get attracted as no prudent businessman would allow taxation of the interest income de hors the expenditure incurred for earning such income. The words 'included any such profits' following the words receipts by way of interest, commission, brokerage etc., is a clear pointer to the fact that only net interest would be includable in arriving at the business profit.(Para 25.2)
Once business income has been determined by applying accounting standards
as well as the provisions contained in the Act, the assessee would be permitted
to, in terms of Section 37 of the Act, claim as deduction, expenditure laid out
for the purposes of earning such business income.(Para25.6)

The word “interest” in clause (baa) to the Explanation in Section 80HHC is indicative of “net interest, i.e. gross interest less the expenditure incurred by the assessee in earning such interest.”(Para 25.10)

We affirm the decision of the Special Bench of the ITAT in Lalsons Enterprises that the expression “interest” in clause (baa) of the Explanation to Section 80HHC connotes “net interest” and not “gross interest”(Para 26.6)

It will bear examination whether obtaining the loan and paying interest thereon (laying out the expenditure by way of interest) was “wholly and exclusively” for the purpose of earning the interest on the fixed deposit, to draw an analogy from Section 37. This nexus will have to be shown by the assessee for application of the netting principle.(Para 30)

Where, as a result of the computation of profits and gains of business and profession, the AO treats the interest receipt as business income, then deduction should be permissible, in terms of Explanation (baa) of the net interest i.e. the gross interest less the expenditure incurred for the purposes of earning such interest.(Para32 )
(i) In computing what the profits derived from exports for the purposes of 80HHC(1) read with 80HHC(3) are, the nexus test has to be applied to exclude that which does not partake of profits that can be said to have been derived from the business of exports.
(ii) In the specific context of clause (baa) of the Explanation to Section 80HHC, while determining the “profits of the business”, the AO has to undertake a two-step exercise in the following sequence. He has to first “compute” the profits of the business under the head “profits and gains of business or profession.” In other words, he will have to compute business profits, in terms of the Act, by applying the provisions of Sections 28 to 44 thereof.
(iii) In arriving at profits of the business by the above method, the AO will exclude all such incomes which partake the character of “income from other sources” which in any event are treated under Sections 56 and 57 of the Act and are therefore not to be reckoned for the purposes of Section 80HHC. The AO will apply the law as explained in the judgments of the Kerala High Court referred to above which have been affirmed by the Hon’ble Supreme Court.
(iv) Where surplus funds are parked with the bank and interest is earned thereon it can only be categorised as income from other sources. This receipt merits separate treatment under Section 56 of the Act which is outside the ring of profit and gains from business and profession. It goes entirely out of the reckoning for the purposes of Section 80HHC.
(v) Interest earned on fixed deposits for the purposes of availing credit facilities from the bank, does not have an immediate nexus with the export business and therefore has to necessarily be treated as income from other sources and not business income.
(vi) Once business income has been determined by applying accounting standards as well as the provisions contained in the Act, the assessee would be permitted to, in terms of Section 37 of the Act, claim as deduction, expenditure laid out for the purposes of earning such business income.
(vii) In the second stage, the AO will deduct from the profits of the business computed under the head profits and gains of business or profession the following sums in order to arrive at the “profits of the business” for the purposes of Section 80HHC (3):
(a) 90% of any sum referred to in clauses (iiia), (iiib) and (iiic) of Section 28 i.e. export incentives;
(b) 90% of any receipts by way of brokerage, commission, interest, rent, charges
or any other receipt of a similar nature included in such profits; and
(c) profits of any branch, office, warehouse or any other establishment of the
assessee situate outside India
(viii) The word “interest” in clause (baa) of the Explanation connotes “net interest” and not “gross interest”. Therefore, in deducting such interest, the AO will take into account the net interest i.e. gross interest as reduced by expenditure incurred for earning such interest. The decision of the Special Bench of the ITAT in Lalsons to this effect is affirmed. In holding as above, we differ from the judgments of the Punjab and Haryana High Court in Rani Paliwal and the Madras High Court in Chinnapandi and affirm the ruling of the Special Bench of the ITAT in Lalsons.
(ix) Where, as a result of the computation of profits and gains of business and profession, the AO treats the interest receipt as business income, then deduction should be permissible, in terms of Explanation (baa) of the net interest i.e. the gross interest less the expenditure incurred for the purposes of earning such interest. The nexus between obtaining the loan and paying interest thereon (laying out the expenditure by way of interest) for the purpose of earning the interest on the fixed deposit, to draw an analogy from Section 37, will require to be shown by the assessee for application of the netting principle.(Para 33)

( Click here for full text of ruling  AIT-2007-30-HHC )

(  The Writer is a Well known Consultant on tax matters and is advising several MNCs and Indian Corporates on tax issues. He can be mailed at rssharma@gmail.com )