Income Tax Officer vs Prospect Fund Managers LLP

1.

That the Ld. CIT(A) erred in law and on facts in deleting the addition of Rs. 5,00,00,000/- made by the AO u/s. 68 of the Act without appreciating the fact that the assessee has failed to discharge the primary onus cast upon it under section 68 of the Act to establish the source, creditworthiness, and genuineness of the capital contributions credited in the partners’ accounts.

2.

That the CIT(A) erred in holding that notional book entries or capital contributions are outside the scope of section 68, contrary to binding judicial precedents.

3.

That the CIT(A) erred in deleting the disallowance of business loss of Rs. 20,70,899/- ignoring the admitted fact that no business operations were carried out during the relevant year.

4.

That the CIT(A) wrongly concluded that there was violation of principles of natural justice, despite repeated opportunities granted u/s. 142(1), draft assessment order, which the assessee has miserably failed to explain.

“The present appeal has been filed by Prospect Fund Managers LLP against the assessment order passed under section 143(3) read with sections 143(3A) & 143(3B) of the Income-tax Act, 1961, for the Assessment Year 2018-19. The Assessing Officer (AO) assessed total income at Rs.5,00,00,000 as against the returned loss of Rs.20,70,899.

The key issues raised in this appeal pertain to the addition of Rs.5 crore on account of unexplained partners’ capital contribution under section 68, the disallowance of administrative expenditure amounting to Rs.20,70,899, and the consequential tax, interest, and penalty arising from these additions.

After careful consideration of the appellant’s submissions, perusal of records, and examination of legal principles, the following detailed analysis and findings on each ground of appeal are set out.

6.1 Addition of Rs.5 crore under section 68 (Partners' Capital Contribution)

Facts

The appellant LLP was constituted on 20 September 2017 with two partners: Mr. Pramod Bhasin (Rs.2.55 crore, 51%) and Mr. Anil Chawla (Rs.2.45 crore, 49%), contributing to a total agreed capital of Rs.5 crore as per clause 6.1 of the LLP agreement. No actual cash or cheque was received from the partners during the year. The capital was credited in the partners' capital accounts and simultaneously shown as receivable from partners under "Other Current Assets" in the balance sheet.

Appellant’s Submission

The appellant contended that the capital contribution was only a notional journal entry recorded as per the LLP agreement and that no actual receipt of money took place during the year. In accordance with the principle of double-entry accounting, the partners’ capital accounts were credited, and a corresponding debit entry was shown under receivables. It was argued that section 68 applies only to real sums of money actually received and credited, and not to notional or contra entries. The identity and creditworthiness of the partners were duly proved through their income tax returns and other supporting documents. Furthermore, the appellant emphasized that the Assessing Officer ignored these facts and passed the order in violation of the principles of natural justice by refusing the adjournment requested till 22 March 2021 and finalizing the order prematurely on 20 March 2021.

AO’s View

The AO concluded that since the amount of Rs.5 crore was credited in the books, it attracted the provisions of section 68. According to the AO, the assessee failed to furnish adequate documentary evidence regarding the source of capital, such as bank statements or proof of the partners' financial capacity to contribute the declared amounts. The AO further held that mere mention of "receivable from partners" did not absolve the assessee from the statutory onus under section 68 to establish source and creditworthiness.

Observation and Conclusion

On careful consideration of the facts and submissions, it is evident that there was no actual cash or bank receipt involved in respect of the partners’ capital contribution. The entries were passed merely as notional journal adjustments in accordance with the LLP agreement, whereby the partners’ capital accounts were credited and a corresponding debit entry was recorded as "capital receivable" under current assets.

Section 68 of the Income-tax Act, 1961 provides that where any sum is found credited in the books of an assessee, and the assessee either does not offer an explanation about the nature and source thereof or the explanation offered is not satisfactory in the opinion of the Assessing Officer, the sum so credited may be charged to tax as the income of the assessee. A plain reading of the section makes it clear that it applies to cases involving actual receipt of money, which is credited in the books, thereby triggering an obligation on the part of the assessee to explain the nature and source, establish the identity of the creditor, the creditworthiness of the creditor, and the genuineness of the transaction. In the present case, it is a settled position that section 68 does not apply to mere notional or contra journal entries which do not involve real cash inflows. This principle has been upheld in various judicial pronouncements. The Hon’ble Supreme Court in CIT v. H.H. Shri Rama Varma (1991) 187 ITR 308 (SC) held that the expression "sum" refers to a definite amount of money and implies actual receipt. Similarly, the Hon’ble Calcutta High Court in Jatia Investment Co. v. CIT (1994) 206 ITR 718 held that when there is no real credit of cash but merely a notional or book entry without actual inflow, section 68 cannot be invoked.

In the appellant’s case, the audited balance sheet clearly discloses the partners’ capital contributions as receivable, and there is no evidence on record to suggest that any actual money was received during the year. The capital contribution entries were purely in compliance with clause 6.1 of the LLP agreement and in accordance with the principle of double-entry bookkeeping. Moreover, the identities of the partners were duly established through filed income tax returns and other statutory documents, and their creditworthiness was not disputed by the Assessing Officer on substantive grounds.

It is also pertinent to note that the addition was made without appreciating these factual and legal aspects and in violation of principles of natural justice. The appellant had requested additional time to submit a detailed response to the draft assessment order, which was unreasonably denied, thereby depriving the appellant of a fair opportunity to present its case.

In view of the above discussion, it is held that the notional entries recorded in the books, without any actual receipt of funds, do not fall within the ambit of section 68. Accordingly, the addition of Rs.5 crore made by the Assessing Officer is found to be unsustainable both in law and on facts and is therefore directed to be deleted.

6.2 Disallowance of administrative expenditure (Rs.20,70,899)

Facts

The appellant claimed administrative expenses totaling Rs.20,70,899, including SEBI registration fees, professional fees (KPMG, Deloitte), rent, printing, audit fees, and travel expenses.

Appellant’s Submission

The appellant argued that the LLP had duly set up its business operations during the year under consideration. It was contended that the LLP agreement was executed, a bank account was opened, an application for SEBI registration was filed, and other necessary regulatory and statutory compliances were initiated. The appellant emphasized that the expenses were incurred wholly and exclusively for the purposes of the business and were revenue in nature. It was further submitted that, as per settled legal principles, actual earning of income is not a pre-condition for allowability of business expenses once the business is set up and operational readiness is achieved. The appellant also highlighted that all expenses were paid out of partner loans and were duly supported by bills, vouchers, and proper TDS deduction and compliance wherever applicable.

AO’s View

The Assessing Officer disallowed the expenses on the grounds that no business activity had been carried out during the year, as evidenced by the absence of any revenue. According to the AO, since no income had been earned, the expenses could not be considered business expenditure and, therefore, were not allowable as deductions.

Observation and Conclusion

On careful examination of the facts and materials on record, it is clear that the business was indeed set up during the year under consideration. The execution of the LLP agreement, opening of the bank account, engagement of professional firms, and completion of various regulatory formalities, including the SEBI application, clearly demonstrate the readiness of the business to commence its intended activities. It is well settled through various judicial pronouncements, including the decisions of the Hon'ble Supreme Court in Indian Molasses Co. (P) Ltd. v. CIT, Sarabhai Management Corporation Ltd. v. CIT, and of the Hon'ble Delhi High Court in Carefour WC & C India (P) Ltd. v. DCIT, that expenses incurred after the business is set up are allowable even if no revenue has been earned during the year. Furthermore, the expenses claimed by the appellant are supported by detailed documentary evidence, including invoices, payment proofs, and compliance with TDS provisions, thereby substantiating the genuineness and business necessity of such expenditure.

Accordingly, the disallowance of Rs.20,70,899 is unjustified and deserves to be deleted. This ground of appeal is allowed.

6.3 Consequential tax, interest, and penalty

Facts

Based on the above additions, the AO computed tax under section 115BBE at Rs.3.86 crore, along with interest and penalty, raising total demand to Rs.5.33 crore.

Appellant’s Submission

The appellant argued that the additions made under section 68 as well as the disallowance of expenses were themselves untenable and, therefore, the consequential tax demand, interest, and penalty could not survive. The appellant also submitted that the demand raised was high-pitched and arbitrary in nature, resulting in severe financial hardship. Accordingly, a prayer was made to stay the recovery of the demand till the disposal of the appeal.

Observation and Conclusion

Upon consideration, it is noted that since the main additions under section 68 and the disallowance of administrative expenses have been deleted, the consequential tax demand, interest, and penalty computed on these additions do not survive and automatically fail. In view of this, there remains no basis for recovery of the demand, and no liability for penalty arises. Accordingly, this ground of appeal is allowed, and the Assessing Officer is directed to cancel the demand and penalty proceedings in full.

6.4 Final Conclusion

In view of the detailed discussions and findings above, it is concluded that the addition of Rs.5 crore made under section 68 is hereby deleted, and the disallowance of administrative expenses amounting to Rs.20,70,899 is also deleted. Consequently, the tax demand, interest, and penalty arising from these additions stand cancelled. The assessment order is thus modified accordingly to give full effect to these directions.

6.5 Result

In the result, the appeal is allowed in full. The Assessing Officer is directed to re-compute total income and tax liability in accordance with this appellate order and to cancel the demand notices accordingly.”