Deduction towards PMS fees on the grounds of by diversion of income by overriding title

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Deduction towards PMS fees on the grounds of by diversion of income by overriding title

 

 

ITAT Mumbai in Devendra Motilal Kothari Vs. DCIT has made following key observation:

In this case, tThe deduction on account of fees paid for PMS has been claimed by the assessee as deduction in computing capital gains arising from sale of shares and securities. He however has failed to explain as to how the said fees could be considered as cost of acquisition of the shares and securities or the cost of any improvement thereto. He has also failed to explain as to how the said fees could be treated as expenditure incurred wholly and exclusively in connection with sale of shares and securities. On the other hand, the basis on which the said fees was paid by the assessee shows that it had no direct nexus with the purchase and sale of shares and as rightly contended by the Departmental Representative, the said fees was payable by the assessee going by the basis thereof even without there being any purchase or sale of shares in a particular period. As a matter of fact, when the CIT(A) required the assessee to allocate the fees paid for PMS in relation to purchase and sale of shares as well as in relation to the shares held as investment on the last date of the previous year, the assessee could not furnish such details nor could he give any definite basis on which such allocation was possible. The fees paid by the assessee for PMS was not inextricably linked with the particular instance of purchase and sale of shares and securities so as to treat the same as expenditure incurred wholly and exclusively in connection with such sale or the cost of acquisition/improvement of the shares and securities so as to be eligible for deduction in computing capital gains under s. 48.

The court ruled that fees paid by the assessee towards PMS activity could neither be considered as cost of acquisition of the shares and securities nor the cost of any improvement thereto. It had no direct nexus with the purchase and sale of shares and such fee was payable even without there being any purchase or sale of shares in a particular period.

 

Fees paid by the assessee for PMS was not inextricably linked with the particular instance of purchase and sale of shares and securities so as to treat the same as expenditure incurred wholly and exclusively in connection with such sale or the cost of acquisition/ improvement of the shares and securities so as to be eligible for deduction in computing capital gains under s. 48.

 

Such fees are rightly held to be not deductible under s. 48 while computing capital gains

In short, court has ruled it against the assessee.

On the another pleading as to claim of deduction regarding Diversion of income by overriding title, it has held that profit arising from the sale of shares was received by the assessee directly which constituted his income at the point when it reached or accrued to the assessee. Fees for PMS on the other hand was paid separately by the assessee to discharge his contractual liability. It was thus a case of an obligation to apply income which had accrued or arisen to the assessee and the same amounted to a mere application of income

Even though the assessee was under an obligation to pay the fees for PMS, the mere existence of such obligation to pay the said amount was not enough for the application of the rule of diversion of income by an overriding title. The true test for applicability of the said rule is whether such obligation is in the nature of a charge on source i.e. the profit earning apparatus itself and only in such cases where the source of earning income is charged by an overriding title, the same can be considered as diversion of income by an overriding title. The profit arising from the sale of shares was received by the assessee directly which constituted his income at the point when it reached or accrued to the assessee. The fees for PMS on the other hand was paid separately by the assessee to discharge his contractual liability. It was thus a case of an obligation to apply income which had accrued or arisen to the assessee and the same amounted to a mere application of income. Therefore, the payment of fees by the assessee for PMS did not amount to diversion of income by overriding title.

The court applied the ruling of CIT vs. Sitaldas Tirathdas (1961) 41 ITR 367 (SC) and CIT vs. Udayan Chinubhai & Ors. Etc. (1996) 135 CTR (SC) 430 : (1996) 222 ITR 456 (SC) on this issue.

 

 

Here is the complete order of the case:

DEVENDRA MOTILAL KOTHARI vs. DEPUTY COMMISSIONER OF INCOME TAX

ITAT, MUMBAI ‘D’ BENCH

P.M. Jagtap, A.M. & V.D. Rao, J.M.

ITA No. 1356/Mum/2008; Asst. yr. 2004-05

26th March, 2010

(2010) 29 CCH 0246 MumTrib

(2011) 136 TTJ 0188 : (2011) 50 DTR 0369 : (2011) 132 ITD 0173

Legislation Referred to

Section 4, 45, 48

Case pertains to

Asst. Year 2004-05

Decision in favour of:

Revenue

Case referred to

Asstt. CIT vs. Mrs. Leela P. Nanda (2006) 105 TTJ (Mumbai) 192 : (2006) 102 ITD 281 (Mumbai)

Chemmancherry Estates Co. vs. ITO (2008) 118 TTJ (Chennai) 691 : (2008) 13 DTR (Chennai)(Trib) 478

CIT vs. Crawford Bayley & Co. (1977) 106 ITR 884 (Bom)

CIT vs. R. Ranga Setty (1985) 49 CTR (Kar) 366 : (1986) 159 ITR 797 (Kar)

ITO vs. Prakash Roadlines Corporation (1992) 43 TTJ (Cal) 390 : (1992) 40 ITD 406 (Cal)

Jt. CIT vs. Video Electronics Ltd. (2006) 99 ITD 342 (Del)

Mathurdas Mangaldas Parekh vs. CIT (1980) 18 CTR (Guj) 390 : (1980) 126 ITR 669 (Guj)

Smt. B. Subhadra L/R of B. Paparaju vs. ITO (2005) 92 TTJ (Hyd) 405 : (2005) 92 ITD 285 (Hyd)

Smt. Savita Mohan Nagpal vs. CIT (1984) 42 CTR (Raj) 211 : (1985) 154 ITR 449 (Raj)

Counsel appeared:

Y.P. Trivedi & P.R. Toprani, for the Appellant : Ankur Garg, for the Respondent

ORDER

P.M. JAGTAP, A.M. :

ORDER

This appeal filed by the assessee is directed against the order of the CIT(A)-XVI, Mumbai, dt. 28th Nov., 2007 and the solitary issue arising out of the same relates to the disallowance made by the AO and confirmed by the CIT(A) on account of assessee’s claim for deduction on account of fees for Portfolio Management Services (PMS) while computing long-term capital gain and short-term capital gain arising from sale of shares and securities.

  1. The assessee in the present case is an individual who filed his return of income for year under consideration on 21st Oct., 2004 declaring the total income of Rs. 1,40,02,396. In the said return, long-term capital gain of Rs. 1,00,65,913 was declared by the assessee and the same was partly adjusted against the brought forward long-term capital gain of Rs. 22,45,576 for the asst. yr. 2003-04. Similarly, the short-term capital gain of Rs. 44,76,726 declared by the assessee was partly adjusted against the brought forward short-term capital loss of Rs. 1,43,798.
  2. During the course of assessment proceedings, the working of short-term capital gain and long-term capital gain declared by the assessee was verified by the AO and on such verification, he found that the fees paid for PMS amounting to Rs. 85,63,233 was added by the assessee to the purchase cost of shares while computing the long-term capital gain and short-term capital gain to the extent of Rs. 23,15,947 and Rs. 62,47,286 respectively. According to the AO, the fees paid by the assessee for PMS was not a part of purchase cost of the shares. He, therefore, required the assessee to explain why the said fees should not be disallowed while computing the capital gains. In reply, the following submissions were made on behalf of the assessee vide letter dt. 27th Oct., 2006 :

“The appellant has paid the aggregate sum of Rs. 85,63,233 during the year the investment management agreements entered into by the appellant with 4 parties, the details of the same have been submitted in the course of personal hearings.

The said amount has been treated as forming part of the cost of purchase and deducted whilst out the capital gain.

It is respectfully submitted that the fees and other charges form part of the cost of purchase and/or expenditure incurred by the appellant and therefore must be taken into account whilst determining the chargeable capital gain. Such fees and other expenses incurred by the appellant as an investor including fees for managing the investments constitute the cost of purchase and are allowable for the purpose of computing the short-term or long-term capital gain.

The appellant is following cash system of accounting and accordingly the fees paid to the investment manager and expenses incurred by the investment manager on behalf of the appellant are allowable as deduction from the long-term and short-term capital gains.

The Madras High Court in the case of CIT vs. R. Ramanathan Chettiar (1987) 61 CTR (Mad) 132 : (1985) 152 ITR 489 (Mad) held as under :

‘…that the expenses incurred in connection with the preparation of the layout land and getting it sanctioned would have to be taken as expenses solely incurred for the transfer of the lands for better price. Other expenses such as salary to the clerk for attending to the expenses incurred exclusively for the transfer of lands.’

It is respectfully submitted that the various expenses incurred and the fees paid to the investment manager are allowable as expenses from the capital gains as claimed by the appellant.”

  1. The AO did not find merit in the above submissions made by the assessee and proceeded to disallow the deduction claimed by the assessee on account of fees for PMS while computing long-term capital gain and short-term capital gain holding that the same was not part of cost of acquisition of shares or units.
  2. The disallowance made by the AO on account of fees paid for PMS while computing long-term capital gain and short-term capital gain was challenged by the assessee in an appeal filed before the learned CIT(A). During the course of appellate proceedings before the CIT(A), it was submitted on behalf of the assessee that the fees paid for PMS constituted the cost of purchase of shares and securities and the same therefore was allowable as deduction while computing the capital gains. It was also submitted that without payment of said fees, no investments could have been made by the assessee and the question of realization of capital gain would not have arisen. Alternatively, it was also contended that the fees paid for PMS could be allocated between purchase and sale of shares for the purpose of computing capital gain. Keeping in view these alternative contentions raised on behalf of the assessee, the learned CIT(A) required the assessee to submit a working allocating the fees paid for PMS in connection with purchase and sale of shares and also in relation to opening and closing stock of shares during the year under consideration. In reply, it was submitted on behalf of the assesseeinter alia that the assessee is a pure investor and managed his portfolio on his own as well as through PMS providers. He also explained the tenets of the investment philosophy of the portfolio managers which are as under :

“PMS are an asset management company and not a brokerage firm. They do not churn their client’s portfolio to generate extra brokerage for themselves. They manage portfolios with an objective to create wealth in the long-term. Their investment philosophy does not permit them to take short-term view on the companies they are investing in.

They are highly specialized and focused fund management house. They base all their investment decisions with relation to the long-term fundamentals of a company and investment of their client’s money with a view to maximizing returns over a longer time frame. The proof of their strategy is evidenced in the case of appellant where they contribute to hold shares for over one year.

They build a very concentrated portfolio for their client. This means that they make large investments in a few companies where they are comfortable to hold these investments with great conviction for many years to come.”

  1. On the basis of the above submissions made before the learned CIT(A), it was claimed by the assessee that the fees paid for PMS is an allowable expenditure for the purpose of computing capital gains. Alternatively, it was also submitted that the said fees can be allocated on the basis of values of opening stock, long-term purchases, short-term purchases, long-term capital sale, short-term capital sale and closing stock and based on such allocation, deduction may be allowed while computing long-term capital gain and short-term capital gain.
  2. The learned CIT(A) did not find merit in the submissions made on behalf of the assessee before him. From the copies of the agreement filed by the assessee with two portfolio managers, he found that the quantification of their fees was based on either the market value of the assets or net value of the assets of the assessee as held by them either at the beginning or at the end of each quarter. He held that the assessee could not explain as to how the fees paid to the portfolio managers on such explicit basis could be considered differently so as to constitute either the cost of acquisition of asset or expenditure incurred for selling such assets. He noted in this context that nothing was furnished by the assessee to establish any such nexus.
  3. The learned CIT(A) also noted that the deductions which are allowable while computing capital gain are specifically provided under s. 48 as under :

(i) the cost of acquisition of the assessee,

(ii) the cost of any improvement therein,

(iii) expenditure incurred wholly and exclusively in connection with the transfer of assets.

He held that the quarterly payment of fees paid by the assessee to the portfolio manager had no nexus either with the acquisition of assets or transfer of specific assets. He also held that it was just not possible to break-up the fees paid by the assessee to the portfolio manager so as to hold that the same was relatable to the expenditure solely incurred for the purchase or transfer of assets. He held that the assessee was paying the said fees to the portfolio managers even on the interest accrued to him and dividend received and it was therefore not acceptable that the said fees was exclusively paid for acquiring or selling of shares as claimed by the assessee. The disallowance made by the AO on account of the assessee’s claim for deduction for fees paid to PMS while computing the capital gains therefore was confirmed by the learned CIT(A).

  1. The learned counsel for the assessee submitted that the assessee had entered into investment management agreements with four concerns for managing his investments and fees was paid to them for the said services. He submitted that the said fees thus was paid by the assessee for the advice given by the investment management consultants for purchase and sale of particular shares and securities as well as for the advice given by them not to sell particular shares and securities. He contended that the expenditure incurred by the assessee on payment of the said fees thus was in connection with acquisition/improvement of assets as well as in connection with sale of assets. He contended that the same therefore was deductible in computing the capital gains arising to the assessee from the sale of assets i.e. shares and securities as per the provisions of s. 48 of the IT Act. In support of this contention, the learned counsel for the assessee relied on the following case law :
  • Chemmancherry Estates Co. vs. ITO (2008) 118 TTJ (Chennai) 691 : (2008) 13 DTR (Chennai)(Trib) 478;
  • Mathurdas Mangaldas Parekh vs. CIT (1980) 18 CTR (Guj) 390 : (1980) 126 ITR 669 (Guj);
  • Asstt. CIT vs. Mrs. Leela P. Nanda (2006) 105 TTJ (Mumbai) 192 : (2006) 102 ITD 281 (Mumbai);
  • Smt. B. Subhadra L/R of B. Paparaju vs. ITO (2005) 92 TTJ (Hyd) 405 : (2005) 92 ITD 285 (Hyd);
  • CIT vs. R. Ranga Setty (1985) 49 CTR (Kar) 366 : (1986) 159 ITR 797 (Kar).
  1. Without prejudice to his contention that the fees paid for PMS was deductable under s. 48 in computing capital gains and as an alternative, the learned counsel for the assessee contended that the said expenditure was deductible even on the basis of real income theory and the rule of diversion of income by overriding title. In this regard he contended that the said fees was in the nature of a charge against the consideration received by the assessee on sale of shares and securities and therefore was deductible from the sale consideration being diversion of income by overriding title. In support of this contention, he relied on the following case law :
  • Jt. CIT vs. Video Electronics Ltd. (2006) 99 ITD 342 (Del);
  • ITO vs. Prakash Roadlines Corporation (1992) 43 TTJ (Cal) 390 : (1992) 40 ITD 406 (Cal);
  • CIT vs. Sitaldas Tirathdas (1961) 41 ITR 367 (SC);
  • CIT vs. Crawford Bayley & Co. (1977) 106 ITR 884 (Bom);
  • Smt. Savita Mohan Nagpal vs. CIT (1984) 42 CTR (Raj) 211 : (1985) 154 ITR 449 (Raj).
  1. The learned Departmental Representative on the other hand submitted that the relevant provisions in respect of computation of income from capital gains are very specific and the real income theory cannot be applied while computing the income from the capital gains. He submitted that the PMS are generally not required in the case of investment in shares and that is why there is no provision for allowing deduction for the fees paid for PMS in computation of capital gains. He contended that the income can be taxed in generic terms applying real income theory, but the said theory is not relevant in respect of allowing any deduction. He contended that all the case laws cited by the learned counsel for the assessee are distinguishable on facts and none of them is applicable to the facts of the assessee’s case and the issue specifically involved therein. He invited our attention to page No. 5 of the impugned order of the learned CIT(A) and submitted that the basis on which fees for PMS was paid by the assessee is such that there was no relationship with purchase or sale of shares. He contended that even without making any purchase or sale of shares and securities, the assessee was liable to pay substantial amount of fees for PMS. He therefore strongly supported the impugned order of the CIT(A) and urged that the same may be upheld on this issue.
  2. We have considered the rival submissions and also perused the relevant material on record. It is observed that the profit arising to the assessee on sale of shares and securities is chargeable to tax under the head ‘Capital gains’ and this position is not in dispute. The only dispute is whether the fees paid by the assessee for PMS can be allowed as deduction in computing such income or not. In this regard, it is observed that the charge of income-tax is created by virtue of the provisions contained in s. 4 according to which the income-tax is charged for the relevant assessment year in accordance with and subject to the provisions of IT Act in respect of the total income of the relevant previous year of every person. As per the scheme of the Act income is broadly classified under five different heads and the income chargeable to tax under these heads has to be computed as per the relevant provisions applicable to respective heads of income. Sec. 45 to s. 55A falling under Chapter IV-E deal with assessment of income under the head “Capital gains” and s. 48 in particular prescribes the mode of computation of capital gains. As provided in s. 48, expenditure incurred wholly and exclusively in connection with transfer and the cost of acquisition of the asset and cost of any improvement thereto are deductible from the full value of the consideration received or accruing to the assessee as a result of transfer of the capital assets.
  3. In the present case, the deduction on account of fees paid for PMS has been claimed by the assessee as deduction in computing capital gains arising from sale of shares and securities. He however has failed to explain as to how the said fees could be considered as cost of acquisition of the shares and securities or the cost of any improvement thereto. He has also failed to explain as to how the said fees could be treated as expenditure incurred wholly and exclusively in connection with sale of shares and securities. On the other hand, the basis on which the said fees was paid by the assessee shows that it had no direct nexus with the purchase and sale of shares and as rightly contended by the learned Departmental Representative, the said fees was payable by the assessee going by the basis thereof even without there being any purchase or sale of shares in a particular period. As a matter of fact, when the learned CIT(A) required the assessee to allocate the fees paid for PMS in relation to purchase and sale of shares as well as in relation to the shares held as investment on the last date of the previous year, the assessee could not furnish such details nor could he give any definite basis on which such allocation was possible. Having regard to all these facts of the case, we are of the view that the fees paid by the assessee for PMS was not inextricably linked with the particular instance of purchase and sale of shares and securities so as to treat the same as expenditure incurred wholly and exclusively in connection with such sale or the cost of acquisition/improvement of the shares and securities so as to be eligible for deduction in computing capital gains under s. 48.
  4. As regards the case law cited by the learned counsel for the assessee in support of the assessee’s case on the point under consideration, it is observed that the facts involved therein were altogether different in as much as the relevant amounts claimed by the assessee as deduction in computing capital gains were found to be in the nature of expenditure/cost covered by s. 48. For instance, in the case ofMathurdas Mangaldas Parekh vs. CIT (supra), payment of betterment charges made under town planning scheme had resulted in increase in potential value of land and the same therefore was held to be cost of improvement of the said land. Similarly, in the case of Chemmancherry Estates Co. vs. ITO (supra), funds borrowed by the assessee was utilized for acquisition of land and the interest paid thereon thus was held to be the forming part of the cost of acquisition of the land. In other cases also, the brokerage expenses incurred by the assessee were in respect of particular sale of capital assets and the same therefore were held to be deductable while computing capital gain being expenditure incurred wholly and exclusively in connection with such transfer/sale.
  5. At the time of hearing before us, the learned counsel for the assessee has raised an alternative contention in support of the assessee’s claim for deduction on account of fees paid for PMS in computing the capital gains relying on the theory of real income and the rule of diversion of income by an overriding title. He has contended that the fees for PMS being contractual liability directly relatable to the capital gains, there was a diversion of income from capital gain by an overriding title to the extent of the amount of such fees and the same therefore was not the income belonging to the assessee which was chargeable to tax under the head ‘‘Capital gains”. In this regard, we may observe that even though the assessee was under an obligation to pay the fees for PMS, the mere existence of such obligation to pay the said amount was not enough for the application of the rule of diversion of income by an overriding title. The true test for applicability of the said rule is whether such obligation is in the nature of a charge on source i.e. the profit earning apparatus itself and only in such cases where the source of earning income is charged by an overriding title, the same can be considered as diversion of income by an overriding title.
  6. In the case ofCIT vs. Sitaldas Tirathdas (supra), it was held by the Hon’ble Supreme Court that the true test for the application of the rule of diversion of income by an overriding title is whether the amount sought to be deducted, in truth, never reached the assessee as his income. Obligations, no doubt, are there in every case, but it is the nature of the obligation which is the decisive fact. Explaining further, it was observed by the Hon’ble Supreme Court that there is a difference between an amount which a person is obliged to apply out of his income and an amount which by the nature of the obligation cannot be said to be a part of the income of the assessee. Where by the obligation, income is diverted before it reaches to the assessee, it is deductible, but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence, in law, does not follow. It was held by the Hon’ble Supreme Court that it is the first kind of payment which can truly be excluded and not the second. The second payment is merely an obligation to pay another a portion of one’s own income which has been received and is since applied.
  7. In the present case, the profit arising from the sale of shares was received by the assessee directly which constituted its income at the point when it reached or accrued to the assessee. The fee for PMS on the other hand was paid separately by the assessee to discharge his contractual liability. It was thus a case of an obligation to apply income which had accrued or arisen to the assessee and the same amounted to a mere application of income. We, therefore, have no hesitation to hold that the payment of fees by the assessee for PMS did not amount to diversion of income by overriding title and the contentions raised by the assessee in this regard cannot be accepted being devoid of any merit.
  8. As regards the contention of the learned counsel for the assessee in support of assessee’s claim for deduction on account of fees paid for PMS based on real income theory, we agree with the learned Departmental Representative that the theory of real income cannot be applied to allow deduction to the assessee which is otherwise not permissible under the IT Act. In the case ofCIT vs. Udayan Chinubhai & Ors. Etc. (1996) 135 CTR (SC) 430 : (1996) 222 ITR 456 (SC), it was held by the Hon’ble Supreme Court in the similar context that what is not permissible in law as deduction under any of the heads cannot be allowed as a deduction on the principle of real income theory.
  9. For the reasons given above, we find no merit in the arguments raised by the learned counsel for the assessee in support of the assessee’s case on the issue under consideration and rejecting the same, we hold that the fees paid by the assessee for PMS was not deductible in computing the capital gains as rightly held by the AO. The impugned order of the learned CIT(A) confirming the disallowance made by the AO on this issue is therefore upheld dismissing this appeal filed by the assessee.
  10. In the result, the assessee’s appeal is dismissed.

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