AO Cannot Make Ad-Hoc Disallowances Without Evidence: Key Income Tax Ruling Explained

Overview

Recent Income Tax Appellate Tribunal (ITAT) rulings have reinforced a balanced principle in tax assessments: while Assessing Officers (AOs) cannot make arbitrary or ad-hoc disallowances without identifying specific defects in books of account, taxpayers must also establish the commercial expediency and business purpose behind every expenditure claimed.

In Sanjay Transport Agency vs ACIT , ITAT Kolkata held that ad-hoc disallowances of business expenses are unsustainable when sales are accepted and no defects are found in the books or supporting records. At the same time, in Sri Dinesh Devraj Ranka vs ACIT , ITAT Bengaluru emphasized that merely producing bills and bank payment proofs is not enough—taxpayers must demonstrate a clear nexus between the expenditure and business objectives.

Further, ITAT Kolkata in ACIT vs Safal Properties Pvt. Ltd. reiterated that once business expediency is established and no related-party provisions under Section 40A(2) apply, tax authorities cannot substitute their judgment for that of a businessman or question the commercial wisdom of business decisions.

The rulings collectively underscore an evolving tax environment where MSMEs are increasingly maintaining proper documentation and successfully challenging arbitrary additions, while also highlighting the importance of robust evidence to support expense claims.

Upteen no. of times during assessments it is seen that AOs have made additions by disallowing purchases, and the same is accepted by assesses. However, it is a good development that even SME businesses are now fighting for their rights. AOs have to now earn every bit of tax rightfully without resorting to ad-hoc deductions as New India’s MSME’s become more organized and have evidences and vouchers to substantiate their expenses and purchases. ITAT Kolkata has passed a judgement in the case of SANJAY TRANSPORT AGENCY Vs ACIT, CIRCLE-3(1), ASANSOL [2023-VIL-437-ITAT-KOL] which may not be very significant as far as jurisprudence is concerned but reflects on the new business environment. In this case, In course of appellate proceedings before CIT(A), the assessee had given complete details of expenditure on spare parts as well as machines purchased for purpose of carrying out contractual work. CIT(A) did not doubt the genuineness of the type of expenditure incurred by assessee, but sustained disallowance @20% without finding any specific defect in these details. It was held that the disallowance made by CIT(A) is merely ad hoc in nature. Sales/gross receipts are not disputed at any stage, and for achieving the same, it was held that the assessee needs to incur expenditure. It was held that the AO was not justified in making additions towards bogus expenditure. CIT(A) has erred in sustaining addition by making ad hoc disallowance without specifying any defect in books of accounts and records maintained by the assessee. The order passed by CIT(A) was thus set aside.

However, there is a counter-departmental dimension also. It is important to assesses also to show business purpose and commercial expediency for every expenditure and expenses will not be allowed merely because bills are there and payment has been made by Bank Account. Especially in the case of trading firms, there are sometimes huge charges for business promotion expenses. It has to be substantiated how these business promotion expenses actually led to or at least were considered to lead to a proportionate increase in business. It was held in the case of SRI DINESH DEVRAJ RANKA Vs THE ADDITIONAL COMMISSIONER OF INCOME TAX [2023-VIL-401-ITAT-BLR] that mere assertion that expenditure was incurred for promoting business cannot be accepted without establishing nexus between expenditure and business. However, in the interest of justice, the matter was remitted back to CIT(A) to examine the issue afresh based on evidence that the assessee may submit in this regard. In the same matter claim of assessee in regard to amount paid towards property advance, not supported by any documents which AO called for during assessment proceedings - not substantiated, Amount written off against salary advance - not substantiated and Claim of bad debts - not substantiated with proper documentary evidence to prove that it is incurred in regular course of business and amount could not be recovered, were all disallowed by The Hon'e Tribunal.

However, once the business expediency is shown, and there is no related party transaction involved within meaning of Section 40A(2) of the Income Tax Act, then the ALP cannot be disputed. AO cannot step into the shoes of a businessman and interfere with the business decision of the assessee. The same was held by the ITAT-Kolkata in the case of ASSISTANT COMMISSIONER OF INCOME TAX, CIRCLE-11(2), KOLKATA Vs SAFAL PROPERTIES PVT LTD [2023-VIL-414-ITAT-KOL]. Here the interest charged by one party at 16% instead of 10% was disputed as an exorbitant rate.