Trust loses tax exemption for suspicious timber advance to trustee’s wife

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Case Name

Ilahia Trust vs. Commissioner of Income Tax, (High Court of Kerala)

ITA No. 18 of 2019

Date: 15th November 2021

Key Takeaways

• Trust exemptions have strict conditions: Educational trusts can lose their tax-exempt status if they divert funds for personal benefit of interested parties
• Timing matters in tax cases: Making payments before obtaining necessary approvals can undermine credibility of explanations
• TDS compliance is mandatory: Failure to deduct tax at source results in disallowance of expenses
• Related party transactions face scrutiny: Transactions with entities owned by trustees or their family members are closely examined
• Documentary evidence is crucial: Courts require proper documentation to support claims, especially for large transactions

Issue

The central legal questions were:

1. Whether the trust’s advance payment of Rs. 72,45,000 to a timber company owned by the managing trustee’s wife violated Section 13(1)© of the Income Tax Act?
2. Whether the trust’s failure to deduct TDS on payments to contractors violated Section 40(a)(ia) of the Income Tax Act?

Facts

Ilahia Trust is an educational trust registered under Section 12AA of the Income Tax Act since April 1, 2000. They run four educational institutions and filed their return for Assessment Year 2012-13 showing ‘Nil’ income, claiming tax exemption.

The trouble started when the tax officer noticed two suspicious transactions:

First Issue - The Timber Advance:

• On February 16, 2012, the trust paid Rs. 72,45,000 to M/s. VUS Timbers
• VUS Timbers is owned by Mrs. K Sainaba, who happens to be the wife of the trust’s managing trustee, Sri V U Sidhik
• The trust claimed this money was an advance for purchasing wood for a proposed medical college

Second Issue - The Contractor Payment:

• The trust paid Rs.21,27,846 to one Varghese Innocent for construction work
• They failed to deduct tax at source (TDS) on this payment

Here’s where it gets interesting - when the tax officer dug deeper, they found that the trust had applied for permission to establish a medical college on November 29, 2012, but the payment to the timber company was made much earlier on February 16, 2012. The application was actually returned by Kerala University of Health Sciences on December 3, 2012.

Arguments

Trust’s Arguments (through Senior Advocate Mr. T M Sreedharan):

• The trust has been operating blamelessly since inception
• The advance was genuinely made for purchasing wood for a planned medical college
• The fact that the timber company owner is the trustee’s wife is just a coincidence and shouldn’t be held against them
• Since the medical college plan didn’t work out, the money was returned during Financial Years 2012-13, 2013-14, and 2014-15
• The tax authorities made prejudicial assumptions based solely on the family relationship

Tax Department’s Arguments (through Standing Counsel Mr. Christopher Abraham):

• The trust failed to provide adequate documentation supporting their medical college plans
• The timing of the payment (before applying for permissions) undermines the trust’s explanation
• The trust couldn’t demonstrate the bona fides of their reply
• No material was provided regarding permissions for establishing a medical college
• The advance was made without proper justification and constituted diversion of trust funds

Key Legal Precedents

The judgment primarily relies on specific sections of the Income Tax Act rather than citing other case precedents. The key legal provisions referenced are:

• Section 12AA of the Income Tax Act: Registration of trusts
• Section 13(1)© of the Income Tax Act: This section states that if trust income is used directly or indirectly for any person referred to in sub-section (3) of section 13, the exemption under section 11 will not apply
• Section 13(3) of the Income Tax Act: Defines interested parties (including trustees and their relatives)
• Section 40(a)(ia) of the Income Tax Act: Deals with TDS compliance requirements
• Section 234A and 234B of the Income Tax Act: Interest provisions
• Section 260A of the Income Tax Act: Appeals to High Court

Judgement

The High Court ruled completely in favor of the tax department. Here’s what they decided:

On the Timber Advance Issue:

The court found that there was a clear violation of Section 13(1)© of the Income Tax Act. The key reasoning was:

• The payment was made before any steps were taken for the medical college project
• This timing “is sufficient to belie the entire explanation offered by the assessee”
• The advance was made to an entity owned by the managing trustee’s wife, falling under prohibited related party transactions
• The court noted: “Therefore, in the garb of purchase of timber, advance amounts were diverted for the personal benefit of an interested party”
• Even though the money was later returned, this didn’t cure the original violation

On the TDS Issue:

The court confirmed that the trust violated Section 40(a)(ia) by not deducting TDS on the Rs.21,27,846 payment to Varghese Innocent. The statutory obligation was clear and undisputed.

Final Orders:

• All appeals by the trust were dismissed
• The tribunal’s findings were confirmed
• No costs were awarded
• The trust had to pay tax of Rs. 2,86,95,959 including interest

FAQs

Q1: Why did the trust lose its tax exemption?

A: The trust violated Section 13(1)© by advancing money to a company owned by the managing trustee’s wife without proper justification. This constituted using trust funds for the benefit of an “interested party,” which is prohibited for tax-exempt trusts.

Q2: Wasn’t the money returned later?

A: Yes, but the court held that returning the money doesn’t cure the original violation. The damage was done when the advance was made without proper authorization or documentation.

Q3: Why was the timing of payments so important?

A: The trust claimed the advance was for a medical college project, but they made the payment in February 2012 before even applying for necessary permissions in November 2012. This sequence of events made their explanation unbelievable.

Q4: What about the TDS issue?

A: The trust was required by law to deduct tax at source when paying contractors. Their failure to do so resulted in the expense being disallowed, which increased their taxable income.

Q5: Could the trust have avoided this problem?

A: Yes, by either: (1) obtaining all necessary approvals before making any payments, (2) avoiding transactions with entities owned by trustees’ family members, or (3) ensuring proper documentation and compliance with TDS requirements.

Q6: What’s the broader lesson for other trusts?

A: Trusts must be extremely careful about related party transactions and maintain proper documentation. Tax exemptions come with strict compliance requirements, and even well-intentioned actions can result in loss of exempt status if not properly executed.

Heard learned Senior Advocate Mr. T M Sreedharan for appellant and learned Standing Counsel Mr. Christopher Abraham for respondent.

2. M/s. Ilahia Trust/Assessee is the appellant herein. The Commissioner of Income Tax, Cochin/Revenue is the respondent. The assessee is a Trust registered under Section 12AA of the Income Tax Act 1961 (for short ‘the Act’). The instant appeal arises from the order of the Income Tax Appellate Tribunal (for short ‘Tribunal’) Cochin Bench dated 29.10.2018 in I.T.A. No.313/Coch/2018. The issues relate to the return filed by the assessee for the Assessment Year 2012-13.

2.1 As an Educational Trust registered under Section 12AA, the assessee claims that the income of the Trust for the Assessment Year up to and including the Assessment Year 2010-11 is exempt from the computation of total income of the assessee. The assessee for the subject assessment year, on 01.01.2013, filed the return under the Act declaring the total income of the assessee as ‘Nil’. The assessee, admittedly, established and running four educational institutions. The case of the assessee was selected for scrutiny and statutory notices under Section 143(2) and 142(1) were issued by the Assessing Officer. The Assessing Officer issued notice calling upon the assessee to explain the advance of a sum of Rs.72,45,000/- in favour of M/s.VUS Timbers. M/s. VUS Timbers is a proprietary concern of Mrs. K Sainaba. The Proprietrix K Sainaba is the wife of Managing Trustee Sri V U Sidhik of the assessee/Educational Trust. The advance made in favour of M/s. VUS Timbers since is not compliant with the general purpose of running the Trust, the Assessing Officer called upon the assessee to show-cause as

to why the provisions of Section 13(1)(c) of the Act should not be invoked and disallow the advances made by the assessee in favour of M/s. VUS Timbers. The assessee, in its reply dated 19.11.2014, stated that the assessee had taken steps to establish a medical college; the wood requirement of the proposed building for the medical college has been placed on M/s. VUS Timbers and, therefore, the amount has been advanced to M/s.

VUS Timbers. The assessee does not dispute the standing of M/s. VUS Timbers vis-a-vis the Managing Trustee of the assessee. It is stated the amount received from the assessee was repaid by M/s. VUS Timbers during the Financial Years 2012-13; 2013-14; and 2014-15.

2.2 The other issue which needs to be referred to at this

stage is, the assessee has described one Mr Varghese Innocent

in the list of sundry creditors. The total amount shown against

the name of Varghese Innocent is Rs.21,27,846/-. The assessee

was called upon to explain the outflow from the Trust account a

sum of Rs.21,27,846/-. The reply is that the said Varghese

Innocent carried out a few works for the assessee/Trust and the

amount has been paid towards consideration for the works

carried out by the said contractor. Then, the next question

raised by the Department is what are the works carried out by

Varghese Innocent and whether TDS was effected while making

the payment. The assessee could not place on record the details

of effecting TDS on the amount paid to Varghese Innocent. The

failure to comply with Section 40(a)(ia) of the Act has been

noted and the amount claimed towards capital investment has

been disallowed by the Assessing Officer.

2.3 The Assessing Officer, through order in Annexure-A

dated 11.03.2015, finalized the assessment of the assessee

calling upon the total tax payable by the assessee together with

interest amounting to Rs.2,86,95,959/-. The assessee filed

appeal before the Commissioner of Income Tax (Appeals). The

CIT (Appeals), through the order dated 10.04.2018 in Annexure-

B, dismissed the appeal. The assessee filed second appeal before

the Tribunal in ITA No.313/Coch/2018. The Tribunal, through

the order dated 29.10.2018 filed as Annexure-D, dismissed the

appeal filed by the assessee. Hence, the appeal under Section

260A of the Act.

3. The issues relate to the payment of Rs.72,45,000/- in

favour of M/s. VUS Timbers and Rs.21,27,846/- in favour of

Varghese Innocent. Rs.72,45,000/- is claimed as advance paid

for the purchase of wood and the sum of Rs.21,27,846/- is shown

as expenses incurred for construction work and payment made

without TDS to the contractor Varghese Innocent.

Substantial Question Nos. 1 to 3

3. Substantial question nos. 1 to 3 read thus:

“(i) Whether on the facts and in the circumstances of the

case, the Appellate Tribunal is justified in dismissing the appeal

by rejecting all the claims for exemption/deduction in the

Assessment Order Annexure-A?

(ii) Is the Appellate Tribunal justified in making addition of

Rs.72,45,000/- and estimating interest thereon as diversion of

funds of the Trust amounting to violation of exemption u/s.11

of the Act r.w.s. 13(1)(c) and in levying tax at maximum

marginal rate thereon?

(iii) Whether on the facts and in the circumstances of the

case, the assessing and Appellate Authorities, including the

Appellate Tribunal are justified in estimating and adding

Rs.13,04,700/- as income of the Trust and assessing the same at

maximum marginal rate as stated in the ground above? Are not

the above additions arbitrary, illegal and unsustainable in

law?”

4. Senior Advocate Mr T M Sreedharan contends that

the assessee was granted registration under Section 12AA of the

Act on 01.04.2000 and the assessee being an Educational Trust,

the income is exempt from the computation of total income for

the subject assessment year as well. The conduct of assessee

since its inception till the show-cause notice issued by the

Assessing Officer is completely blemishless. The assessee, being

an Educational Trust, is discharging the objects for which the

Trust has been established. The assessee, as part of providing

education and establishing more colleges, planned to establish a

medical college in the State of Kerala. The assessee, as a

measure in this behalf, paid a sum of Rs.72,45,000/- to M/s. VUS

Timbers and the said amount is an advance made by the

assessee in favour of M/s. VUS Timbers. The Assessing Officer

erred in fact by prejudicially presuming against the assessee by

referring to the solitary circumstance that the Proprietrix of

M/s. VUS Timbers is the wife of the Managing Trustee – Mr V U

Sidhik. The plan of the assessee since could not go forward, the

assessee during the Financial Years referred to above has

received the advance paid to M/s. VUS Timbers. Therefore, the

order of the Assessing Officer, as confirmed by the CIT (Appeals)

and the Tribunal, is suffering from the erroneous and illegal

understanding of the normal circumstances which had taken

place in the subject Assessment Year. The order, giving effect

to the provision under Section 13(1)(c), is untenable. According

to him, the issues require reconsideration, if this Court is not

convinced on the ground that the findings recorded by the

authorities suffer from excessive subjective satisfaction, to wit,

matter could be remanded to Tribunal.

5. Learned Standing Counsel Mr Christopher Abraham,

replying to the argument of assessee, states that the Assessing

Officer and the CIT (Appeals) have, in fact, taken note of each

one of the circumstances stated by the assessee by way of reply

to the show-cause notice, and the authorities were convinced

because of the failure of the assessee to establish the bona fides

of the reply given by it in the payment made to M/s. VUS

Timbers. In other words, the assessee failed to place material

relating to permissions granted for establishing a medical

college, the timing of payments made to M/s. VUS Timbers and

that the advance payment was made in furtherance of a project

planned by the assessee. In the absence of material on the very

basic reply given by the assessee, acceptance of reply given by

the assessee would be illegal and the Officers do not enjoy so

much discretion under the Act to accept unsupported reply. He

invited our attention to each one of the findings recorded by all

the three authorities and argued that the questions raised,

firstly, do not arise for consideration and secondly, there is no

perversity in any of the findings recorded by the orders in

Annexures-A, B and D. This Court ought not to decide the

legality of the conclusions recorded by the authorities by

looking at fresh material now placed by the assessee before this

Court. Even, such material does not inspire confidence for the

limited purpose of remitting the matter to the Tribunal. He

prays for answering all the three questions in favour of the

Revenue and against the assessee.

6. The argument of assessee proceeds to convince this

Court that the reply given by the assessee is not considered and

led to a finding which resulted in the inclusion of Rs.72,45,000/-

as income of the assessee. The further argument is that the

orders did not consider the material placed by the assessee in

support of its plan to establish a medical college and/or

subsequent inability to go ahead with the establishment of

medical college as planned. Therefore, the assessee prays for

firstly answering the questions in favour of the assessee, and

secondly for sending the matter back to Tribunal for

consideration and disposal afresh. We can, having perused the

record, state that the argument is de hors what has been

categorically and specifically adverted to by the Assessing

Officer, CIT (Appeals) and the Tribunal. However, we would

look at a few circumstances to appreciate the argument of

assessee.

7. To begin with, this Court takes note of the fact that

M/s. VUS Timbers is a proprietary concern of Mrs K Sainaba,

and Mrs K Sainaba is the wife of Managing Trustee Sri V U

Sidhik. From Annexure-E ledger account extract of Ilahia Trust,

of M/s. VUS Timbers it is shown that on 16.02.2012 under two

receipts a sum of Rs.72,45,000/- was paid to M/s. VUS Timbers.

As per Annexure-G(a) the communication received by the

assessee from Kerala University of Health Sciences dated

03.12.2012 shows that the application of the assessee was

returned. The assessee, in Annexure-G(b)(5) dated 29.11.2012,

has applied for the grant of Essentiality Certificate by the

Health University. A bare look at even the very documents now

filed by the assessee discloses that the payment/advance in

favour of M/s. VUS Timbers is anterior to any of the steps now

relied on by the assessee. This circumstance is sufficient to

belie the entire explanation offered by the assessee in this

behalf. The admitted circumstances are that advances have

been made in favour of the Managing Trustee’s wife. The

explanation offered is for the purchase of wood for proposed

construction of a medical college. The purchasing of wood is

for the medical college to be established by the

assessee/Educational Trust. Each one of the above reasons

looked at independently, in the background of material placed

on record by the assessee, this Court is of the view that the

findings recorded by the Tribunal confirming the findings of

facts recorded by the authorities under the Act are available

conclusions, and do not warrant interference of this Court. The

reasoning of Tribunal's order in paragraph 3.5, reads as follows:

“3.5 We have heard the rival submissions and perused the

material on record. Section 13(1)(c) of the I.T.Act states that if

any income of the trust during the previous year is used or

applied directly or indirectly to any person referred to in sub-

section (3) of section 13, provisions of section 11 will not have

application. Admittedly, the amount has been advanced to

M/s. VUS Timbers, a proprietory concern of wife of the

Managing trustee. Therefore, the advance clearly comes within

the mischief of section 13(1)(c) of the I.T.Act unless it is proved

that the said advance is for the purpose of assessee-trust itself.

It is the claim of the assessee that the amount has been

advanced for purchase of timber for the proposed construction

of a medical college. It is an admitted fact that permission was

given for the setting up of medical college. The assessee has

also not produced any application or other documents which

ought to have been submitted to the Governmental authorities

or Medical Council of India for the proposal for setting up of

medical college. The story of the assessee is far from convincing

that the advance has been made for the purchase of timber. The

timber is normally purchased only subsequent to the

construction of the building and even without constructing any

building, the assessee had made the advance for purchase of

timber. It is also an admitted fact that no wood was received by

the assessee. Therefore, in the garb of purchase of timber, the

advance amounts were diverted for the personal benefit of an

interested party, who is mentioned in section 13(3) of the

I.T.Act. Therefore, there is clear violation of provisions of

section 13(1)(c) of the I.T.Act. The contention of the assessee

that the amounts were returned by account payee cheques and

within a short period is of no consequence. Only a small portion

of the advance was repaid to the assessee trust within four

months from the date of advance. Therefore, the repayment by

M/s.VUS Timbers of all the advance by account payee cheques

is of no significance insofar as there was already a violation of

provisions of section 13(1)(c) of the I.T.Act. Therefore, the

CIT(A) is justified in directing the A.O. to treat an amount of Rs.

72,45,000 as advance as income the assessee. The assessee was

paying interest on borrowings, and therefore, notional interest

at the rate of 18% on the of advance of Rs.72,45,000 was rightly

brought to tax as income of the assessee by the A.O. Therefore,

we see no reason to interfere with the findings of the CIT (A).

Accordingly, we confirm the order of the CIT (A) on this issue.”

Nothing more is needed except to record that the findings of

fact recorded are tenable from available circumstances and

there is no substantial question involved warranting

interference of this Court. Hence, the questions are answered

in favour of the Revenue and against the assessee.

Substantial Question nos. 4 and 5

8. Substantial question nos. 4 and 5 deal with issues

arising under Section 40(a)(ia) related to non-compliance with

the requirement of deduction of TDS. The questions read thus:

“(iv) Did not the Appellate Tribunal err in law in disallowance

of Rs.21,27,846/- being the amount paid for contract executed

by invoking Sec.40(a)(ia) and in levying income thereon at

maximum marginal rate, as if the same constituted income of

the appellant?

(v) Did not the Appellate Tribunal err in law in disallowing

labour charges expenses to the extent of Rs.5,40,390/- and

treating the same as payment in violation of the statutory

provision and levying income tax thereon at maximum

marginal rate? Are not the findings of the Appellate Tribunal

perverse in law and liable to be set aside?”

8.1 The statutory obligation of the assessee to conform

to the requirement of Section 40(a)(ia) of the Act is not in

dispute. The fact that no TDS was effected while making the

payment of Rs.21,27,846/- in favour of one Varghese Innocent

towards consideration for contract works is also not in dispute.

The explanation, in the understanding of this Court, does not

deal with any of the relevant aspects of law or fact for

independently examining the question to find out whether the

findings recorded by the orders referred to above warrant

interference. It is sufficient to refer to the findings recorded by

the Tribunal in this behalf which read as follows:

“4.4 We have heard the rival submissions and perused the

material on record. Admittedly, no tax was deducted on the

payment of Rs.21,27,846. The assessee has not proved that the

provisions of section 40(a)(ia) of the I.T.Act does not have any

application on the said payment of Rs.21,27,846. Hence, the A.O.

was correctly disallowed the expenditure by invoking the

provisions of section 40(a)(ia) of the I.T.Act, which was

confirmed by the CIT(A). Hence, we see no reason to interfere

with the order of the CIT(A) and we confirm the same.”

8.2 The assessee failed to demonstrate how the above

finding warrants interference of this Court, particularly by

referring to the substantial questions framed in this behalf. The

questions are not substantial questions of law, and the

adjudication is in accordance with the requirements of law and

circumstances presented by the very return filed by the

assessee. The questions are answered, hence, in favour of the

Revenue and against the assessee.

Substantial Question Nos. 6 & 7

9. Substantial question nos. 6 & 7 read as follows:

“(vi) Is not the computation of total income and the levy of

interest u/s 234A and 234B as per the modified order dated

25.05.2018 erroneous and contrary to the statutory provision

and hence, liable to be set aside?

(vii) Is not the entire order of the Appellate Tribunal arbitrary,

illegal and unsustainable in law?”

9.1 The questions relate to the levy of interest under

Section 234A and 234B of the Act. The non-compliance with

statutory requirements and inviting one or the other

consequence thereof is not disputed. The discretion is rightly

exercised by the Assessing Officer for levying interest on the tax

determined in this behalf. Since the other questions are

answered in favour of the Revenue and against the assessee,

these questions follow suit and are answered, accordingly, in

favour of the Revenue and against the assessee All the findings

of the Tribunal are confirmed. The order of the Tribunal is in

accordance with law and no exception could be taken and

questions answered accordingly.

Income Tax Appeal is dismissed. No order as to costs.

Sd/-

S.V.BHATTI

JUDGE

Sd/-

BASANT BALAJI

JUDGE