In Maxopp Investment Ltd v/s CIT 402 ITR 640 (SC), the Supreme Court has laid down important law on the interpretation of section 14A and Rule 8D. Advocate Vipul Joshi has conducted a detailed study of the judgement in juxtaposition with the earlier judgements of the apex court in Godrej & Boyce Mfg. Co. Ltd v/s DCIT 394 ITR 449 (SC)] and CIT v/s. Essar Teleholdings Ltd 401 ITR 445 (SC) and explained its precise implications
THE DECISION IN CASE OF MAXOPP INVESTMENT LTD.
[ON SECTION 14A]
– An Analysis
–VIPUL B. JOSHI
ADVOCATE
{Note: The underline and the bold font, whenever used, are for emphasis purpose only}
The decision delivered by the Supreme Court in the case of Maxopp Investment Ltd. &Ors. v/s. CIT – [(2018) 402 ITR 640 (SC)] completes trilogy of the judgments on core issues relating to section 14A of the Income – tax Act, 1961 [“the Act”]; the first one being the case of Godrej & Boyce Mfg. Co. Ltd. v/s. DCIT – [(2017) 394 ITR 449 (SC)] and the second being the case of CIT v/s. Essar Teleholdings Ltd. – [(2018) 401 ITR 445 (SC)]. While the issue in the case of Godrej was applicability of section 14A vis – a – vis the dividend income which has already suffered dividend distribution tax in terms of section 115-O and 115-R,the issue in the case of Essar was prospective /retrospective operation of Rule 8D. The issue involved in the case of Maxopp was applicability of section 14A vis– a – vis shares held as strategic investments / shares held as stock in trade. The discussion in this article is confined to the issues arising from the decision in the case of Maxopp Investment Ltd. [“Maxopp”].
It is one of the fundamental principles of law on precedent that a decision has to be understood and analyzed on the basis of the facts and the specific issues that were before the court, on the basis of which arguments from both the sides proceeded. A slight variation in these factors can prevent the case from being a binding precedent for a subsequent case having different factual and arguments matrix that are relevant on the issue. Further, it is also important to appreciate a decision in the backdrop of the legal precedents and the legislative history. Therefore, since this decision in case of Maxopp has very far reaching effects and repercussions, it becomes imperative to revisit the entire issue afresh, with the legislative history and legal precedents connected therein – albeit at the cost of breaching the limitation oflength of this article – so as provide assistance to understand and appreciate the ratio and impact of this judgment in true perspective. For the very same reason – limitation of length of article– the discussion is divided into three parts, the first part devoted to tracing the legislative history and legal precedents prior to insertion of section 14A as well as legislative intention behind introduction of section 14A, the second part devoted to legal precedents post insertion of section 14A, including the decision of Maxopp, and the third part containing analysis and comments.
PART ONE
PRE SECTION 14A POSITION
Essentially, the focal point of the entire controversy is the issue of allowance / disallowance of the expenditure incurred in connection with earning of tax free income. To analyze the issue, one has to, necessarily, go to the very genesis of the provisions of section 14A of the Income – tax Act, 1961 [“the Act”] due to the very nature of the issue. The entire controversy has arisen due to the words “in relation to” as used in section 14A while stipulating that ‘… … no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under this Act.”
Now, the phrase “in relation to” is not defined in the Act, nor there is much judicial precedent on this phrase so far as the income tax law is concerned. Therefore, the same is to be interpreted keeping in view:
I. The background and the prior position in law
II. The legislative history
III. The legislative intention / The mischief sought to be remedied
IV. The legal precedents on the issue post insertion
V. The relevant principles of interpretation of statute
I. THE BACKGROUND AND THE PRIOR POSITION
It is very essential to analyze the background and the prior position in order to appreciate the legislative intention behind brining an amendment 40 years after enactment of the Act; that too, giving retrospective effect of 40 years. It may also be essential to understand the mischief that was sought to be addressed / avoided by the legislature while bringing section 14A. The analysis is also important in order to appreciate whether, with one stroke of pen, is it that the legislature intended to overrule all judicial precedents on all aspects concerning this issue that stood test for more than half a century so as to make them totally redundant; or is it that the intention was to affect only certain specific fact situations.
Now, this can be best analysedby summarizing some of the propositions laid down by catena of legal precedents on the aspect of allowability of a deduction, which is otherwise eligible under the Act, vis– a –vis generation of tax free income, arising out of itdirectly or incidentally. Some of them are analyzed hereunder, which are, by no means, exhaustive to the issue.
A. GENERAL
1. Proposition: If a tax free security is capable of producing [taxable] profit and loss, no part of the cost can be disallowed on the reasoning that the same was incurred for producing tax – free interest income arising therefrom.
In one of the pioneering judgments on this aspect, A Three Judges Bench of the Supreme Court, in the case of CIT v/s. Indian Bank Limited – [(1965) 56 ITR 77 (SC)], was concerned with a case of a banking company that had invested large sum in tax free government securities out of interest bearing funds. The securities were treated by the assessee as its stock – in – trade; the profit / loss arising out of which was computed under the head “business”. The contention of the Department was that a part of the interest expenses was disallowable as the securities generated tax free interest income, on the basis of the general principle that no expenditure can be allowed as a deduction from the profits of a business unless the part of the business to which the expenditure is attributable is capable of producing income or profits liable to be taxed under the Act. In other words, it was contended that if a part of profits of a business is not taxable, no expenditure incurred for the purpose of earning those profits can be allowed as deduction. Otherwise, it was contended, it would amount to double benefit to the assessee. It was argued that if a particular income has no taxable quality, it also loses quality for qualifying for expenditure allowable u/s. 10 of Indian Income-tax Act, 1922 [parimateria with section 28 / 29 of the Act].The Three Judges Bench, at the very threshold, rejected the stand of the Department on the preliminary ground that even if the stand of the Department was to be accepted, such stand did not assist the revenue in that case as it was not controverted that the profits and losses accruing from the sale and purchase of such securities had been included in the assessment [that is, taxed]. Therefore, as the tax – free securities were capable of producing [taxable] profits and losses, the Apex Court held that the appeal of the Department must fail on this ground alone. {These observations are quite significant in the present context.}
2. Proposition: Allowability of business expenditure is not dependent upon producing taxable or non – taxable income. The fact that the income arising from a part of that business is not exigible to tax under the Act is not a relevant criteria.
(i) In the above referred case of Indian Bank Limited, the Apex Court, after holding as above, proceeded to adjudicate this second proposition as under:
“We must look at section 10 (2) and deduct all the allowances permissible to him. In allowing a deduction which is permissible the question arises: Do we look behind the expenditure and see whether it has the quality of directly or indirectly producing taxable income? The answer must be in the negative for two reasons: First, Parliament has not directed us to undertake this enquiry. There are no words in section 10 (2) to that effect. On the other hand, indications are to the contrary. In section 10 (2) (xv), what Parliament requires to be ascertained is whether the expenditure has been laid out or expended wholly and exclusively for the purpose of the business.
The legislature stops short at directing that it be ascertained what was the purpose of the expenditure. If the answer is that it is for the purpose of the business, Parliament is not concerned to find out whether the expenditure has produced or will produce taxable income.
Secondly, the reason may well be that Parliament assumes that most types of expenditure which are laid out wholly and exclusively for the purpose of business would directly or indirectly produce taxable income, and it is not worth the administrative effort involved to go further and trace the expenditure to some taxable income.
Therefore, it seems to us that there is nothing in the language of section 10 from which it can be fairly implied that an expenditure or allowance falling within the section must fulfill some other condition before it can be allowed.”
The Apex Court followed the ratio laid down in the case of Hughes v/s. Bank of New Zealand – [(1938) 6 ITR 636 (SC)] and reproduced the following observations of Greene L. J., which may be relevant for the present purpose:
"when the statute says that interest is to be exempt, I am quite unable to read it as meaning that in giving effect to that exemption by implication, some repercussion is to take place on a different provision of the Act altogether…… I can find nothing in the statute which requires this interest to be treated, so to speak, as a trade within a trade. This is really what the Crown contend, that in some way this interest which is to be brought into account as an item of receipt is to be taken out of it with some apportioned expenses appropriated to it as though it were a trade by itself."
The Court held that there is no general principle that if a part of the income of a business is tax free, expenditure incurred for the purpose of earning this income is outside the purview of section 10 of Income – tax Act, 1922.
(ii) In an interesting case before the Full Bench of the Madras High Court, {S. A. S. S. ChellappaChettiar v/s. CIT –[(1937) 5 ITR 97 (Madras) (FB)]}, most part of the interest bearing funds of the assessee – money lender stood invested in agriculture land that was received by the assessee from his constituent towards repayment of loan that was given in course of his money lending business. The assessee managed and cultivated the agriculture land and earned tax free agriculture income. The contention of the Department was on the same line as above. The Income Tax Officer disallowed 4/5th of the interest expenditure on the ground that 4/5th of borrowed money had been invested in such agriculture land that generated tax free income. The officer also disallowed 50% of establishment expenses. The High Court, very pertinently, observed that the cultivation was merely a necessary incident of his involuntary possession which came to him because as a money – lender he had lent money to a borrower who could not repay his money.
The High Court held that if money is originally borrowed for the purpose of business, it is immaterial whether, later on, tax free income gets generated in course of the business activity as a necessary incident and the assessee is not to be deprived of the advantages conferred by exemptions such as section 10 (2) (iii) [parimateria with section 36 (1) (iii) of the Act] because the capital benefiting therefrom by means of permissible deductions happens to produce a non – taxable income. The High Court also made a very interesting observation, which is very relevant for post section 14A scenario. The Court observed that if the Department’s contention was to be accepted, the assessee would have been better off if he had not taken this land from the debtor and, therefore, unable to realize anything in cash as, in such a situation as he would then be able to at least get (full) benefit of deduction of interest under section 10 (2) (iii).
{Post section 14A / Rule 8D, there have been numerous cases where the disallowance under section 14A comes to a figure many times more than the dividend income itself; in many cases more than even the entire expenses, compelling the assessee to lament about the dividend income being tax free or about at all receiving such dividend (tax free)! Recent amendments in Rule 8D do not mitigate such situations completely and satisfactorily.}
This decision was approved by the Apex Court in the case of Indian Bank [discussed earlier] and Maharashtra Sugar [discussed later].
(iii) The above proposition was applied by the Bombay High court in the case of CIT v/s. Industrial Investment Trust Co. Ltd. –[(1968) 67 ITR 436 (Bom)], where the business of the assessee was a single activity, which did not have two distinct or different businesses: one yielding a tax – free profit and the other a profit which was subject to tax, and the expenses were incurred for the carrying on of such single business, which produced income partly of one kind and partly of another. The Court granted the benefit of deduction to the assessee, rejecting the argument of the department that otherwise the assessee would get double advantage.
(iv) In the case of CIT v/s. Maharashtra Sugar Mills Ltd. – [(1971) 82 ITR 452 (SC)], the Supreme Court was concerned with the case of the assessee, a company, which was having extensive land on which it was growing sugar – cane which was used for manufacturing sugar in its factory. Both the businesses were, admittedly, indivisible. The issue was disallowance of a part of managing agency commission which, according to the Department, was incurred in respect of the tax free agriculture activity of growing sugar – cane. The Apex Court found no basis for the same, by observing as under:
“This contention proceeds on the basis that only expenditure incurred in respect of a business activity giving rise to income, profit or gains taxable under the Act can be given deduction to and not otherwise. We see no basis for this contention.To find out whether the deduction claimed is permissible under the Act or not, all that we have to do is to examine the relevant provisions of the Act. Equitable considerations are wholly out of place in construing the provisions of a taxing statute. We have to take the provisions of the statute as they stand. If the amount claimed is permissible under the Act then the same has to be deducted from the gross profit. If it is not permissible under the Act, it has to be rejected.As mentioned earlier, it is not disputed that the cultivation of sugar-cane and the manufacture of sugar constituted one single and indivisible business. Section 10 (2) says that profits under section 10 (1) in respect of a business should be computed after deducting the allowances mentioned therein. One of the allowances allowed is that mentioned in section 10 (2) (xv) which says that any expenditure laid out or expended wholly an exclusively for the purpose of such business shall be deducted as an allowance. The mandate of section 10 (2) (xv) is plain and unambiguous.Undoubtedly, the allowance claimed in this case was laid out or expended for the purpose of the business carried on by the assessee. The fact that the income arising from a part of that business is not exigible to tax under the Act is not a relevant circumstance.”
(v) The above principle was followed by the Apex Court, even after 30 years, in the celebrated case of Rajasthan State Warehousing Corporation v/s. CIT – [(2000) 242 ITR 450 (SC)]. This decision is very significant as it is this decision that was sought to be nullified by introducing section 14A. This was a case where the assessee, a State Government Corporation, derived income from various sources, which included income from warehousing that was exempt u/s. 10 (29) of the Act. The A.O. disallowed business expenses allocable to non – taxable income. Allowing the appeal of the assessee, the Court laid down the following principles:
“(i) if income of an assessee is derived from various heads of income, he is entitled to claim deduction admissible under the respective head whether or not computation under each head results in taxable income;
(ii) if income of an assessee arises under any of the heads of income but from different items, e.g., different house properties or different securities, etc., and income from one or more items alone is taxable whereas income from the other item is exempt under the Act, the entire permissible expenditure in earning the income from that head is deductible; and
(iii) in computing "profits and gains of business or profession" when an assessee is carrying on business in various ventures and some among them yield taxable income and the others do not, the question of allowability of the expenditure under section 37 of the Act will depend on:(a)fulfillment of requirements of that provision noted above; and(b)on the facts whether all the ventures carried on by him constituted one indivisible business or not; if they do, the entire expenditure will be a permissible deduction but if they do not, the principle of apportionment of the expenditure will apply because there will be no nexus between the expenditure attributable to the venture not forming an integral part of the business and the expenditure sought to be deducted as the business expenditure of the assessee.”
It is significant to note that even the Department conceded this legal position.
(vi) However, if, in a given case, the assessee is not able to prove that the various activities carried on by the assessee [generating taxable as well as non – taxable income] constitute one single integrated activity or that such activities do not represent distinct business, then the ratio of Maharashtra Sugar Mills cannot be applied. In such a case, the common expenses, like head office expenses, can be apportioned among such different activities on a reasonable basis.
{Ref: Waterfall Estates Ltd. v/s. CIT – [(1996) 219 ITR 563 (SC)]}
B. CASES CONCERNING ALLOCATION OF EXPENSES WITH RESPECT TO EARNING OF INTEREST FREE INCOME / DIVIDEND FROM SHARES & SECURITIES
Even on this aspect, the law was quite well settled, which will be evident from analysis of few cases as hereunder; the contents of which are very much self – explanatory.
1. General
(i) For the purpose of section 57 (iii), there should be some nexus between the expenditure and the earning of the income. …… The interest (on fixed deposits) accrues sui generis. The interest is payable by the bank whether it is claimed or not and whether there is any establishment or not.
Normally, there was no necessity for spending anything separately for earning the interest. While rejecting the assessee’s claim of administrative expenses, the Court made very pertinent observations as follows:
“The requirement under section 57(iii) that the expenditure should have been incurred ‘for the purpose of making or earning such income’ shows that the object of spending or the end or aim or the intention of such spending was for earning the interest income.”
Vijayalakshmi Sugar Mills Ltd. v/s. CIT – [(1991)191 ITR 641 (SC)]
{Consider this proposition in light of the present position, where now there is a system of direct credit of dividend to the account of the shareholder.}
(ii) There is a difference between an expense relatable to acquisition of share and an expense relatable to dividend being earned upon such shares. An expense may be a former but not necessarily the latter as well.
CIT v/s. General Insurance Corporation of India – [(2002) 254 ITR 203 (Bom)]
{The Department accepted this ratio and did not agitate this ground while preferring appeal against this judgement before Supreme Court on another ground.}
{This ratio goes to the very root of the issue, as this subtle distinction is now completely lost sight of.}
2. Cases concerning 80M
[Section 80M, as existed upto 31.03.2003, essentially, provided for deduction in respect of certain inter – corporate dividends. In other words, dividends derived by companies from domestic companies were taxed on concessional basis. One of the contentious issues was whether the exemption of dividend income was on gross basis or net basis and, if on net basis, how to allocate / apportion expenses to be deducted against such dividend income.]
(i) For the purpose of computing the amount of dividend to be exempted u/s. 80M, only expenditure that are actually incurred for earning dividend income are to be deducted. There is no scope for allocation of notional or estimated expenditure or application of rule of proportionality with respect to the expenses (including the interest) alleged to have been incurred for the purpose of earning such dividend income.
CIT v/s. Central Bank of India – [(2003) 264 ITR 522 (Bom)].The appeal of the Department dismissed by Supreme Court in CIT v/s. Central Bank of India – [(2015) 373 ITR 524 (SC)].}
CIT v/s. United Collieries Ltd. – [(1993) 203 ITR 857 (Cal)]
CIT v/s. Modern Terry Towels Ltd. – [(2013) 357 ITR 750 (Bom)]
CIT v/s. Reliance Industries Ltd. – [(2017) 86 taxmann.com 24 (Bom)]
(ii) “The question may still arise as to whether any notional expenditure can be taken into consideration for the purpose of deduction while calculating the income from dividend or only expenditure actually incurred by an assessee can be taken into consideration while calculating the deduction claimed under section 80M. In our considered opinion, there lies a distinction between what we call notional expenditure and actual expenditure. If it is proved to be a case of actual expenditure incurred by an assessee while earning / depositing the dividend, then certainly the amount actually incurred by way of expenditure has got to be deducted in accordance with the procedure prescribed under the Act. But when there is nothing on record to show that any expenditure is incurred by an assessee while earning / depositing the dividend, then it is difficult for us to hold that some hypothetical and / or notional expenditure can be made a basis for deduction. In other words, we have not been able to notice any provision which may entitle the taxing authorities to work out by way of expenditure any notional figure for the purpose of section 80M though, in fact, it has not been so incurred by an assessee while encashing the dividend.”
State Bank of Indore v/s. CIT – [(2005) 275 ITR 23 (MP)]
{A case where CIT (A) itself had deleted the disallowance vis – a – vis interest, which was accepted by the Department. The appeal of the assessee was vis –a – vis 10% disallowance towards collection charges.}
(iii)The Special Bench of the Tribunal in the case of Punjab State Industrial Ltd. v/s. DCIT – [(2006) 102 ITD 1 (Chd) (SB)], laid down certain propositions with respect to dividend income vis – a – vis section 80M of the Act, after exhaustively dealing with the issue. Some of them, so far as relevant for the present article, are:
“(iv) That actual expenditure incurred is to be taken into consideration. There is no question of taking expenditure on estimate or presumption basis while computing dividend income or while allowing deduction under section 80M.
(v) That where shares are acquired out of borrowed funds, on which dividend is received, deduction of interest paid can be allowed under section 57 provided loan was taken for making and earning dividend income. There is no question of deduction of any amount paid as interest, to which provisions of section 36 (1) (iii) are applicable, while computing deduction under section 80M.”
3. Cases concerning shares acquired for the purpose other than to earn dividend; for example, to acquire controlling interest, etc.
If the ultimate motive of the assessee for acquiring shares of a company is to obtain controlling interest in that company, it cannot be said that the immediate purpose of acquisition of shares was to earn income from dividends. Consequently, the interest expenses incurred on the monies borrowed for acquisition of the shares cannot be reduced from the dividend income for section 57 (iii).
(i) CIT v/s. Amritaben R. Shah – [(1999) 238 ITR 777 (Bom)]
(ii) CIT v/s. Jardine Henderson Ltd. – [(1994) 210 ITR 981 (Cal)]
[Dividend merely an incidental benefit]
Refer also: SatishBalaMalhotra v/s. CIT – [(2017) 391 ITR 256 (P&H)]
C. CASES CONCERNING SHARES HELD AS STOCK – IN – TRADE
(i) There is a marked and subtle distinction between an investor in share and a dealer in share. More particularly, an investor’s intention is to earn dividend income while a dealer’s intention is to earn business profit. Therefore, if an individual invests in shares for the purpose of earning dividend, he is not carrying on the business and vice – versa.
Bengal & Assam Investors Ltd. v/s. CIT – [(1966) 59 ITR 547 (SC)]
(ii) In case of a dealer in shares, since purchase and sale of the shares generate taxable profit / loss, as long as such shares are capable of producing taxable profit, no part of expenditure can be disallowed on the plea that the dividend thereon is tax free.
{Ref: CIT v/s. Indian Bank Ltd. – [(1965) 56 ITR 77 (SC)]}
(iii) Dividend accruing on the shares held as stock – in – trade, as trading assets, retains the same character as business income.
Western States Trading Co. v/s. CIT – [(1971) 80 ITR 21 (SC)]
(iv) ‘In view of the law as laid down by the Supreme Court it appears to us that the expenditure in the instant case has been shown to be referable to the business activity carried on by the assessee and must be allowable under the head “Business income”. ….. We had occasion to consider a similar question in Income – tax Reference Nos. 365, 369 and 367 of 1971 (Commissioner of Income – tax v/s. Birds Investment (Anniversary Investment Agency)), where we held that where the assessee was holding shares as its circulating capital and it was not possible to ascertain if any shares were held solely for the purpose of earning dividends, there was no justification for apportioning the expenditure incurred by the assessee against income arising under two separate heads i.e., business and dividend.”
CIT v/s. New India Investment Corporation Ltd. – [(1978) 113 ITR 778 (Cal)]
–Followed in CIT v/s. Devenport& Co. Pvt. Ltd. – [(1986) 158 ITR 348 (Cal)].
–Followed in CIT v/s. Anniversary Investments Agencies Ltd. – [(1989) 175 ITR 199 (Cal)], where the Court observed: “There is no dispute that the assessee was doing investment business and holding of stock and shares par took of the nature of circulating capital. It was not possible to distinguish shares held solely for the purpose of earning dividend and to determine the borrowings made for the purpose of acquiring such shares and the interest paid thereon. It was not possible to attribute any particular item of expenditure for having been incurred solely for the purpose of earning dividend income. The shares being held as circulating capital for the business, the expenditure including the interest, has to be allowed as deduction in computing the business profits. In the premises, there is no question of allocation of such expenses between business income and dividend income.”
– Followed in CIT v/s. Enemour Investments Ltd. – [(1994) 72 Taxman 370 (Cal)], CIT v/s. Carolina Investments Ltd. – [(1996) 87 Taxman 238 (Cal)]–by holding that no apportionment is required vis – a – vis section 80M in case of a dealer in shares, “because in the type of cases like the one before us, the dividend income as such cannot have any outgoing so the question of reducing the gross dividend to net dividend does not at all arise”. Further, “Apportionment will only arise in the case where two or more types of business and expenditure have been incurred. In the absence of any particular expenditure incurred question of apportionment will not arise.”
(v) “The mere fact that income by way of dividend has accrued and that the expenditure incurred is in some manner or other related to the accrual of the dividend income is not sufficient. If this aspect is kept in view and the facts of the case are looked at, it becomes abundantly clear that the object of the assessee in incurring the expenditure was not to earn income by way of dividends.
The borrowing of the assessee by way of overdraft from the bank was not for the purposes of acquiring shares with the object of earning dividends on those shares, but the object of the borrowing was to purchase shares for the purposes of the assessee’s business, namely, buying and selling of shares and securities with a view to earning profits. The object of the borrowing thus was not for making or earning dividend income. ………The dividend received by the assessee from these shares and the interest paid by the assessee to the bank on the loan borrowed by it formed part of its normal business transactions, which as we have already stated is trading in shares and securities. These being the findings, it is not possible to agree with the Tribunal that the interest paid by the assessee to the bank on its borrowing was an expenditure incurred solely for the purposes of making or earning dividend income within the meaning of sub-section (2) of section 12.{parimateria with section 57}
Here the assessee firm is a dealer in shares. It is not a firm doing business of investing money in shares. The borrowings were not with the object of purchase of shares by way of investment with a view to earning dividend thereon. The object with which the borrowings were made was for the purposes of carrying on its business activities of purchasing and selling shares and securities. The accrual of the dividend income had only been incidental in the course of the business.”
CIT v/s. Jagmohandas J. Kapadia– [(1966) 61 ITR 663 (Bom)]
{Interestingly, while rejecting / objecting the claim of the assessee, it was the Department’s case that in case of dealers in shares, no expense can be attributable to the dividend income, as the same was purely incidental.}
(vi) “Where a shareholder receives dividend in respect of the shares held by him, the dividend is received because of the fact of his holding the shares. When an assessee deals in shares and buys them in order to sell them, his main activity is the purchase and sale of shares. It may no doubt be true that the possibility of earning substantial dividend from the shares is one of the circumstances which a dealer in shares takes into account. But his business really consists of purchase and sale of shares. He does not purchase shares with a view to get dividend, but the object of purchasing his shares is to earn profit by the sale of those shares. Earning of dividend is thus merely the incidental result of the main activity of the purchase of shares.”
[According to the Revenue in this case, the dividend income accrued to the assessee effortlessly and automatically by reason of his being owner of the shares in question and he could not, therefore, be said to have exerted himself for earning the said income. The Hon’ble Court accepted the stand and held that the dividend income was immediately derived from the ownership of the shares and not from any personal exertion.]
CIT v/s. D. G. Goenka–[(1981) 129 ITR 260 (Bom)]
Followed in: CIT v/s. RamdasLallubhai – [(1981) 130 ITR 150 (Bom)] – Rejecting the argument of the assessee that the receipt of dividend income was integral part of the business activity of the assessee which consisted of purchase and selling of shares.
Followed in:DeviduttDhurmal Bajaj v/s. CIT – [(1981) 131 ITR 16 (Bom)]
All these decisions involved interpretation of the term “earned income” within the meaning of erstwhile section 2 (47) (iii) of the Finance Act, 1962, which entitled an assessee certain relief if the income was “earned income”. The assessees claimed such relief on the ground that the dividends were earned by the assessees because of their personal exertion and, consequently, were their “earned income”. In the latter case, the Tribunal took the view that the dividend income was generated from mere ownership of shares and not from any activity on the part of the shareholders, “who having bought the share can sit back”. The High Court followed the decision of Bombay High Court in case of CIT v/s. D. G. Goenka–[(1981) 129 ITR 260 (Bom)], and observed as under:
“It is only after the dividend is properly declared that the amount so received by the assessee can be said to be dividend income. It may be that at the time of purchasing or selling of the shares, the assessee may be making an estimate of the expected dividend income while determining either the purchase or the sale price. But, at that stage, no income arises in the form of dividend and, therefore, the argument that dividend income results from personal exertion put in at the time of either acquisition or sale of shares and must, therefore, qualify for being described as "earned income" cannot be accepted.”
(vii) In case of an assessee carrying on business of shares, the expenditure incurred on account of brokerage, share transfer expenses and interest evidently do not fall under either of the two clauses of section 57. “There is nothing to show that any part of it was incurred for earning dividend income”. That being so, it is not allowable as a deduction in the computation of dividend income. The Income Tax officer, therefore, had no power to bifurcate the same on pro rata basis and deduct a part of it from the dividend income. “If the ITO was of the opinion that the whole of the expenditure claimed by the assessee was not allowable as a deduction in computation of business income, he could have said so and restricted the deduction to an amount which is permissible deduction. But deducting a part of it from dividend income without any material to show that it falls under either of the two clauses of section 57, is not tenable in law.”
CIT v/s. Mahendra S. Shah – [(1993) 203 ITR 178 (Bom)]
(viii) “In the case of a dealer in shares, as in the present case, the dividend retains the character of business income though assessed under section 56. The interest on the borrowings is paid for the purpose of business and therefore, allowable under section 36 (1) (iii). The interest paid is not expenditure laid out or expended wholly or exclusively for the purpose of earning the dividend as required under section 57 (iii) and therefore, should not be reduced under section 57 from the dividend income.”
CIT v/s. Emrald Co. Ltd. – [(2006) 284 ITR 586 (Bom)]
{A case of a dealer in shares, where the A.O. had computed exemption u/s. 80M on net basis, after deducting interest component in accordance with the provision of section 56,57, and 58 of the Act. The High Court distinguished the ratio laid down in Distributors (Baroda) P. Ltd. v/s. UOI – [(1985) 155 ITR 120 (SC)], on the reasoning that that case was limited to the question whether deduction under section 80M was available with respect to the gross or net amount of dividend in a case where the assessee was an investment company and not a trader dealing in shares.}
(ix) In case of dealers, unlike investors, shares are not purchased with the object of earning any dividend. Unless evidence is brought on record that purchase at price cum – dividend, it cannot be said that any part of consideration included cost of dividend. Contract of sale is relevant.
Intention of parties must provide, expressly or impliedly, that consideration is paid either for specified goods to be transferred or services to be rendered or both. If there is no such contract, then no part of the consideration can be attributed to any other element, which is incidental to the performance of the contract. Merely because something passes alongwith subject matter intended under the contract would not mean that any part of the consideration is related to that element.
Nothing can be inferred on suspicion. Where shares are purchased without intention of purchasing dividend element, then the entire dividend received should be considered as income and no cost can be attributed to such dividend. In such cases, burden is on revenue.
Smt. Rekha Bharat Chheda v/s. ACIT – [(2007) 107 ITD 245 (Mum)]
{A case decided in the context of section 10 (33)}
D. In fact, there are many cases concerning allowability of expenditure when dividend was taxable u/s. 56 of the Act[Income from Other Sources], where the Courts adopted the test of intention / object / motive behind incurring such expenditure while adjudicating the issue of allowability or otherwise of such expenditure. Two of such judgements, randomly selected, are:
Sarabhai Sons (P) Ltd. v/s. CIT – [(1993) 201 ITR 464 (Guj)] – Test of dominant purpose
CIT v/s. Smt. Swapna Roy – [(2011) 331 ITR 367 (All)]
II. THE LEGISLATIVE HISTORY
There was no such provision, prior to introduction of section 14A, concerning disallowance of expenditure vis– a – vis tax free income or for such apportionment of business expenses. The nearest provision, perhaps, was the erstwhile section 20 of the Act, which was in existence till 31.03.1989.Interestingly, section 20, which fell under the erstwhile head “Interest on Securities” provided for allowing deduction,frominterest income on securities held by a banking company being taxed under this separate head, of common expenses in proportion of receipt from interest on securities to gross receipts by such banking company.Normally, such interest income is a part of business income of a banking company, with common administrative and other expenses that are fully allowable under various sections under the head “Profits and gains of business”, like sections 30, 31, 36 and 37. It was only that since, only for the tax purpose, such interest income was to be taxed under a separate head of income – while rest of the operational income continuing to be taxed under the head “Profits and gains of business” – with all expenses to earn both types of income being common and otherwise allowable under the above referred sections, that a need arose to allocate a portion of such common expensestowards such interest income so that the results are not distorted. As such, this was an enabling provision, to enable banks to reduce their income on securities by the expenses related thereto and not a restricting section putting bar or restriction on allowability of any expense. It will be of relevance if two of the decisions concerning section 20 are briefly discussed.
1. Citibank N.A. v/s. CIT – [(2003) 262 ITR 47 (Bom)]
In this case, the Department sought to apply the cap / restriction of section 40A (5) to such allocated expense under section 20 as well. The Bombay High Court rejected this contention on the ground that “section 40A cannot be read into section 20 merely because section 20(1)(i) refers to appointment of common expenditure allowable, inter alia, under sections 36 and 37.”
2. CIT v/s. Central Bank of India – [(2003) 264 ITR 522 (Bom)]
In this case, the Bombay High Court rejected the action of the Department in importing the ‘Rule of Proportionate expenditure’ contemplated by section 20 into section 80M of the Act, by holding that such rule of section 20 is based on estimation of expenses, whereas the exemption / deduction under section 80M is allowable on dividend after taking into account only actual expenditure incurred for the purpose of earning such dividend income.
SUMMATION OF PRE SECTION 14A LEGAL POSITION
Keeping in mind the legislative intention behind introducing section 14A and the mischief that was sought to be avoided, upon analysis of the judgments that were rendered prior to introduction of section 14A, the following position emerge:
1. In computing “profits and gains of business or profession”, when an assessee is carrying on business in various ventures and some among them yield taxable income and the other do not, if all the ventures constitute one indivisible business, the entire expenditure, if otherwise fulfill requirements of allowability as deduction under normal provisions of the Act, will be permissible deduction.
{Ref: Rajasthan State Warehousing Corp. v/s. CIT – [(2000) 242 ITR 450 (SC)]}
2. To put it differently, an expense, for this purpose, could be categorized into three types:
(i) An expense which is clearly and identifiably incurred in relation to earning tax free income:
There was, and also is, no dispute about the proposition that such expense was, and is, never allowable as deduction, with or without section 14A.
(ii) An expense which is incurred in relation to earning taxable income:
There was, and also is, no dispute about the proposition that such expense is fully allowable, with or without section 14A, if it otherwise fulfills the conditions of the respective provisions under which the deduction is claimed. This is even if a tax free income got generated purely incidentally in the process.
(iii) An expense which is, admittedly and as a matter of fact, incurred in relation to earning tax free income, but arising from indivisible businesses [generating taxable and tax free income] and it is not possible to clearly identify / quantify such expense separately
The only dispute, if at all, was with respect to this type of expense. As per the ratio of the Supreme Court in case of Rajasthan State Warehousing Corpn., the assessee would be allowed deduction of this third type of expense as well, in absence of any legislative provision to disallow a part of it. In other words, the dispute was only with respect to a case where, admittedly, (i) there was a specific and identified exercise / business to earn tax free income and (ii) some expenses were incurred for earning such tax free income and (iii)the businesses (generating tax free income and taxable income) wereindivisible.
3. It should be reiterated that there was no dispute about the first two types of expenses. Neither section 14A affects the judicial precedents on the type of expenses referred to at (i) and (ii) in the preceding para nor was that the legislative intent. The insertion of section 14Awas brought vide Finance Act, 2001 in the wake of the decisions concerning the situation at (iii). As per the legislative intention itself, section 14A was introduced only to overcome the decisions concerning the situation at (iii). Therefore, at the most, it can be said that the section seeks to nullify the ratio laid down by the Supreme Court in the case of Rajasthan State Warehousing Corporation. A very crucial aspect to be appreciated is that in both the cases of Maharashtra Sugar Mills and Rajasthan State Warehousing, the assessees were undertaking, admittedly and undisputedly identifiable, planned and organized activity specifically to earn income, which was exempt from tax, alongwith other activities generating taxable income and, again, admittedly, certain expenses were incurred for these activities. This is in contrast with a case where an assessee merely happens to earn tax free income, like dividend, only incidentally and not as a part of any organized business activity specifically carried on to earn such tax free income. In other words, where, admittedly,some specific exercise / business is undertaken to earn tax free income and, again, admittedly, some expenditure has been incurred for earning such tax free income, that such expenditure, or a portion thereof, is now sought to be disallowed, even if it is not possible to identify / correlate such expenses precisely or directly.However, if there is only one business (say, in case of a share dealer) and that is carried on only to earn taxable income then the ratio of the judgment in the case of Rajasthan Warehousing or Maharashtra Sugar does not get attracted..
4. Further, almost all Courts looked into the object / intention behind incurring a particular expenditure vis – a – vis earning of tax free income, like dividend, interest, etc., while ultimately rejecting disallowance made on apportionment basis. Conversely, the Courts looked into primary object / intent also for rejecting a claim of deduction, more specifically, in terms of section 57 (iii) of the Act. Accordingly, while on one hand it was held that no disallowance out of business expenses was called for in cases of shares& securities held as trading assets / business assets just because a tax free interest / dividend income happened to get generated; on the other hand, expenditure was held to be not allowable / allocable against dividend income, where shares were acquired for controlling purpose, on the ground that the intention was not to earn dividend income.
5. Importantly, while taxing dividend income under the head “Income from other sources”, in fact, it was the Department which used to refuse such assessees deduction of various expenses on the ground that the dividend income is earned effortlessly and no specific expense can be attributable to it.
6. Even assuming dividend income is to be given exemption on net basis, it could be reduced, if at all and at the most, only by actual expenses incurred. There is no scope for any assumed or notional expense to be apportioned.
7. From the above analysis of the position prior to insertion of section 14A, at least one aspect that definitely emerges is that the ‘theory of apportionment’ was not inherent, much less widely and commonly method, in the matter of allowing business deductions vis – a – vis earning to tax free income. Far from it, there was consensus of opinion against that. The rule of apportionment was confined to very few specific and selected area, like section 20, that too, as a matter of allowance and not disallowance.
III. THE LEGISLATIVE INTENTIONFOR INTRODUCING SECTION 14A
1. The only indicator of the legislative intention is the Memorandum explaining the introduction of section 14A, as found in Finance Bill, 2001 and the circular issued thereafter, being Circular No. 14 of 2001, both of which contain, more or less, same language and intent. A bare perusal of both would reveal that what is intended to be covered by section 14A are only those expenses that are “incurred to earn the exempt income …..”. The phraseology used in this regard is near, and somewhat akin, to the language used in section 57 (iii) of the Act, which phraseology has been held to be narrower than ‘for the purpose of’ as found in section 37 of the Act, by catena of decisions. This similarity is for the obvious reason that section 14A seeks to take back / disallow what would have been otherwise allowable, if the dividend was taxable. Dividend was taxable u/s. 56 and the only deductions allowable were as enumerated in section 57, which section, it has been held in many cases, has narrower scope. As such, the legal precedents concerning dividend income vis – a – vis section 57 would be of relevance, especially when the phrase “in relation to” is not defined in the Act.
2. In fact, the last part of the circular is very significant in as much as it says that: “Expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income.”.
As such, it is clearly stated in the circular itself that the expenses which are relatable to earning taxable income are to be allowed, as per the legislative intent itself. As such, section 14A affects, and is intended to affect, only the third type of expense, as illustrated above. This is also accepted by the Department, being in consonance with the ratio laid down by the Apex Court in Walfort’s case. In fact, this is also accepted by the Supreme Court in both the cases, that is, Walfort and Maxopp.
This is of immense significance, as will be discussed in Part Three.
PART TWO
POST SECTION 14A POSITION
LEGAL PRECEDENTS ON THE ISSUE
There have been many decisions of the Tribunal and high courts and also of the Apex Court on various aspects of section 14A that may be relevant for this article; many of which are in favour of the proposition that:
– Section 14A being a disabling section, the onus / burden is on the Department, which is also very heavy, to prove that some expenditure is incurred in relation to a tax free income.
– Nexus, connection and relationship between the expenditure and earning of the tax free income should be clearly established. There is no room for any assumption or presumption.
– In case of stock – in – trade, dividend is merely incidental to the holding of, and trading in, shares for a particular period when the dividend is declared. The intention is to earn profit in share trading and not to earn dividend. Thus, the provisions of section 14A cannot be invoked.
– In case of shares held as strategic investments, the same are acquired and held purely as a part of strategic business decision affecting a group as a whole, not with the intention of earning dividend. Therefore, section 14A does not get attracted in such cases as well.
Since, in view of the Apex Court decision in Maxopp’s case, at least the last two propositions are regarded as no longer correct, the decisions pertaining to those issues are not analyzed for the sake of brevity. However, only few decisions are discussed, before adverting to the decision of Maxopp.
1. DECISION IN CASE OF MAXOPP (TRIBUNAL) TAGGED ALONGWITH DAGA CAPITAL
(i) The origin of this entire controversy can be traced to the famous decision in case of ITO v/s. Daga Capital Management Ltd. – [(2008) 312 ITR (AT) 1 (Mum) (SB)], rendered by Special Bench of the Income Tax Appellate Tribunal, Mumbai, with which the appeal of Maxopp was also tagged and heard. Interestingly, the issue before the Special Bench can be summarized by the very – and the only– question that was referred to the Special Bench, which is as follows:
“Whether, in the facts and the circumstances of the case and in law, the provisions of section 14A of the Income tax Act, 1961, are applicable with respect of dividend income earned by the assessee engaged in the business of dealing in shares and securities, on the shares held as stock in trade and when earning of such dividend income is, therefore, incidental to trading in shares?”
The issue in case of the lead appeal, filed by the Department in case of Daga Capital, was whether section 14A was applicable when dividend was received on the shares held as stock in trade, where, admittedly, interest expenses were incurred in acquisition of the shares. However, the issue involved in the case of Maxopp Investment Ltd. [“Maxopp”] was somewhat different. Maxopp was in the business of finance, investment and dealing in shares and securities. The shares and securities were held partly as investments [capital account] and partly as trading assets. Significantly, the shares held as ‘trading asset’ were for the purpose of acquiring and retaining control over group companies, primarily, Max India Ltd.
(ii) For A.Y. 2002 – 2003, Maxopp declared profit of Rs. 1,28,81,291/- as per P & L A/c, which included receipt of the following nature:
* Interest on loans advanced Rs. 1,94,70,181/-
* Dividend received Rs. 49,90,860/-
[From shares of Max India Ltd.]
* Profit on sale of shares [business income] Rs. 1,49,285/-
Against this,Maxopp had incurred total interest expenditure of Rs. 1,16,21,168/-, which was claimed as deduction u/s. 36 (1) (iii) of the Act. Against the loan taken of Rs. 8,33,40,000/-, Maxopp had given loans of Rs. 14,62,85,000/-.
(iii) Significantly, Maxopp had not denied having incurred interest expenditure with respect to the investment in shares, including shares held as trading asset. Before the A.O., its argument against invocation of section 14A was that “it has acquired shares for selling it as a profit in future and not for earning dividend. According to the assessee, the dividend income was only incidental to such acquisition of shares.”{Refer para 8 of the decision}.
(iv) Rejecting the argument of the assessee, the A.O. invoked section 14A of the Act and apportioned the interest expenditure in the ratio of investment in the shares of Max India Ltd. to the principal amount of the loans, which worked out to Rs. 67,74,175/-. However, the A.O. restricted the disallowance to the extent of the tax free dividend income received, that is, Rs. 49,90,860/-. The CIT (A) confirmed the assessment order.
(v) It was under this specific fact situation that Maxopp’s appeal before the Tribunal, against such CIT (A) order, was tagged with the appeal in the case of Daga Capital Management P. Ltd. and heard by the Special Bench of the Tribunal. Before the Special Bench, Maxopp’s main argument was that the shares (‘investments in quoted shares’) were held as trading assets/ stock in trade, the income arising from sale thereof was being taxed as business income. It is relevant to note here that it was only because of this sole and specific contention that the appeal of Maxopp was tagged with that of Daga Capital, with the only question posed before the Special Bench being applicability of section 14A vis– a – vis shares held as stock in trade.
(vi) It is important to note that before the Special Bench, it was the Department’s argument as well that “To put it differently, the expenses which are directly related to taxable income are to be allowed as deduction.”
(vii) The findings and the observations of Hon’ble Vice – President (minority view, so far as the answer to the question before the Special Bench), as relevant for the present purposes, are as under:
(a) The expression ‘in relation to’ in section 14A of the Act must be understood in the same sense in which their Lordships of the Apex Court understood in the case of H. H. MaharajadhirajaMadhavRaoJivajiRaoScindiaBahadur of Gwalior(supra). Accordingly, the expression ‘in relation to’ would mean dominant and immediate connection. This means that disallowance of expenditure under section 14A can be made only when there is dominant and immediate connection between the expenditure incurred and the income not forming part of the total income. As a necessary corollary, it would mean that disallowance cannot be made if the connection is not dominant and immediate but is merely incidental, ancillary or remote one. The contention of the revenue that the expression ‘in relation to’ would mean any and every relation except remote is, therefore, rejected.
(b) A perusal of this decision [of M/s. Doypack Systems P. Ltd.] shows that it was rendered by Bench of two Judges without considering the decision of the Constitution Bench of Eleven Judges in the case of H. H. Maharajadhiraja Madhav Rao Jivaji Rao Scindia Bahadur of Gwalior (supra). It is a settled rule of precedence that in case of any conflict of opinion between the views expressed by different Benches of a Court then the view taken by the Larger Bench would prevail since the Division Bench cannot enlarge the scope of the decision rendered by the Larger Bench. Therefore, in our opinion, the later decision cannot be applied to determine the scope of section 14A of the Act.
(c) Having held as above, the next question is how to determine the nature of the connection between the expenditure incurred and the income earned by the assessee. In our opinion, the answer to this question would depend upon the intention/object with which the expenditure was incurred. If the expenditure is incurred with a view to earn the taxable income then it can be said that dominant and immediate connection exists between the expenditure incurred and the taxable income and consequently, no disallowance under section 14A can be made even where some tax free income is received incidentally. On the other hand, if the expenditure is incurred mainly with a view to earn the tax-free income then it can be said, that the dominant and immediate connection exists between the expenditure incurred and in the tax-free income and consequently disallowance under section 14A can be made even though some taxable income may arise incidentally.
However, there may also be cases where the expenditure may be incurred with a view to earn tax-free as well as taxable income simultaneously from an indivisible activity. Therefore, in such cases, in our opinion, the disallowance can be made under section 14A on proportionate basis in accordance with the provisions of sub-sections (2) and (3) of section 14A of the Act. At this stage, it may also be pointed out that section 14A was inserted with a view to overcome the effect of the decision of the Supreme Court in the case of RajasthanState Warehousing Corpn. (supra).
(d) Since the existence of dominant and immediate connection is the condition precedent for invoking the provisions of section 14A of the Act, in our opinion, the mere receipt of dividend income incidentally in the case of dealer in shares would not be sufficient for invoking the provisions of section 14A of the Act.”
(e) However, dealing with the facts of the case of Maxopp, the Hon’ble Vice-President observed as under:
“On the basis of the above factual details, it is clear that motive/intention of the assessee was to acquire and hold the shares on long-term basis as an investment company. So the dominant intention is not to sell the shares on regular basis. Since the intention of the assessee is not to sell the shares of these companies in the near future, in our opinion, it cannot be said that there is any dominant and immediate connection between the interest paid and the taxable profits on the sale of shares.”
(viii) However, the Special Bench, by majority decision (2– 1) held that the provisions of section 14A are applicable also to the cases where shares are held as stock – in – trade, even if the earning of dividend is only incidental. Incidentally, the majority decision relied, mainly, on Rule 8D for their conclusion, which rule was introduced only in March’ 2008 and which rule, and the aspect about its retrospectively, was not a subject matter of reference before the Special Bench. In fact, the reference was made when the said rule was not in the statute book. Interestingly, the hearings were already fixed, but adjourned, prior to introduction of Rule 8D. It is, therefore, interesting to ponder what would have been majority judicial view sans the rule, especially Rule 8D now having held to be having prospective operation by the Apex Court in the case of EssarTeleholdings Ltd.
(ix) As discussed earlier, the issue of applicability of section 14A vis– a – vis shares held as strategic investments was not at all a subject matter of reference before the Special Bench. In fact, it was for the first time before the Special Bench that Maxopp also argued that the shares were acquired with the intention to acquire and retain controlling interest of the investee company and that the receipt of the dividend thereon was only incidental. This latter argument about controlling interest was dismissed by the Special Bench at the very threshold, by holding that
“The mere fact that the assessee was one of the promoters of the above two companies, would not lead to the conclusion that the only purpose for acquiring the shares was to have controlling interest. There is nothing on record to hold that investment in shares of these two companies was made with a view to have controlling interest.”
As such, it should be noted that the legal aspect of controlling interest vis – a – vis section 14A was not even adjudicated, though raised by Maxopp for the first time before the Special Bench, as the Bench found the same not having been proved as a matter of fact.
(x) While Hon’ble Vice – President held non – applicability of section 14A vis– a – vis stock – in – trade while dismissing Department’s appeal in case of the lead appeal of Daga Capital [thereby holding in favour of the assessee], in case of Maxopp, which was assessee’s appeal, Hon’ble Vice – President decided against the assessee, with the above observations. The other two Hon’ble Members, while dissenting from the view of Hon’ble Vice – President on the aspect of stock in trade [as concerned with the case of Daga Capital], did not give any separate / dissenting observations as far as the facts concerning Maxopp, thereby confirming the view of Hon’ble Vice – President so far as the case of Maxopp was concerned.
2. CIT V/S. WALFORT SHARES & STOCK BROKERS P. LTD. – [(2010) 326 ITR 1 (SC)]
[A.Y.: 2000 – 2001]
Before proceeding to analyse subsequent decisions on this aspect and the ultimate decision of the Apex Court in Maxopp, it is most essential to analyse the decision of the Apex Court in the case of Walfort Shares. Since this decision, in a way, ultimately forms bedrock for the decision in the case of Maxopp, it is essential that this decision is analyzed in extenso, so as to appreciate the context and the background leading to the observations contained therein, which observations have been used extensively in numerous cases rendered thereafter, including in the case of Maxopp.
A. THE BACKGROUND / FACTS
(i) The assessee, a member of Bombay Stock Exchange, earned income mainly from share trading (own account and clients account) and brokerage. One Chola Mutual Fund [“the Fund”] published an advertisement in newspapers sometime in March, 2000, inviting the general public to invest in their units before 24th March, 2000 and get double advantage, namely, 100 per cent investment in high growth technology stocks and 40 per cent tax free dividend on the said units, subject to 2 per cent entry load and 2 per cent charge on exit if the unit purchaser sought redemption of the units within 3 months of purchase. Within two days of the advertisement, the Fund sold nearly 67 crore units to taxpayers for a consideration of Rs. 1,200 crores and paid dividend at the rate of Rs. 4 per unit. On the next working day, the Fund repurchased the entire 67 crore units from the taxpayers for approximately Rs. 873 crores. The balance amount, it was alleged by the Department, represented the dividend payout. The Fund had income of only Rs. 2.72 crores but it had distributed dividend of Rs. 290 crores, without, it was alleged, having reserves or any other funds to do so.
(ii) The assessee purchased 45,53,215 units at total cost of Rs. 8 crores and sold them on the very next working day, as follows:
|
Basic rate per unit |
2% Load |
Total |
|
|
In Rs. |
In Rs. |
In Rs. |
|
|
Purchased on 24-3-2000 |
17.23 |
0.34 |
17.57 |
|
Sold on 27-3-2000 |
13.23 |
0.26 |
12.97 |
|
Difference |
4.00 |
[NAV: Net Assets Value]
{The fall in NAV was exactly same as the amount of dividend payout.}
As such, against the total investment of Rs. 8 crores, the assessee received:
Rs. 1,82,12,862/- Dividend at Rs. 4/- per unit (on the very same date of purchase)
Rs. 23,76,778/- Incentive
Rs. 5,90,55,207/- Sale proceeds
———————
Rs. 7,96,44,847/- Total
=============
The assessee claimed the dividend of Rs. 1,82,12,862/- as exempt u/s. 10 (33) of the Act and also claimed set off of the loss of Rs. 2,09,44,793/- in its return [Rs. 8 crores less Rs. 5.90 crores].
(iii) The Assessing Officer, accepting the exemption for the dividend income, disallowed the loss of Rs. 2,09,44,793/- by reducing therefrom the incentive income of Rs. 23,76,778/-. In other words, the loss disallowed was Rs. 1,82,12,862.80, which was the same as the amount of the dividend income. This disallowance was confirmed by CIT (A), who confirmed that this loss is to be totally ignored and the same should not be allowed to be set off or carried forward. The Special Bench of the Tribunal, however, deleted the disallowance.
(iv) It was in this background that the following two questions were admitted by the Hon’ble Bombay High Court for adjudication:
“(i) Whether on the facts and in the circumstances of the case, the Tribunal was justified in holding that the transaction of purchase and sale of the units of Chola Freedom Technology Fund was a bona fide commercial transaction and not a colourable device adopted with a view to avoid the tax liability and, therefore, the loss arising from the transaction was liable to be set off against the taxable income of the assessee?
(ii) Whether on the facts and in the circumstances of the case, the Tribunal was justified in holding that the artificial loss arising from the above transaction could not be considered as an expenditure incurred for earning tax free dividend, so as to make disallowance under s. 14A of the IT Act, 1961?”
It should be noted that it was only by way of an alternative argument that the issue regarding implication of section 14A cropped up, when the Department argued that the artificial loss incurred by the assessee would constitute ‘expenditure’ incurred for earning the tax free dividend income and hence,otherwise also, disallowable under section 14A of the Act. It was claimed, alternatively, that the differential amount between the purchase price and sale price of the units constituted ‘expenditure’ incurred by the assessee for earning the tax free dividend income.
(v) The main case of the Department was that the entire dividend stripping transactions, which were entered into with the connivance of the mutual fund and brokers, were pre –designed & preordained / bogus / sham / paper transactions having no real commercial purpose or intention, except to earn tax free income and for set off of the pre – knowledged occurrence of the resultant loss. As such, the loss was artificial loss. Thus, in effect, it was alleged, the mutual fund returned to the tax – payers their own money within a span of a day or two in two different nomenclatures, namely, dividend and sale proceeds. Nothing materially had happened to alter the financial position of the tax – payer except to the extent of entry/exit load paid to the mutual funds. Apart from other, heavy reliance was placed on the decision of the Apex Court in the case of McDowell on the aspect of tax avoidance.
On the other hand, the claim of the assessee was that it had off loaded the units solely to guard against the further loss in the wake of fall in price of the units, which sale was based on the Net Assets Value (NAV) and it had nothing to do with the dividend declared by the Fund. According to the assessee, prior to the insertion of section 94 (7) by Finance Act, 2001 w.e.f. 01.04.2002, it was legally permissible to claim the loss in the manner in which the assessee had done and the same was allowable.
B. PER HIGH COURT
(i) “The basic question to be considered in this appeal is, where dividend bearing units of a mutual fund are purchased on or before the record date and redeemed at a loss immediately after the record date, whether the loss could be disallowed on the ground that the transaction was not a business transaction and that the transaction was executed with the sole intention of tax avoidance by creating artificial loss which could be set off against other taxable income of the assessee?”
(ii) After analysing the legislative background and history, including the circular issued in the context of section 94(7), the Court, inter alia, held that the Revenue cannot take a stand which renders section 94(7) redundant or nugatory. The Court further observed that it is only because such losses were allowable and it resulted in revenue loss that section 94(7) has been enacted subsequently but prospectively.
(iii) The Court also rejected the arguments of the Department based on the alleged tax avoidance motive.
(iv) It was only at the end of the decision that the Court dealt with the alternative argument on the aspect of section 14A, in one para, as follows:
“… … What section 14A contemplates is the expenditure actually incurred for earning tax free income and not assumed expenditure or deemed expenditure. In these circumstances, the decision of the Tribunal in rejecting the alternate argument of the Revenue cannot be faulted.”
C. BEFORE THE SUPREME COURT
It appears that by the time the matter travelled to its last destination, the main focus of the controversy shifted, from tax avoidance/fiscal nullity to sec. 14A issue, which is evident from the issues formulated by the Apex Court as follows:
[Page 21]
“In this batch of cases, we are required to decide three distinct points which are as follows:
(a) Whether “return of investment” or “cost recovery” would fall within the expression “expenditure incurred” in section 14A?
(b) Impact of section 94(7) w.e.f. 1st April, 2002 on the impugned transactions.
(c) Reconciliation of section 14A with section 94(7) of the Act.
… … …
… … …
The main issue involved in this batch of cases is whether in dividend stripping transaction (alleged to be colourable device by the Department) the loss on sale of units could be considered as expenditure in relation to earning of dividend income exempt under section 10(33), disallowable under section 14A of the Act?”
D. AS PER DEPARTMENT
(i) Apart from the main attack on the aspect of colourable device / fiscal nullity, in so far as the aspect of sec. 14A is concerned, it was argued, alternatively, that if the so-called “dividend” did not constitute a return of investment, then since the price of units necessarily included the price of dividend as an identifiable element embedded therein to which a definite value could be assigned at the time of the purchase, the “dividend” was in effect “paid for”. In such circumstances, that part of the price of units which clearly represented the cost of the dividend was the expenditure incurred for obtaining the exempt dividend income and if that is the case then section 14A requires that such expenditure should be netted against the receipt of dividend. In the present case, Rs. 4 will be expenditure attributable towards earning tax – free dividend income which is disallowable under section 14A of the Act.
(ii) Only that expenditure is deductible which is incurred in relation to business or profession. Expenditure which is incurred in relation to income subject to tax would be admissible under sections 30 to 43B whereas expenditure incurred to earn exempt income would be extraneous.
(iii) In all cases where the assessee has some exempt income, his total expenditure has got to be apportioned between taxable income and exempt income and the latter would have to be disallowed.
E. AS PER THE ASSESSEE
{In so far as the aspect of section 14A is concerned}
(i) The two provisions, ss. 94(7) & 14A, operate in different time and space zones, having different objects. If section 14A is also to apply simultaneously then section 94(7) will become nugatory.
The term ‘loss’ as contained in section 94(7) and the term ‘expenditure’ as contained in section 14A are conceptually different. Section 14A is not concerned with a purchase and subsequent sale of an asset which is dealt with in section 94(7) alone.
(ii) The embargo in section 14A on the deductibility of expenditure applies where admittedly an expense has been incurred and a deduction is claimed specifically in respect thereof.
As such, the issue of section 14A was argued by both the sides only alternatively and, that too, cursorily. Neither the legislature history nor even any legal precedent was cited, much less argued.
F. PER THE SUPREME COURT
It was in the above factual matrix that the Apex Court made certain observations, while dismissing the Department’s appeal, concerning section 14A. The observations are summarized as under (Page 25 onwards of Report):
(i) The insertion of section 14A with retrospective effect is the serious attempt on the part of the Parliament not to allow deduction in respect of any expenditure incurred by the assessee in relation to income, which does not form part of the total income under the Act against the taxable income (see Circular No. 14 of 2001 dt. 22nd Nov., 2001). In other words, section 14A clarifies that expenses incurred can be allowed only to the extent they are relatable to the earning of taxable income. In many cases the nature of expenses incurred by the assessee may be relatable partly to the exempt income and partly to the taxable income. In the absence of section 14A, the expenditure incurred in respect of exempt income was being claimed against taxable income.
(ii) The basic principle of taxation is to tax the net income, i.e., gross income minus the expenditure. On the same analogy the exemption is also in respect of net income. Expenses allowed can only be in respect of earning of taxable income. This is the purport of section 14A.
(iii) The permissible deductions enumerated in sections 15 to 59 are now to be allowed only with reference to income which is brought under one of the above heads and is chargeable to tax. If an income like dividend income is not a part of the total income, the expenditure / deduction though of the nature specified in Sections 15 to 59 but related to the income not forming part of total income could not be allowed against other income includible in the total income for the purpose of chargeability to tax.
(iv) The theory of apportionment of expenditures between taxable and non-taxable has, in principle, been now widened under s. 14A. Reading s. 14 in juxtaposition with ss. 15 to 59, it is clear that the words "expenditure incurred" in s. 14A refers to expenditure on rent, taxes, salaries, interest, etc. in respect of which allowances are provided for (see ss. 30 to 37). Every payout is not entitled to allowances for deduction. These allowances are admissible to qualified deductions.
These deductions are for debits in the real sense. A pay-back does not constitute an "expenditure incurred" in terms of s. 14A. Even applying the principles of accountancy, a pay-back in the strict sense does not constitute an "expenditure" as it does not impact the P&L a/c.
(v) Therefore, one needs to read the words "expenditure incurred" in s. 14A in the context of the scheme of the Act and, if so read, it is clear that it disallows certain expenditure incurred to earn exempt income from being deducted from other income which is includible in the “total income” for the purpose of chargeability to tax.
(vi) For attracting s. 14A, there has to be a proximate cause for disallowance, which is its relationship with the tax exempt income. Pay-back or return of investment is not such proximate cause, hence, s. 14A is not applicable in the present case. Thus, in the absence of such proximate cause for disallowance, s. 14A cannot be invoked.
(vii) In our view, return of investment cannot be construed to mean "expenditure" and if it is construed to mean "expenditure" in the sense of physical spending still the expenditure was not such as could be claimed as an "allowance" against the profits of the relevant accounting year under ss. 30 to 37 of the Act and, therefore, s. 14A cannot be invoked.
(viii) The fact that the dividend received was tax-free is the position recognized under s. 10(33) of the Act. The assessee had made use of the said provision of the Act. That such use cannot be called "abuse of law". Even assuming that the transaction was pre-planned there is nothing to impeach the genuineness of the transaction. With regard to the ruling in McDowell & Co. Ltd.’s vs. CTO (1985) 47 CTR (SC) 126: (1985) 154 ITR 148 (SC), it may be stated that in the later decision of this Court in Union of India vs. AzadiBachaoAndolan&Anr. (2003) 184 CTR (SC) 450: (2003) 263 ITR 706 (SC) it has been held that a citizen is free to carry on its business within the four corners of the law. That, mere tax planning, without any motive to evade taxes through colourable devices is not frowned upon even by the judgment of this Court in McDowell & Co. Ltd.’s case (supra).
(ix) … (after 1-4-2002) Parliament has not treated the dividend stripping transaction as sham or bogus.
(x) Sections 14A and 94(7) were simultaneously inserted by the same Finance Act, 2001. As stated above, s. 14A was inserted w.e.f. 1st April, 1962 whereas s. 94(7) was inserted w.e.f. 1st April, 2002. The reason is obvious. Parliament realized that several public sector undertakings and public sector enterprises had invested huge amounts over last couple of years in the impugned dividend stripping transactions so also declaration of dividends by mutual fund are being vetted and regulated by SEBI for last couple of years. If s. 94(7) would have been brought into effect from 1st April, 1962, as in the case of s. 14A, it would have resulted in reversal of large number of transactions. This could be one reason why the Parliament intended to give effect to s. 94(7) only w.e.f. 1st April, 2002. It is important to clarify that this last reasoning has nothing to do with the interpretations given by us to ss. 14A and 94(7). However, it is the duty of the Court to examine the circumstances and reasons why sec. 14A inserted by Finance Act, 2001 stood inserted w.e.f. 1st April, 1962 while s. 94(7) inserted by the same Finance Act as brought into force w.e.f. 1st April, 2002.
(xi) Sections 14A and 94 (7) operate in different fields. Section 14A comes in when there is claim for deduction of an expenditure whereas section 94(7) comes in when there is claim for allowance for the business loss. We may reiterate that one must keep in mind the conceptual difference between loss, expenditure, cost of acquisition, etc. while interpreting the scheme of the Act.
As such, while making the above observations, it appears, the conceptual issues of section 14A were not analysed, much less was interpretation of the term “in relation to”. Neither the legislative history of section 14A was traced nor was any legal precedent on this aspect discussed or analysed.It is, therefore, to be seen whether the observation regarding ‘theory of apportionment’ was in the context of the issue / subject matter involved in the appeal or whether it had relevance or effect on the final decision or the ratio laid down in that case.
3. MAXOPP INVESTMENT LTD. V/S. CIT – [(2012) 347 ITR 272 (DEL)]
Against the order of the Special Bench discussed at Sr. 1, Maxopp preferred appeal before Delhi High Court.
A. ARGUMENTS OF THE ASSESSEE BEFORE HIGH COURT
{Importantly, again, it was not the case of the Maxopp even before the High Court that no interest expenditure was incurred for acquiring the shares on which the dividend was received; it was not even the case of the source being mixed funds. The only case of the Maxopp was that the intention behind acquiring the shares was to acquire and retain control of operating companies, which amounted to business and, consequently, the dividend income on such shares was in the nature of business income.}
(i) The word ‘incurred’ must be taken literally in the sense that the expenditure must have actually taken place. Further, such expenditure must also should have taken place ‘in relation to’ the tax free income, implying the direct and proximate connection with the subject matter.
(ii) The expression ‘in relation to’ means having a dominant and immediate connection with, and does not mean merely having a reference to.{Relying upon the decision of the Supreme Court in the case of MadhavRaoScindia v/s. UOI – [AIR 1971 SC 530]}. It means a direct and proximate relationship {Relaying upon Navin Chemicals Manufacturing and Trading Co. Ltd. v/s. Collector of Customs – [1993 (68) the LT 3 (SC)]}.
B. FINDINGS OF THE COURT
(i) The Court analyzed the legislative history of section 14A as well as the law prior to section 14A, including the principles laid down in the case of Maharashtra Sugar Mills Ltd. and Rajasthan State Warehousing Corporation. (as discussed earlier).The Court distinguished the ratio laid down in the case of MadhavRaoScindia on the ground that in the said case the Supreme Court was concerned with interpretation of Constitutional provision dealing with the jurisdiction of the courts, which was not the case before it. Further, in terms of the observation of the Supreme Court in the said judgement itself, the High Court held that meaning of a word or an expression used in an enactment is colored by the context in which it occurs. To the similar effects are also observations in the case of Navin Chemicals, as per the Court. Further reference was made to the decision in the case of Doypack Systems P. L[td. v/s. UOI – [AIR 1988 SC 782], in which it was held that:
“49. The expression "in relation to" (so also "pertaining to"), is a very broad expression which presupposes another subject matter. These are words of comprehensiveness which might both have a direct significance as well as an indirect significance depending on the context”
“…In this connection reference may be made to 76 Corpus JurisSecundum at pages 620 and 621 where it is stated that the term "relate" is also defined as meaning to bring into association or connection with.It has been clearly mentioned that "relating to" has been held to be equivalent to or synonymous with as to "concerning with" and "pertaining to". The expression "pertaining to" is an expression of expansion and not of contraction.”
(ii) Relying upon certain decisions, the Court observed that the expression ‘in relation to’ is, ordinarily, of wide import. In the normal course, the said expression would have an expansive meaning unless the context would otherwise suggest.
(iii) In so far as section 14A is concerned, the Court observed that the context does not suggest that the narrow meaning ought to be given to the said expression. For this, reference was also made to the fact that section 14A was inserted by the Finance Act, 2001 with retrospective effect from 01.04.1962.
(iv) However, ultimately, reliance was placed on the observations of the Supreme Court in the case of Walfort [as discussed above], mainly to the effect that the basic principle of taxation is to tax net income and that the deductions enumerated in sections 15 to 59 are now to be allowed only with reference to income which is brought under one of the heads of income chargeable under tax.
(v) In so far as the other argument with respect to interpretation of the term ‘expenditure incurred’ as appearing in section 14A (1) is concerned, referring the decision in the case of CIT v/s. Hero Cycles Ltd. – [(2010) 323 ITR 518 (P&H)], the Court observed as under:
“28. It was contended that unless and until there was actual expenditure for earning the exempted income, there could not be any disallowance under section 14A. While we agree that the expression "expenditure incurred" refers to actual expenditure and not to some imagined expenditure we would like to make it clear that the ‘actual’ expenditure that is in contemplation under section 14A(1) of the said Act is the ‘actual’ expenditure in relation to or in connection with or pertaining to exempt income. The corollary to this is that if no expenditure is incurred in relation to the exempt income, no disallowance can be made under section 14A of the said Act.”
(vi) The Court then proceeded further to hold as under:
(a) The insertion of sub – sections (2) and (3) of section 14A and insertion of Rule 8D have prospective effect and do not apply retrospectively.
(b) For the pre Rule 8D insertion period, the A.O. has to, first of all, ascertain the claim of the assessee with regard to the expenditure or no expenditure, as the case may be, in relation to the tax free income. Only after verifying and satisfying with correctness or otherwise of the claim that the A.O. can proceed further. If he rejects the claim it should be on the basis of objective criteria and after giving the assessee a reasonable opportunity and after stating the reasons for the same. Thereafter the A.O. is required to determine the amount of disallowance on the basis of a reasonable and acceptable matter of apportionment [relying upon the observations of the Supreme Court in the case of Walfort].
(c) With respect to the post Rule 8D insertion period, Rule 8D would come into play only after undertaking the process as mandated in sub – section (2) and (3); in other words, only after the A.O. rejects the claim of the assessee by indicating cogent reasons for the same.
4. DECISION IN CASE OF CCI LTD. V/S. JCIT – [(2012) 250 CTR 291 (KARN)]
The assessee was, among other, dealer in shares and securities. It had availed interest free loan of Rs. 14 crores for the purpose of acquiring certain shares [stock – in – trade] and had incurred brokerage / commission expenses of Rs. 28 lacs for availing such loan, which expenses were claimed as normal business expenditure. During the year, 63% of the shares so purchased were sold and the income derived therefrom was offered as business income. The remaining 37% of unsold shares yielded dividend income of Rs. 46.67 lacs, which was claimed as exempt. The A.O. held that the entire commission / brokerage expense was directly attributable to earning of the dividend income and disallowed the same. He also disallowed other expenses in terms of Rule 8D. The Tribunal, though in principle agreed with the action of the A.O., held that the entire commission expense cannot be attributed to earning of the dividend income only, as the profit earned on sale of such shares was taxed as business income. The Tribunal, therefore, set aside the order, directing the A.O. to bifurcate the expenditure proportionately and allow the expenditure in accordance with the law. The High Court disposed of the appeal, filed by the assessee against such direction, in favour of the assessee with the following observations:
“5. When no expenditure is incurred by the assessee in earning the dividend income, no notional expenditure could be deducted from the said income. It is not the case of the assessee retaining any shares so as to have the benefit of dividend. 63% of the shares, which were purchased, are sold and the income derived therefrom is offered to tax as business income. The remaining 37% of the shares are retained. It has remained unsold with the assessee. It is those unsold shares have yielded dividend, for which, the assessee has not incurred any expenditure at all. Though the dividend income is exempted from payment of tax, if any expenditure is incurred in earning the said income, the said expenditure also cannot be deducted.But in this case, when the assessee has not retained shares with the intention of earning dividend income and the dividend income is incidental to his business of sale of shares, which remained unsold by the assessee, it cannot be said that the expenditure incurred in acquiring the shares has to be apportioned to the extent of dividend income and that should be disallowed from deductions. In that view of the matter, the approach of the authorities is not in conformity with the statutory provisions contained under the Act. Therefore, the impugned orders are not sustainable and require to be set aside. … … …”
5. PR. CIT V/S. STATE BANK OF PATIALA – [(2017) 391 ITR 218 (P&H)]
{This decision has been sustained by the Supreme Court in Maxopp’s case}
[A.Y. 2008 – 2009]
A. BACKGROUND
(i) The assessee was in receipt of exempt income of Rs. 12.19 crores [dividend and tax free interest].
(ii) The arguments of the assessee were that the investments in shares, bonds, etc. constituted its stock – in – trade; that the investment had not been made only for earning tax free income; that the tax free income was only incidental to the assessee’s main business for sale and purchase of securities and, therefore, no expenditure had been incurred;that the expenditure would have remained the same even if no dividend or interest income had been earned by the assessee from the said securities and that no expenditure on proportionate basis should be allocated against such exempt income. The assessee also contended that, in any event, it had acquired the securities from its own funds and, therefore, section 14A was not applicable.
(iii) The A.O. applied Rule 8D and computed disallowance u/s. 14A at Rs. 40.72 crores. However, he restricted the disallowance to the amount of exempt income, that is, Rs. 12.20 crores.
(iv) The CIT (A), however, enhanced the disallowance by bringing it back to the actual amount computed under Rule 8D, that is, Rs. 40.72 crores, on the ground that there is no legal provision to restrict the amount of disallowance to the amount of exempt income.
(v) In the appeal filed by the assessee before the Tribunal, the arguments of the assessee were two folds; section 14A has no application in case of securities held as stock – in – trade and, alternatively, the securities, in the assessee’s case, were acquired out of interest free funds / mixed funds and, therefore, no interest bearing fund could said to have been used for acquiring such securities. It is to be noted that the aspect of the action of the CIT (A) in enhancing the disallowance was not even argued by the assessee.Accordingly, there is not a whisper in the entire order of the Tribunal against this aspect of the enhancement made by the CIT (A), much less, any finding or observation given by the Tribunal on this aspect. The Tribunal set aside the order of the Assessing Officer as well as CIT (A) by upholding the contention of the assessee that the provisions of section 14A are not attracted / are inapplicable all together, where the securities are held as stock – in – trade and the income [dividend / interest] earned therefrom is only incidental to the business.
B. THE ISSUE / QUESTION OF LAW BEFORE THE COURT
(i) This aspect is very important, as will be discussed later on. Therefore, the question of law / the issue, which the High Court was called upon to adjudicate, will be best demonstrated by reproducing, verbatim, para 2 & 3 of the judgment as reported in the magazine (ITR):
“2. The appeal is admitted on the following substantial question of law:—
"Whether in the facts and circumstances of the case, the Hon’ble ITAT is right in law in deleting the addition made on account of disallowance under section 14A of the Income Tax Act, 1961?"
The question really is whether the provisions of section 14A of the Income Tax Act (for short – ‘the Act’) apply where the exempt income such as dividend or interest is earned from securities held by the assessee as its stock-in-trade. The assessee had raised other issues as well. The Tribunal having decided the above question in favour of the assessee did not decide the other issues.
3. As we have also decided the question in favour of the assessee, it follows that section 14A is inapplicable altogether. The appeal must, therefore, be dismissed. Had we decided the issue against the assessee, we would have remanded the matter to the Tribunal for its decision on the other aspects, such as, whether the investments and securities yielding exempt income were from interest free funds/assessee’s own funds or from interest bearing funds as the Tribunal had not decided the same.”
In other words, the issue was regarding total deletion of the entire addition as done by the Tribunal and not with respect to only the amount of enhancement as done by the CIT (A).
C. ARGUMENTS OF THE ASSESSEE BEFORE THE COURT
(i) As the securities, on which the assessee earned dividend and interest income, were the assessee’s stock – in – trade, such income was only incidental to its business of banking and the main income on account of trading in such securities was assessed as business income.
(ii) As regard section 14A, reliance was placed on certain observations in the case of Walfort Shares & Stock Brokers P. Ltd.
D. ARGUMENT OF THE DEPARTMENT
The department also relied upon the same decision of Walfort Shares & Stock Brokers P. Ltd. vis – a – vis certain observations therein.
E. FINDING OF THE HIGH COURT
(i) The Court held that there is no quarrel about the aspects as raised by both the sides on the basis of the decision of Walfort Shares & Stock Brokers P. Ltd. and remarked that the question, however, is “whether the assessee incurred any expenditure to earn dividend or interest arising from such securities”.
(ii) Adverting to the observations of the Supreme Court in the case of Walfort Shares & Stock Brokers P. Ltd., the Court observed as under:
“That question does not arise before us and the result in that case is not relevant to the issue before us. What is relevant to this appeal are the observations regarding the ambit of section 14A which we have dealt with earlier.
………
………What is of vital importance in the above judgment are the observations emphasised by us. Each of them expressly states that what is disallowed is expenditure incurred to "earn" exempt income. The words "in relation to" in section 14A must be construed accordingly. Thus, the words "in relation to" apply to earning exempt income. The importance of the observation is this.”
(iii) The Court observed that, it is axiomatic that the entire expenditure including administrative costs was incurred for the purchase and sale of the stock-in-trade and, therefore, towards earning the business income from the trading activity of purchasing and selling the securities. Irrespective of whether the securities yielded any income arising therefrom, such as, dividend or interest, no expenditure was incurred in relation to the same.
(iv) It is only after categorical holding so that the Court also referred the observations of the Karnataka High Court in the case of CCI Ltd., with concurrence.
(v) The Court further observed as under:
“Once it is found that no expenditure was incurred in earning this income, there would be no further expenditure in relation thereto that falls within the ambit of section 14A. All that the assessee does thereafter i.e. after dividend and interest is received is to protect, preserve and utilize the same. The expenditure incurred in that regard would be to administer and manage the same. In other words, such expenditure cannot be said to be for the purpose of earning the same. An amount once received as income loses its character as income and thereafter forms a part of the assets or wealth of the assessee. There is no concept, such as, once an income always an income.”
Ultimately, the Court held that section 14A was inapplicable altogether.
6. GODREJ & BOYCE MFG. CO. LTD. V/S. DCIT – [(2017) 394 ITR 449 (SC)]
[A.Y.: 2002 – 2003]
(i) The main issue in this case was challenge to the vey applicability of 14A to the dividend income, on the ground that the dividend income is not tax free as it has already suffered tax u/s. 115 – O/ 115 – R. However, for the purpose of this article, what is relevant is the other issue, that is, disallowance u/s. 14A on the facts of the case.
(ii) For A.Y. 1998 – 1999, the A.O. had notionally allocated a part of the interest expenditure as referable to earning of the dividend income and had disallowed such interest expenditure and, consequently, had reduced the exemption available under Section 10 (33) of the Act to the net dividend. In appeal, the Commissioner of Income Tax (Appeals) allowed exemption of the entire dividend income on the ground that the Assessing Officer had failed to show any nexus between the investments in shares and units of mutual funds on one hand and the borrowed funds on the other. The Tribunal confirmed the appellate order and the said order had attained the finality. The A.Y. 1999 – 2000 and A.Y. 2000 – 2001 followed the similar pattern.
(iii) A.Y.: 2002 – 2003:AS PER A.O.: Disallowed Rs. 6.92 crores out of the interest expenditure, on the basis of proportion between the investments attributable to the dividend receipts to the total assets of the assessee, by invoking sec. 10 (33) (not 14A) of the Act.
– According to him, since there was a common pool, it was difficult to ascertain whether the investment had been made out of internal accruals or from borrowed funds. Further, if the assessee had not made investments in these securities, it would not have been required to borrow funds to that extent and, consequently, interest burden would have reduced.
(iv) BEFORE CIT (A)
– The assessee admitted that the exemption u/s. 10 (33) of the Act was to be allowed only on net dividend income. However, it contended that it was not permissible to notionally ascribe expenses to the earning of dividend income when, in actual facts, no such expenses were incurred.
– The CIT (Appeals) held that the issue had been considered by the Tribunal in the case of the assessee for Assessment Year 1998-99 where it had been held that no nexus between the investments made by the assessee in dividend earning shares and borrowings by the assessee had been established and no expenditure could be notionally attributed to the earning of dividend income, which decision was followed in A.Y.’s. 1999 – 2000 & 2001 – 2002. Following the decisions of the Tribunal for the earlier Assessment Years, the CIT (Appeals) directed the Assessing Officer to consider the whole of the dividend receipts of Rs. 34.34 crores as exempt under Section 10(33).
(v) AS PER TRIBUNAL
- The Tribunal, it seems, simply followed the decision of the Special Bench of the Tribunal in the case of Daga Capital Management P. Ltd. and set aside the matter to the A.O., by observing that since sub-sections (2) and (3) of section 14A are procedural in nature and, accordingly, are retrospective in nature and since the A.O. had, as a matter of fact, not considered section 14A (2) as it had not been enacted on the date when order was passed, the matter required re-examination.
(vi) THE QUESTIONS RAISED before the court
“(A) Whether on the facts and in the circumstances of the case, the Tribunal ought to have held that as the limited issue raised by Respondent No.1 in the assessment order was as to the quantum of the exemption under Section 10 (33) that was available and not to disallow any part of the expenditure claimed, hence it was not open to the Revenue to expand the scope of appeal by invoking the provisions of Section 14A of the Act to disallow the expenditure incurred;
(B) Whether on the facts and in the circumstances of the case, the Tribunal ought to have held that no disallowance could be made under Section 14A of the Act and hence erred in setting aside the issue relating to calculation of disallowance under Section 14A of the Act to Respondent No.1;
(C) Whether the Tribunal erred in directing Respondent No.1 to apply Rule 8D of the Rules for computing the amount of disallowance under Section 14A of the Act.”
(vii) At the time of arguments before the Court,various issues were raised by the assessee, including constitutional validity of 14A, Rule 8D, etc. as the Assessee’s a separate writ petition challenging constitutional validity of section 14A / Rule 8D was tagged with this Assessee’s appeal. However, so far as the present article is concerned, the issue raised by the assessee was that “on the facts of this case, there was no factual basis for effecting the disallowance and the order of remand by the Tribunal was not warranted.”
[In so far as the present article is concerned, the aspect regarding the disallowance u/s. 14A vis– a – vis facts of the case is only covered in the present analysis.]
(viii) PER HIGH COURT
(a) Even for A.Y. 2002 – 2003, the expenditure which had been incurred in relation to the earning of dividend income would have to be apportioned and disallowed. Even if Rule 8D has no application to A.Y. 2002 – 2003, the A.O. would be duty bound to compute the extent of the disallowance by the application of a reasonable method having regard to all the facts and circumstances of the case. In order to facilitate this exercise, an order of remand to the AO would be necessary.
(b) RE: EARLIER YEARS’ TRIBUNAL FINDINGS THAT NO NEXUS WAS ESTABLISHED
The fact that the assessee had utilized its own funds in making the investments would not be dispositive of the question as to whether the assessee had incurred expenditure in relation to the earning of such income. Even if the assessee has utilized its own funds for making investments which have resulted in income which does not form part of the total income under the Act, the expenditure which is incurred in the earning of that income would have to be disallowed.
(c) RE: THE PRINCIPLE OF RES JUDICATA
The Court rejected the plea of the assessee to follow the decisions for the earlier years, on theground that each year is separate and the principle of res judicata does not apply. The Court also held that in none of the earlier years’ decisions was the disallowability of expenses incurred in relation to exempt income earned out of investments made out of own funds considered. The exercise contemplated u/s 14A to arrive at the satisfaction by the AO was not carried out in the assessee’s case. The Court further held that the fact that the Tribunal failed to consider the applicability of section 14A in its proper perspective for A.Y. 2001 – 2002 would not bar the Tribunal from considering disallowance u/s. 14A in A.Y. 2002 – 2003.
(ix) FINDINGS OF THE SUPREME COURT
(a) Whether such determination is to be made on application of the formula prescribed under Rule 8D or in the best judgment of the Assessing Officer, what the law postulates is the requirement of a satisfaction of the Assessing Officer that having regard to the accounts of the assessee, as placed before him, it is not possible to generate the requisite satisfaction with regard to the correctness of the claim of the assessee. It is only thereafter that the provisions of Section 14A (2) and (3) read with Rule 8D of the Rules or a best judgment determination, as earlier prevailing, would become applicable.
(b) While it is true that the principle of res judicata would not apply to assessment proceedings under the Act, the need for consistency and certainty and existence of strong and compelling reasons for a departure from a settled position has to be spelt out which conspicuously is absent in the present case.
(c) Accordingly, the Court held that for the Assessment Year in question i.e. 2002-2003, the assessee is entitled to the full benefit of the claim of dividend income without any deduction.
(d) Some relevant observations of the Court are as under:
“The object behind the introduction of Section 14A of the Act by the Finance Act of 2001 is clear and unambiguous. The legislature intended to check the claim of allowance of expenditure incurred towards earning exempted income in a situation where an assessee has both exempted and non-exempted income or includible or non-includible income…….there can be no scintilla of doubt that if the income in question is taxable and, therefore, includible in the total income, the deduction of expenses incurred in relation to such an income must be allowed,……….
What cannot be denied is that the requirement for attracting the provisions of Section 14A(1) of the Act is proof of the fact that the expenditure sought to be disallowed/deducted had actually been incurred in earning the dividend income.
………what the law postulates is the requirement ofa satisfaction in the Assessing Officer that having regard to the accounts of the assessee, as placed beforehim, it is not possible to generate the requisite satisfaction with regard to the correctness of the claim of theassessee. It is only thereafter that the provisions of Section 14A(2) and (3) read with Rule 8D of the Rules ora best judgment determination, as earlier prevailing, would become applicable.
In the present case, ….. neitherany basis has been disclosed establishing a reasonable nexus between the expenditure disallowed and the dividend income received. That any part of the borrowings of the assessee had been diverted to earn tax free income despite the availability of surplus or interest free funds available (Rs. 270.51 crores as on 1.4.2001 and Rs. 280.64 crores as on 31.3.2002) remains unproved by any material whatsoever.”
7. DECISION IN CASE OF CIT V/S. ESSAR TELEHOLDINGS LTD. – [(2018) 401 ITR 445 (SC)]
At this juncture, a very brief reference of the decision of the Supreme Court in the case of CIT v/s. EssarTeleholdings Ltd. – [(2018) 401 ITR 445 (SC)]will not be out of place. In this case, the issue was whether Rule 8D is prospective or retrospective in operation. The Apex Court held that it is prospective in operation. However, suffice will be, for the present purpose, to refer only one paragraph, which may find relevance to the present issue:
“32. Explanatory memorandum issued with the Finance Bill, 2006 and the CBDT circular dated 28.12.2006, thus, clearly indicates that department understood that sub-section (2) and sub-section (3) was to be implemented with effect from assessment year 2007-2008. The Rule 8D prescribing the method was brought into statute book with effect from 24.03.2008 to implement sub-section (2) and sub-section (3) with effect from assessment year 2007-2008, is clear indicator of the fact that a new method for computing the expenditure was brought in by the rules which was to be utilized for computing expenditure for the Assessment Year 2007-2008 and onwards.”
8. DECISION IN CASE OF MAXOPP INVESTMENT LTD. &ORS. V/S. CIT – [(2018) 402 ITR 640 (SC)]
(i) It was under these legal precedents and legislative background that the appeal filed by Maxopp against the Delhi High Court judgment (discussed at Sr. 3 hereinabove) came up for adjudication before the Apex Court. The appeals of the Department against the decision in case of State Bank of Patiala (P & H High Court, discussed at Sr.5 hereinabove) and other such appeals were also heard together.The facts leading to the appeals concerning these two assessees are already discussed earlier. To avoid repetition, the same are not discussed again here.
(ii) Though it is not clear what were the exact grounds of challenge taken up by the Appellants before the Supreme Court, the same are discerniblefrom the observations of the Court as under:
“In these appeals, the question has arisen under varied circumstances where the shares/stocks were purchased of a company for the purpose of gaining control over the said company or as ‘stock-in-trade’. However, incidentally income was also generated in the form of dividends as well.”
“However, all these cases pertain to dividend income, whether it was for the purpose of investment in order to retain controlling interest in a company or in group of companies or the dominant purpose was to have it as stock-in-trade.”
“We have two scenarios in these sets of appeals. In one group of cases the main purpose for investing in shares was to gain control over the investee company. Other cases are those where the shares of investee company were held by the assessees as stock-in-trade (i.e. as a business activity) and not as investment to earn dividends. In this context, it is to be examined as to whether the expenditure was incurred, in respective scenarios, in relation to the dividend income or not.”
Further, the Supreme Court specifically clarified that it was interpreting section 14A (1) and was not concerned with 14A (2) & (3).
A. ARGUMENTS OF THE ASSESSEE – APPELLANT BEFORE THE COURT [LEAD APPEAL OF MAXOPP]
“(i) The holding of investment in group companies representing controlling interest, amounts to carrying on business, as held in the various cases.
(ii) Notwithstanding that dividend income is assessable under the head “income from other sources”, in view of the mandatory prescription in Section 56 of the Act, the nature of dividend incomehas to be ascertained on the facts of the case. Where dividend is earned on shares held as stock – in – trade/shares purchased for acquiring/retaining controlling interest, dividend income is in the nature of business income.
(iii) Interest paid on loans borrowed for acquiring shares representing controlling interest in the investee company is allowable business expenditure in terms of Section 36(1)(iii) of the Act, since acquiring controlling interest in companies and managing, administering, financing and rehabilitating such companies are for business and/or professional purposes and not for earning dividend.
(iv) Conversely, interest paid on funds borrowed for investment insharesrepresentingcontrolling interest does not representexpenditure incurred for earning dividend income and is notallowable under Section 57(iii) of the Act (prior to introduction ofSection 14A).
(v) When the shares were acquired, as part of promoter holding, the dominant object was to keep control over the management of the company and not to earned dividend from investment in such shares. The assessee would not liquidate these shares irrespective of whether dividend is declared or not.
(vi) The term ‘in relation to’ in section 14A is to be accorded playing grammatical interpretation, meaning thereby mandating a direct and toximate nexus and link between the expenditure actually incurred and the earning of the actual income. This would be so even if contextual / purposive interpretation is to be given.”
B. ARGUMENTS OF THE DEPARTMENT
Apart from relying upon the Delhi High Court judgment – from which the appeal arose – the Department relied on the observations of Walfort’s case. It was argued that otherwise the assessee would get double benefit. Under the circumstances, it was argued, the expression ‘in relation to’ has to be given expansive meaning in order to sub – serve the purpose of the said provision.
C. AS PER COURT
The relevant observations of the Court can be summarized as under:
(i)The effect of section 14A is that ‘if certain income isearned which is not to beincluded while computing total income, any expenditure incurred to earn that income is alsonot allowed as adeduction. Net income is arrived at after deducting the expenditures incurred in earningthat income. Once a particular income itself is not to beincluded in the total income and is exempted from tax, there is noreasonablebasis for giving benefit of deduction of the expenditureincurredin earning such an income.”
(ii) The purpose behind Section 14A of the Act, by not permitting deduction of the expenditure incurred in relation to income, which does not form part of total income, is to ensure that the assessee does not get double benefit.
(iii) “Normally, interest paid on the loan would be expenditure incurred for earningdividend income. Such an interest would not be allowed as deductionas it is an expenditure incurred in relation to dividend income which itselfis spared from tax net. There is no quarrel upto this extent.”
(iv) “Axiomatically, it isthat expenditure alone which has been incurred in relation to theincome which is includible in total income that has to be disallowed.”
(v) "If anexpenditure incurred has no causal connection with the exemptedincome, thensuch an expenditure would obviously be treated as notrelated to the income that is exempted from tax, and such expenditurewould be allowed as business expenditure.To put it differently, suchexpenditure would then be considered as incurred in respect of otherincome which is to be treated as part of the total income.
There is no quarrel in assigning this meaning to section 14A of theAct. In fact, all the High Courts, whether it is the Delhi High Court on theone hand or the Punjab and Haryana High Court on the other hand,have agreed in providing this interpretation to section 14A of the Act.”
(vi) “The first and the foremost issue that falls for consideration is as to whether the dominant purpose test, which is pressed into service by the assessee would apply while interpreting section 14A of the Act or we have to go by the theory of apportionment.”
(vii) The fact that the dominant purpose was to gain control of the investee company is not a relevant factor as the fact remains that such dividend income is not taxable. “In such scenario, expenditure whichis attributable to the dividend income has to be disallowed.Considered in this hue, the principle of apportionment of expensescomes into play as that is the principle which is engrained in Section 14Aof the Act. This is so held in Walfort Share & Stock Brokers P. Ltd.……….”.
(viii) “However, by virtue of Section 10(34) of the Act, this dividend income is not to be included in the total income and is exempt from tax. This triggers the applicability of Section14A of the Act which is based on the theory of apportionment of expenditure between taxable and non – taxable income as held in Walfort Share and Stock Brokers P Ltd. case. Therefore, to that extent, depending upon the facts of each case, the expenditure incurred in acquiring those shares will have to be apportioned.”
(ix) Therefore, the view of the Delhi High Court – holding that the dominantpurpose of acquiring controlling interest is not relevant – is to be accepted and, consequently, the appeal of the assessee in that judgement is to be dismissed.
(x) As regards the judgment of Punjab & Haryana High court in the case of State Bank of Patiala regarding shares held as stock – in – trade, the Apex Court observed “Punjab and Haryana High Court pointed out that this circular (referred therein)carves out a distinction between ‘stock-in-trade’ and ‘investment’and provides that if the motive behind purchase and sale of shares is toearn profit, then the same would be treated as trading profit and if theobject is to derive income by way of dividend then the profit would besaid to have accrued from investment. To this extent, the High Courtmaybe correct. At the same time, we do not agree with the test ofdominant intention applied by the Punjab and Haryana High Court,which we have already discarded.”
(xi) Observing that in the case of State Bank of Patiala, while the A.O. had already restricted the disallowance tothe amount of exempt income by applying Rule 8D and that, in spite of this exercise of apportionment carried on by the A.O., the CIT (A) disallowed the entire deduction of the expenditure, the Court held:“That view of the CIT(A) was clearlyuntenable and rightly set aside by the ITAT. Therefore, on facts, thePunjab and Haryana High Court has arrived at a correct conclusion by affirming the view of the ITAT, though we are not subscribing to thetheory of dominant intention applied by the High Court”.
(xii) In a case where the shares are held as stock – in – trade, whether dividend is earned or not is immaterial. In fact, it would be a quirk of fate that the investee company declared dividend on the shares held by the assessee, though the assessee has to ultimately sale of the shares to earn profit. The situation is therefore different from the case like Maxopp where the assessee would continue to hold shares in order to retain control. Therefore, even at the time of investing into those shares held for controlling purpose, the assessee knows that it may generate dividend income as well. “In contrast, where the shares are held as stock – in – trade, the main purpose is to liquidate those shares whenever the shares price goes up in order to earn profit.In the result, the appeals filed by the Revenuechallenging the judgment of the Punjaband Haryana High Court in StateBank of Patiala also fails, though law in this respect has been clarified hereinabove.”
(xiii) Further, the Supreme Court clarified that “before applying theory of apportionment, the A.O. needs to record satisfaction that having regard to the kind of the assessee, suomotodisallowanceunderSection 14A was not correct. It will be in those cases where the assessee in his return has himself apportioned but the AO was notaccepting the said apportionment. In that eventuality, it will have torecord its satisfaction to this effect. Further, while recording such asatisfaction, nature of loan taken by the assessee for purchasing theshares/making the investment in shares is to be examined by the AO.”
PART THREE
BRIEF COMMENTS
As serious doubts linger in the minds of many about implications of this judgment, especially on the cases concerning dealer in shares, some of the issues that arise for consideration are discussed, briefly, as hereunder:
1.1 As it appears, ultimately, it was the observations of the Apex Court in the case of Walfort that paved way for the final conclusion in Maxopp’s case, if not the sole base. That’s precisely the reason that the decision in case of Walfort is extensively analyzed earlier to understand the background and the context under which these observations were made by the Court in that case.
Now, as far as the decision in the case of Walfort is concerned, as it is self – evident and as was pointed out by the High Court itself (in that case), the basic question / issue involved in that case was disallowance of the ‘loss’concerning dividend stripping transaction in pre – 94 (7) period, where the loss was disallowed on the ground that it was not a business transaction but was executed with the sole intention of tax avoidance by creating artificial loss. The issue regarding section 14A was only an alternative argument as raised by the Department and, that too, on the limited aspect that the ‘loss’ should be considered as ‘expenditure’ for the purpose of section 14A of the Act. It was precisely for this reason that the order of the High Court was almost entirely concerned with the issue of disallowance of the loss and the aspect of section 14A was dealt with by the High Court only at the end and, that too, in one small paragraph. Even before the Supreme Court, the main emphasis of the Department was on the aspect of disallowance of the loss. The Department had raised the issue of section 14A only as an alternative argument. In response, the main argument of the assessee also revolved around the primary aspect of disallowance of the loss. In fact, the entire emphasis of the assessee before the Court was to disassociate section 14A from the controversy / main issue before the Court concerning dividend stripping transaction for pre section 94 (7) period. As such, it was because the Department had dragged section 14A into the controversy that the assessee’s defense was that section 94 (7) and section 14A operate in different field, having different objects and having different fact situations:“The two provisions operate in different time and space zones”.
Neither the core issue nor the arguments from either side were with respect to the basic principles concerning section 14A, much less with respect to interpretationof the term “in relation to” and, much less, with respect to the shares held as stock – in – trade / strategic investments. Neither the legislative history nor any legal precedentthereonwasanalysed. This can be understandable as these were not otherwise also required to dispose of the main issue involved in the appeal; the main issue being allowability of loss arising in course of, admittedly, dividend stripping transaction before insertion of section 94 (7) of the Act.
The observations of the Supreme Court on the aspect of section 14A, covering substantial portion of the judgment, therefore, are to be evaluated in this background.
1.2 In any case, as far as the aspect of section 14A is concerned, incidentally and not surprisingly, thereafter, this decision in case of Walfortwas being relied upon by both, assessees as well as the Department, with equal force and so in the judgments rendered subsequently.The Department had been relying upon certain observations of this judgement in support of their stand about the so called widened scope of section 14A. In particular, this judgment was being relied upon for the following propositions:
– The theory of exempting only net income
– The theory of apportionment of expenditure between taxable and non – taxable income has, in principle, been now widened u/s. 14A.
On the other hand, the assessees had been relying upon this judgement for the proposition regarding the necessity to have “proximate cause”between the expenditure and the exempt income, before invoking section 14A. There have many decisions wherein the observation regarding necessity to have proximate cause has been relied upon to construe the scope of section 14A strictly and narrowly.
1.3 Interestingly, in the case of State Bank of Patiala, where the issue involved was disallowance u/s. 14A vis – a – vis shares held as stock – in – trade,boththe sides before the High Court had referred and relied upon the observations contained in this judgement in case of Walfort in support of their respective stand. The Hon’ble High Court (in the case of State Bank of Patiala), after reproducing the observations of the Supreme Court in the case of Walfort, as relied upon by both the sides, pertinently observed, quite correctly, that “………What is of vital importance in the above judgment are the observations emphasised by us. Each of them expressly states that what is disallowed is expenditure incurred to "earn" exempt income. The words "in relation to" in section 14A must be construed accordingly. Thus, the words "in relation to" apply to earning exempt income. The importance of the observation is this.”. Ultimately, the Court held that section 14A is not applicable to the dividend received on the shares held as stock – in – trade.
1.4 Therefore, the first issue that arises for consideration is: How far and to what extent a judgment of a court is to be relied upon for its precedent value? Agreed, a judgement rendered by the Apex Court has the highest precedent value and is binding on all subordinate courts, under Article 141 of Constitution of India. However, and at the same time, it is equally a well – settled position on the law of precedentthat a ruling of a court is to be read, understood and interpreted in the context of not only the issue that was under adjudication but also in the context of the points of the arguments canvassed by both the sides. Though there is plethora of judicial precedents on this aspect, suffice will be here to refer the judgment of the Apex Court in the case of CIT v/s. Sun Engineering Works (P) Ltd. – [(1992) 198 ITR 297 (SC)], rendered in the context of Income-tax Act. The following extract of the judgment is self – explanatory and illuminating:
“It is neither desirable nor permissible to pick out a word or sentence from the judgment of this court, divorced from the context the question under consideration and treat it to be the complete law declared by this court. The judgment must be read as a whole and the observations from the judgment have to be considered in the light of the questions which were before the court. As their Lordships observed, “A decision of the Court takes its colour from the questions involved in the case in which it was rendered and while applying the decision to a later case, the Courts must carefully try to ascertain the true principles laid down by the decision….”.
1.5 Corollary to the above principle is the principle that while appreciating precedent value of adecision, it may also be relevant to ascertain whether the decision is rendered per incuriamorispassedsubsilentio.In the case of UOI &Ors.v/s. Dhanwanti Devi &Ors. – [(1996) 6 SCC 44], the Apex Court, after dealing with this aspect, observed as under:
“9. …….What is of the essence in a decision is its ratio and not every observation found therein nor what logically follows from the various observations made in the judgement. Every judgment must be read as applicable to the particular facts proved, since the generality of the expressions which may be found there is not intended to be exposition of the whole law, but governed and qualified by the particular facts of the case in which such expressions are to be found.
10. Therefore, in order to understand and appreciate the binding force of a decision is always necessary to see what were the facts in the case in which the decision was given and what was the point which had to be decided. No judgment can be read as if it is a statute. A word or a clause or a sentence in the judgment cannot be regarded as a full exposition of law. Law cannot afford to be static and therefore, Judges are to employ an intelligent in the use of precedents………”
Similarly, in the case of Municipal Corporation of Delhi v/s. GurnamKaur – [(1989) 1 SCC 101], the Apex Court observed as under:
“Precedents sub silentio and without argument are of no moment……… The weight accorded to dicta varies with the type of dictum. Mere casual expressions carry no weight at all. Not every passing expression of a Judge, however eminent, can be treated as an ex cathedra statement, having the weight of authority.”
2.1 The second issue that arises for consideration is: Is the theory of apportionment really inherent, and ‘engrained’, in section 14A (1)? Is it that section 14A has implicit within it a notion of apportionment?
2.2 This issue is most crucial as it became bedrock for the ultimate decision. This is because, according to the Court, “The first and the foremost issue that falls for consideration is as to whether the dominant purpose test, which is pressed into service by the assessee would apply while interpreting section 14A of the Act or we have to go by the theory of apportionment.” As already discussed earlier, prior to insertion of section 14A, the predominant view was against application of “theory of apportionment” in the cases where the Departmentsought to disallow a part of business expenses [interest as well as establishment expenses]where tax free income [interest / dividend] accrued to the assessee only incidentally.The “theory of apportionment” was never preferred/ commonly used theory and the decisions were, in fact, against applying such theory in such type of cases. In the case of Godrej& Boyce Mfg. Co. Ltd. v/s. DCIT – [(2010) 328 ITR 81 (Bom)], reliance was placed by the Court, in this regard, on the Apex Court decision in the case of Madras Co-op. Bank and Bombay High Court decision in the case of Broach Co-op. Bank. Now, in the former case, the Apex Court had merely confirmed the method of apportionment adopted by the assessee therein, which was the method notified by the Government itself for earlier periods and which method was being followed and allowed in past many years. In the latter short decision of Bombay High Court, the issue was about the rule of presumption and the court approved the apportionment of the interest expenses to arrive at the amount of interest eligible for deduction, in the absence of any better rule or a more equitable rule having pointed out. However, as against that, there is plethora of decisions – of the Apex Court, of the Bombay High Court and of other high courts – to the contrary effect; some of them already discussed in Part One. There are decisions, including in the context of dealers in shares, in which it has been held that no apportionment / pro – rata apportionment at all is permissible in such cases. In any case, the theory of apportionment was pressed into service only in cases where the expenses were common to various businesses and the need arose to cull out expenses relating to a particular business, in contrast with the situations where attempts were made by the Department to “apportion”, and disallow, a part of business expenses towards tax free income that was earned incidentally.
2.3 It should be noted that the phrase “in relation to” has been used at many places in the Act (around 363) and nowhere ever any necessity was found to supply such apportionment formula to make such provisions working. As such, the so called ‘theory of apportionment’ was not inherent, much less commonly used vis – a – vis this phrase “in relation to”. This is for very obvious reason and logic, as both are not on the same footing. The latter terms signifies qualitative relationship while the forever term is merely a quantitative formula.
2.4 In fact, the substantive section, that is, sub-section (1) of section 14A, did very well and independently operate and function de hors the method of apportionment prescribed under Rule 8D for seven years. If it was not meant to work independently and if the formula of apportionment was so vital and integral part of the main provision, then it would have been introduced in 2001 itself. The legislature would not have taken seven years to introduce this formula, that too, with prospective effect. Most importantly, the Apex Court itself [in case of EssarTeleholdings] would not have held it [Rule 8D] to be not retrospective in operation, by holding that “…a new method for computing the expenditure was brought in by the rules which was to be utilized for computing expenditure for the Assessment Year 2007 – 2008 and onwards.”. Therefore, the issue that arises is: Is it so that the apportionment method was the only method that was available and that was implicit / inherent / engrained in section 14A (1)?It may be that only with a view to standardize the process of estimation of disallowance under section 14A and to eliminate the necessity for subjective/individual exercise of discretion that rule 8D was introduced, as a matter of convenience of the Department. But this is totally different from asserting that the theory of apportionment is implicit in section 14A (1).
2.5 This issue is very crucial as the Supreme Court decision in the case of Maxopp is based on this premise that the principle of apportionment of expenses automatically comes into play while interpreting section 14A (1).
3.1 However, in this melee on the aspect of the theory of apportionment, it seems that the main issue that lost focus is that, for the purpose of section 14A (1), what is crucial is to find out the true meaning and scope of the term “in relation to” and that is the starting point. The method of apportionment, etc. come into picture only aftersome expense is found to have been incurred in relation to earning of tax free income. It is to be appreciated that section 14A (1) does not refer to any rule nor is subject to any rule.It is only in section 14A (2) and (3) that it is provided that if the A.O. is not satisfied with the correctness of the claim of the assessee in respect of an expenditure incurred / not incurred in relation to the exempt income then the A.O. has to determine the amount of such expenditure in accordance with the method as may be prescribed, which is Rule 8D. As such, the scheme and the languageof section 14A as a whole and, more particularly, the placement of the relevant provisions therein are very crucial so as to bring out the legislative intent, in so far as the relevance and the scope of the term “in relation to” and the theory of apportionment / Rule 8D is concerned.Thethird issue, therefore, that arises is: Whether the scope of a charging provision can be interpreted on the basis of the machinery / computational provision, which comes into operation only after the charging provision first gets invoked? The computational method/ formula may provide for apportionment of all expenses – direct or indirect – and cover all types of assets. However, that, by itself, does not signify that the charging section also automatically provides for regarding all indirect expenses also as the expenditure incurred in relation to earning tax free income.
It should be noted that the real issue is not whether an expense is direct or indirect in nature but whether it is incurred, if at all, in relation to earning tax free income; whether such expense, direct or indirect, has any “proximate cause” or “reasonable nexus” or “causal connection” with the tax free income. Otherwise also, sub- section (1) is required to be read and interpreted on a standalone basis and some meaning has to be given to the words “in relation to”. It is only after an expenditure is found, as a fact, to have been incurred in relation to an income that does not form a part of the total income that, for quantifying the same, resort is to be taken to sub-section (2) and (3) read with Rule 8D.
In other words, the main “charging” section is sub-section (1) which lays down the scope of, and the condition precedent for attracting, the provision of section 14A. It is only where an expense falls within the ambit of section 14A, that is, within the meaning of the language of sub – section (1), that, for quantification purpose, one has to go to sub – section (2) and (3). For this, the onus is on the A.O., as he seeks to invoke provisions of a particular section, especially when such invocation tends to restrict / curtail an important and substantive right of the assessee to claim a business deduction which he is otherwise entitled to. This is also in consonance with the stand of the department itself that sub – section (2) and (3) as well as Rule 8D are only procedural in nature and no substantive right is created or curtailed by these provisions. As clarified by the Court itself section 14A (2) / (3) were not subject matter of adjudication before it.
3.2 Importantly, the limitation to the applicability of the theory of apportionment / Rule 8D can be found in sub-section (2)& (3) itself when it lays downs that resort to such method can be taken only after the assessing officer is satisfied about the claim of the assessee in this regard (which claim includes the claim that no expenditure is incurred in relation to tax free income), having regard to the accounts of the assessee. Now, the term ‘satisfied’ has acquired a very well established legal connotation under the Act; it means an objective satisfaction with full application of mind & reason. In other words, if the officer is satisfied about the claim of the assessee, then the question invoking the rule / theory of apportionment simply does not arise.
3.3 In fact, if the theory of apportionment / Rule 8D is to be applied blindly to all cases without regard to the facts of a particular case, it would bring absurd results that can never said to be intended by the legislature. For example, the artificial amount of disallowance would be, in some cases, much more than the amount of dividend income or, worst, more than even the amount of total expenditure; in some cases, irrespective whether any dividend income is earned at all during the year. In fact, the formula – then and even now – has absolutely no regard or relationship with the exempt income, much less with any expenditure connected with such exempt income. The fact that this Rule had to be amended (with effect from 02.06.2016) – one of the off shoot being to restrict the amount of disallowance to the extent of the total expenditure claimed by the assessee – itself is a very clear pointer to the fact that the so called apportionment formula was never, and is also not, indicative of correct, full proof and omnipresent answer or solution.
3.4 Therefore, neither sub-sections (2) & (3) nor Rule 8D nor the ‘theory of apportionment’ can affect, control, override or enlarge scope of the main provision, that is, sub-section (1); much less can be used or relied upon to interpret the main provision. The artificial and mechanical formula of Rule 8D, introduced after almost seven years of existence of section 14A, can never be the basis to interpret, and in that process enlarge & broaden, the scope of the main section. If the rule of thumb formula of the Rule / ‘theory of apportionment’ is to be regarded as integral to the provision of section 14 (1) as held by the Court, and is to applied in all cases blindly and mechanically as is being done by the Department, it will render the main provision of sub-section (1) in general, and the specific use of the words ‘in relation to’ by the legislature therein, otiose, nugatory,totally redundant & meaningless. No rule of interpretation permits such process.
3.5 There does not appear to be any discussion on these fundamental aspects of the interpretation of the term ‘in relation to’ and as to what is its true scope and coverage, except for the observations as referred at Sr. No. 8 of Part Two.
4.1 The fourth issue is: Is it so that the phrase “in relation to” has no meaning and has no role to play? What is true scope of these words? As regards interpretation of the term ‘in relation to’, it should be appreciated that whenever the legislature wanted to give wide meaning to a term, the words used are “attributable” or “for the purpose of”. The fact that these words are not used signifies the intention to give narrower and restricted meaning. There are legal precedents on the principle of interpretation of statue, majority of which in favour of interpreting a term in the context of the overall scheme of the concerned provisions. As such, it is not that given a tax free dividend received by an assessee, automatically, the apportionment formula is required to be adopted, without first considering whether any expense – direct or indirect – is at all incurred by the assessee in relation to earning of the dividend income.
4.2 A very crucial aspect that has been totally lost sight is that there is a subtle distinction between an expense incurred in relation to acquiring shares and an expense incurred in relation toearning dividend income thereon. It is not that each and every expense that is incurred for the purpose of acquiring shares automatically and invariably becomes the expense incurred for the purpose of earningthe dividend income received on such shares. It is this subtle distinction that has been taken note by the Bombay High Court in the case of CIT v/s. General Insurance Corporation of India – [(2002) 254 ITR 203 (Bom)]. This factor is very fundamental for interpreting the term “in relationto” in section 14A,especially in the context of tax free dividend income. This vital distinction has been totally ignored and everywhere the procedure seems to be assume that all expenses that are incurred for acquiringshares are to be automatically regarded as expenses incurred for earning dividend income thereof as well, even if the dividend is purely incidental.
4.3 In any case, as discussed earlier, majority of the decisions was against disallowance of a proper business deduction [including interest expense], expended on acquiring shares / securities,even if interest / dividend income arising therefrom was exempt, when earning of such income was purely incidental. Under the circumstances: Is it so that “interest paid on such loan would be expenditure incurred for earning dividend income”, as observed by the Supreme Court in Maxopp’s case, and, that too, for which “there is no quarrel”?
4.4 At this stage, it is very interesting to note that while the Supreme Court in the Maxopp’s case heavily relied upon certain observations in the case of Walfort, more particularly, on the aspect of the “theory of apportionment”, in the very same judgment of Walfort, the Supreme Court has also held that “For attracting section 14A, there has to be proximate cause for disallowance, which is its relationship with the tax exempt income……… Thus, in the absence of such proximate cause for disallowance, section 14A cannot be invoked.” These vital observations are conspicuous by their absence in Maxopp’s case.Further, in case of Godrej, the Apex Court again observed that there has to be ‘reasonable nexus’ between the expenditure disallowed and the dividend received. In fact, in Maxopp’s case itself, the Court has observed that if an expense has ‘no causal connection with the exempted income’, such expenditure cannot be disallowed. Therefore, in terms of the observations of the Supreme Court in these three cases, an expense cannot be disallowed unless it is proved that there exists a “proximate cause” [Walfort’s case], “reasonable nexus” [Godrej’s cases] or“causal connection” [Maxopp’s case]. This is the primary requirement to start with and at this stage, the “theory of apportionment” has no role to play for interpreting this term “in relation to”.
4.5 Therefore, the phrase “in relation to” has to be given its due importance, emphasis and relevance. As this term is not defined, to interpret this term it may be permissible to seek internal and external aids for its interpretation. The legislative intent, as manifest from the Memorandum explaining the provisions as well as the circular issued thereafter, indicates that what is sought to be disallowed is the expenses incurred for earning tax free income. To the similar effects were the arguments of the Department before the Supreme Court and to the similar effects also are the observations of the Supreme Court in all the three cases, that is, Walfort, Godrej and Maxopp. Therefore, due regard should be given to the phrase ‘an expense incurred to earnan exempt income’, which phrase, as stated earlier, is somewhat akin tothe language used in section 57 (iii) of the Act. This is rightly soas the dividend was otherwise taxable under this residuary head “Income from Other Sources” and allowability of deduction of an expenditure against this income was governed by this section 57 (iii) of the Act. Now, there is a very well – settled legal position on the scope of the expenses covered u/s. 57 (iii) of the Act. Very shortly put, the scope is narrow, restrictive and limited, requiring proving exact nexus between the expenditure and earning of such the income. In fact, it was theDepartmentwhich used to invoke such restrictive scope of section 57 (iii) to deny, for example, administrative and establishment expenses against dividend income taxable under that head. It is, therefore, very paradoxical that in case of the converse situation in section 14A, the Department contends otherwise and this stand is found acceptable!
4.6 Another important aspect is that to decide whether a particular expenditure is incurred ‘in relation to’ an exempt income, obviously, necessarily and logically, one of the prime factors would be to probe the reason / object / intent for incurring such expenditure. The moot issue was, and is, how to determine whether an expense is incurred in relation to tax free income or in relation to taxable income. The principle criteria, if not the sole, would be to ascertain the purpose for which such expenditure was incurred and this, consequently, would logically and invariably bring in the issue about the intention.Apart from the fact that, as discussed herein before, while adjudicating similar issue in the context of section 57 (iii) of the Act, the Courts had been consistently applying this test of dominant intention, such approach is the most logical and practical way of adjudicating the issue,from a businessman’s point of view and from a common man’s point of view. In Maxopp’s case, the Court has rejected this parameter of dominant intention. The issue, therefore, arises is
“If this test of dominant intention / object is to be discarded then which test can be applied to adjudicate such issue?”
To decide about incurring an expense in relation to an exempt income in such a case, if not the test of dominant purpose / intent, what else can be other test / criteria / parameter to separate chaff from the gain? The Court has not given any indication as to what parameter, if the dominant intention parameter is to be discarded, is to be applied to interpret the term “in relation to”, how do decide “casual connection” that the Court itself held needs to be established. In any case, definitely, the “theory of apportionment” cannot come into picture at all at this stage. However, the Court proceeded as if the choice was between the test of dominant purpose and the theory of apportionment, with the Court opting for the latter, relying upon Walfort’s case. This strikes at the root of the fundamental aspect.
5.1 The fifth issue to be considered is: What is the starting point of approach for section 14A? Ex – facie, the starting point for application / invocation of section 14A is existence of an expense and, that too, which is otherwise claimed as deduction while computing income under the Act. In fact, existence of such expense is the very foundation / subject matter of section 14A.The starting point is not otherwise, as is the very popular view. It will be a fundamental fallacy to assume that what is to be done is, first of all, to identify a tax free income and then to allocate proportionate [mostly artificial and notional] expenses on the basis of “theory of apportionment” / Rule 8D. In other words, according to such view, the starting point for invoking section 14A is an exempt income and once such income is identified, automatically, proportionate expenditure requires to be allocated to such income and to be disallowed accordingly. It appears, this was also the approach in the present case, when it is observed by that Court that the exempt dividend income u/s. 10 (34) “triggers the applicability of section 14A of the Act.”
This is contrary to the ratio laid down in the case of CIT v/s. Williamson Financial Services – [(2008) 297 ITR 17 (SC)]. Refer also: Walfort’s case, at page 20: “Section 14A comes in when there is a claim for deduction of an expenditure………”. Thisview also totally overlooks the basic scheme of the Act, especially of Chapter III vis – a – vis Chapter IV of the Act. Section 14A is incorporated under Chapter IV and it starts with the following words:
“For the purposes of computing the total income under this Chapter ………”
In other words, section 14A gets attracted andbecomes applicable only while computing ‘total income’ under Chapter IV. It has nothing to do with the exempt income which falls under Chapter III, like section 10. This is for the simple reason that such exempt income does not at all form part of total income. As such, the starting point is not an exempt income but whether an expenditure, which is otherwise claimed as deduction against taxable income, can said to have been incurred in relation to an exempt income. Therefore, the issue whether an exempt income can be taxed on gross basis or net basis cannot be a relevant criteria, much less a starting point of inquiry. Unfortunately, this fundamental fallacy has made the safeguards – in terms of sub – sections (2) and (3) – quite ineffective and practically redundant, with the moulded approach and totally bypassing, overlooking and ignoring the crucial requirement of the expenses having incurred “in relation to” the exempt income.
5.2 The next stage of inquiry is whether such expense is incurred in relation to an income which does not form part of total income under the Act or whether is incurred in relation to earning taxable income. This is the very soul of section 14A. It would be a grave and fundamental error in proceeding in totally reverse way, by considering that the starting point is existence of a tax free income and, irrespective of any other factor or consideration, once there exists a tax free income then the artificial and mechanical disallowance u/s. 14A – and consequential application of the theory of apportionment / Rule 8D – would be automatic and would follow as a matter of course.
Here, it should be appreciated that the subject matter for adjudicationbefore the Court was interpretation of section 14A (1) and not section 10 (33) of the Act or, for that matter, section 36 (1) (iii) or section 37 or section 57 of the Act and not even 14A (2) and (3).
6. Even for the purpose of approaching from the tax free income’s stand point of view, the sixth issue that arises is: Is it so that exemption of an income is always and invariably on net basis – that is, after reducing it by the related expenses – irrespective of the language or the phraseology employed in the provision granting suchexemption? This proposition seems to have been accepted as universal and unchallenged. The issue is: Is it so?
7.1 The seventh issue that arises for consideration is: While interpreting a particular provision, whether the consequences arising from the interpretation sought to be placed by a party is also a relevant factor, especially when the term used therein is ambiguous or is capable of two views?
7.2 It is a well settled legal position that while interpreting a particular provision, the consequences arising from the interpretation sought to be placed by a party is also a relevant factor, especially when the term used therein is ambiguous or is capable of two views. Now, the issue of interpreting the term “expenditure incurred in relation to income which does not form part of the total income”, as appearing in section 14A (1), presents an unique situation and also poses an unique challenge in as much as, in the process of so interpreting, one would also be simultaneously and automatically interpreting the ‘expenditure incurred in relation to income which forms part of the total income’. This is because both types of expenditure are mutually exclusive. In other words, if an expenditure is interpreted and held, and computed, as having incurred in relation to earning tax free income within the meaning of section 14A, it would correspondingly, and automatically, cease to be regarded as having incurred for earning taxable income and, consequently, would lose the deduction that the assessee was otherwise legitimately entitled to under the normal provisions of the Act. Conversely, if an expenditure is said to have been incurred in relation to earning taxable income, and consequently, is otherwise allowed or allowable as legitimate deduction, then it cannot be an expenditure which is incurred in relation to earning tax free income within the meaning of section 14A. This is of immense significance.
This latter part is clear from the legislative intent itself, in terms of the Memorandum and the Circular issued. In fact, this was also the stand of the Department before the Apex Court in the case of Walfort and also before the Court in the case of Maxopp. This is also in consonance with the observations by the courts in both the cases. In fact, in the case of Maxopp, the Court itself has held that “If an expenditure incurred has no causal connection with the exemptedincome, thensuchan expenditure would obviously be treated as notrelated to the income that is exempted from tax, and such expenditurewould be allowed as business expenditure.” However, after so categorically observing and holding, there is no way forward provided or suggested to ensure such allowability. It should be appreciated that here one is not dealing with the classic case of an assessee who, admittedly, carries two businesses, one earning tax free income and one earning taxable income and, admittedly, certain expenses are incurred to earn the tax free income also but both the businesses are indivisible. This is the only situation which the legislature intended to address while inserting section 14A. However, in case of the majority assessees, this is not the situation, where the assessee is not carrying any separate business activity of earning tax free income (say, as in case of a dealer in shares) and also denies having incurred any expenditure specifically for earning such tax free income. If there is only one business and that is carried on to earn only taxable income then the ratio of the judgment in the case of Rajasthan Warehousing or Maharashtra Sugar does not become applicable at all and so will be the remedial insertion of section 14A. In such a case, the safeguard provided in the respective provisions, under which the expenditure are claimed, to disallow, if at all, a portion thereof always get activated, so as to disallow the expenses not incurred for the taxable business income.
7.3 This fundamental aspect is very crucial. It is a well settled principle of interpretation of statute that the statute must be read as a whole and one provision of the Act should be construed harmoniously with reference to other provisions in the same Act so as to make a consistent interpretation of the whole statute. It is the duty of the court to avoid “a head on clash” between two sections of the same Act and, “whenever it is possible to do so, to construe provisions which appear to conflict so that they harmonise”. It should not be lightly assumed that “Parliament had given on one hand what it took away with other”. The provisions of one section of statute cannot be used to defeat those of another, “unless it is impossible to effect reconciliation between them”.
In fact, in the very context of section 14A, the Supreme Court in Walfort’s case has held that: “… … one needs to read the words “expenditure incurred” in section 14A in the context of the scheme of the Act … …”.If the wholesale disallowances made u/s. 14A purely on adhoc basis are to be justified as proper in terms of the Department’s stand, then such disallowances – and the provisions of section 14A – would directly run into conflict with other provisions of the Act under which an assessee is otherwise legitimately entitled to a business deduction.This is especially so as the formula of disallowance u/s. 14A is wholly artificial and adhoc formula without any semblance of relevance with the amount of expenditure that can said to have been incurred for the purpose of earning the tax free income.
7.4 In fact, if one closely scrutinises the Memorandum explaining the provision while inserting section 14A, the circular issued thereon as well as the arguments of the Department in various cases, it becomes clear that the legislative intention was to restrict disallowance only to the expenses incurred to earn tax free income and,on the other hand, to allow deduction of the expenses incurred to earn taxable income. This is so also held by the Apex Court in the case of Walfort and Maxopp.It should be noted that the section 14A has no non-obstante clause. In other words, it does not override any other provisions of the Act.
7.5 The situation becomes more serious with Rule 8D adding fuel to the fire, which rule is assumed to be almost automatically attracted once application of section 14A gets triggered. Firstly, this totally artificial and rule of thumb formula has no regard to the expenses that can be said to have been incurred in relation to an exempt income. Secondly, it appears, once the Assessing Officer does not get satisfied with theclaim of the assessee in terms of sub – sections (2) and (3), he has no option but to invoke this mechanical formula of Rule 8D. There may be many cases where in such a case, the A.O. himself would be otherwise satisfied with making some adhoc / token / small disallowance based on some realistic and practical parameters that are more nearer to the given fact situation, instead of the artificial formula of Rule 8D. However, as it appears, he has no such option but to compulsorily opt for this artificial formula of Rule 8D. The issue, therefore, arises is: “Whether the Assessing Officer has any leeway in such a situation?”
7.6 Interestingly, in the case of Walfort, the assessee had pressed into service the argument based on the consequences that might arise if the Department’s interpretation of section 94 (7) / 14A is to be accepted.
7.7 Keeping the above principles in mind, if one has to appreciate the consequences that may arise on account of regarding ‘theory of apportionment’ as inherent and automatic, it would be seen that it may directly curtail / reduce / affect the amount of expenses that are otherwise fully allowable under the normal provisions of the Act. Therefore, the issue that arises is: By interpreting section 14A in a way so as to encompass all expenditure, irrespective of their relation with the exempt income, and by adopting ‘theory of apportionment’ / the formula as laid down in Rule 8D that has no relation or connection (not to mention ‘proximate connection’) with the expenditure or the exempt income, is not the right of the assessee to be entitled to legitimate deductions under the Act seriously impaired?
8.1 The eighth issue is: How far the theory of ‘double advantage’, propagated heavily by the Department, is correct? This is another serious misconception. The Department strenuously emphasised this theory to drive across its point. According to the Department, if an assessee is allowed to go scot-free from the clutches of section 14A, he will be gaining undue or double advantage. It is completely fallacious to say that but for section 14A – or, for that matter, Rule 8D – the assessee would get away with undue “double benefit” or “double advantage”. There is no question of undue benefit, not to mention double benefit. It should be appreciated that the provisions of section 14A do not apply in vacuum. They apply only when there is a claim of deduction. If there is no claim of deduction, then there is no question of, still, going on further to compute an expense supposed to have been incurred in relation to an exempt income, by pressing the artificial formula of Rule 8D on the basis of theory of the apportionment or, for that matter, to reduce the amountof exemption u/s. 10 (34) on the basis of theory of net income. This is obvious and logical and this is enough to bring out the limitation of the formula provided in Rule 8D as well as the argument of the Department.In such a case, there is absolutely no question of any double advantage. Corollary to this, it is only when an assessee has claimed an expense which is otherwise allowable under certain provisions of the Act that section 14A, if at all, gets attracted. Now, here also, the claim of the assessee for a particular deduction does not arise in vacuum. It is based on certain provisions of the Act under which the assessee has to prove that his claim of deduction is otherwise legitimately allowable, independent to section 14A. Therefore, if, in a given fact situation, it is held that no disallowance u/s. 14A is called for, where is the question of such assessee straightway getting double deduction or double advantage?
8.2 It is not that if an assessee gets out of the clutches of section 14A, he, as a necessary consequence, and automatically, becomes entitled to deduction of the expenditure claimed. As per the Department’s own admission and stand, the assessee still would have to fulfill, and satisfy the A.O. regarding, the conditions for availing the deduction under the concerned provisions. For example, under section 37, he would be entitled to deduction only if the expenditure is found to be incurred wholly and exclusively for the purpose of the business, the income of which is chargeable under that head. Likewise, u/s. 57, deduction will be allowable only if the expenditure is incurred wholly and exclusively for the purpose of making or earning such income.For example, take a case of, say, a chartered accountant or an advocate. If he has incurred any expenditure for acquiring some shares (say, interest on loan) or for earning of dividend (say, administrative and other such expenses) and if he has claimed such expenses as deduction against his professional income, then certainly the same will be otherwise also not allowable, whether section 14A or no section 14A. Similar will be the position in case of, say, a manufacturing company and similar also will be the position in case of a share dealer/ broker. Where is the question of double advantage?
8.3 The case of double advantage, if it all, is confined to only the classic case, as covered by the ratio of Rajasthan State Warehousing, where an assessee is admittedly carrying on the business / activity for the purpose of earning tax free income and again, admittedly, the assessee did incur some expenditure towards earning of such tax free income.In today’s time, more in the context of taxfree dividend income earned incidentally, such cases would represent a tiny percentage. At this juncture, it may be worthwhile to revisit the words of wisdom coming from the Apex Court in the case of Indian Bank Ltd. {Ref: Sr. No. 1 & 2 (i) of Part One I (A)}, wherein, the Court, in very such context, observed as under:
“Secondly, the reason may well be that Parliament assumes that most types of expenditure which are laid out wholly and exclusively for the purpose of business would directly or indirectly produce taxable income, and it is not worth the administrative effort involved to go further and trace the expenditure to some taxable income.”
In any case, if at all there is any perceived undue advantage, the respective sections, under which the expenditure are claimed, have sufficient safeguards to weed out the same.
9.1 This brings out the ninth issue, based on a very fundamental principle of taxation laws: Can an exemption provision make the position of the assessee worst? The method prescribed under Rule 8D has capacity and tendency to do exactly the same as the resulting disallowance computed as per this method has absolutely no relevance with the amount of the exempted income or the expenditure related theretoand it can be many times more than the exempted income or even total expenditure, thereby putting the concerned assessee in a worse position than not earning the exempted income at all. In other words, in such a case the assessee would be better off without receiving the exempt income or if such income is made taxable again. It should be noted that the exemption given u/s. 10 is not optional. Most importantly, section 14A does not have cap on the amount of disallowance, except now with the amended Rule8D restricting the disallowance to the extent of total expenditure. There is no cap restricting the disallowance to the amount of the exempt income, though it has been now so assumed on the basis of some court decisions. But still, even that does not mitigate this fundamental aspect. The amended Rule 8D does not mitigate the situation completely. This amendment is not at all a mercy bestowed upon by the legislature as, otherwise also, on the basis of the first principle, a disallowance cannot be more than the amount claimed.
9.2 Here, it will be pertinent to revisit the observations of the Madras High Court in the case of S.A.S.S. Chellappa Chettiar v/s. CIT – [(1937) 5 ITR 97 (Madras) (FB)], which decision has been approved by the Supreme Court [Ref: Sr. No. 2 (ii) of Part One I (A)], wherein the Court, in the context of somewhat similar controversy involving tax free agriculture income, observed that if the Department’s contention was to be accepted, the assessee would have been better off if he did not receive anything from his constituent, rather than the agriculture land!
10. Interesting tenth issue that arises is: Will the Department accept and apply the same criteria / principle / formula of Rule 8D for determining allowable expenses, if dividend is again made taxable as earlier?The Department would, instead, thenrevert back to the principles governing section 57 deductions. It is interesting to note that the Bombay High Court in case of Godrej & Boyce Mfg. Co. Ltd. v/s. DCIT – [(2010) 328 ITR 81 (Bom)]also has observed that: “If the dividend income had not been exempt under Section 10 (33), the Revenue would have taxed such dividend income and the assessee would have been entitled to a deduction in respect of its expenditure in relation to that income.” Interestingly, while making dividend taxable in case of certain class of “specified” assessees with effect from 01.04.2017, the provision enabling such taxation is incorporated, very smartly, in new section 115BBDA, instead of usual section 56, by providing to tax such dividend income at a flat rate of 10% without deduction of any expenditureor allowance or set off of loss. Smartly, because this is, perhaps, to avoid embarrassment for the Department as all their arguments concerning section 14A would have boomerang if such dividend income was made taxable under the usual head “Income from other sources” u/s. 56 of the Act. That would have been a classic case of “head on collision” between two provisions of the same Act.
11.1 Peculiar features of a dealer in shares:
The provisions of section 14A should not be made applicable in cases where an expense is incurred by a share broker / dealer in shares for purchasing shares in course of his regular trading activities. In case of a dealer in shares, who holds shares as stock in trade, it is a matter of common knowledge and sense that shares get acquired, and so are the expenses incurred in relation thereto, to sell the shares so purchased and, as such, to earn business income that is taxable. No holder of such shares is interested in earning dividend income; the earning of dividend occurs subsequently and is purely incidental. This is the fundamental distinction between a dealer in shares and an investor, as recognised by the Supreme Court and other courts, in the very context of disallowing proportionate expenses, wherein both cases are treated and placed at different footing. In fact, dividend is not even contemplated at the time of acquisition of such shares as:
– the shares are acquired only for the purpose of selling the same for profit at the best available opportunity and time;
– In case of share broker, such shares might not have been retained by the broker at all but for few instances where some shares may remain with him due to default of clients, etc.
– it is not even known, generally, at the time of such acquisitions, what is going to be the ‘record date’ [for the purpose of declaration of dividend] for such shares and whether such shares are going to remain with the assessee on such date;
– it is not known that even on such date, such shares are going to fetch dividend and if they do, how much dividend would accrue. The earning of dividend is purely at the discretion of management of the company whose shares are so held and depends upon various volatile factors. Neither the holder of such shares can predict receiving dividend prior to this nor has he to incur any special effort or expenditure to receive such dividend once declared. Once dividend is declared, accrual and receipt of the same is automatic.
It is a very well settled legal position on interpretation of statute that in absence of any guide in the enactment, a word / term used therein has to be interpreted keeping in mind commercial sense / commercial parlance and also principles of accountancy; specifically when the term is ambiguous in scope. Keeping in mind this principle, the only question that needs to be resolved is: In case of a dealer in shares, commercially and from a businessman’s point of view, are the expenses incurred in relation to earning profits on trading in the shares or in relation to earning dividend income? With which the normal business expenses have ‘proximate cause’ – with the earning of taxable business income or with the earning of tax free dividend income? If it is the former, than automatically the latter would be excluded and so also the provisions of section 14A.
11.2 Interestingly, the Apex Court has dismissed the Department’s appealagainstthe decision of the Punjab & Haryana High Court in case of State Bank of Patiala, thereby affirming that decision. It should be appreciated that the issue before the Punjab & Haryana High Court was the very basis of applicabilityofsection 14A qua dividend receivedon the shares acquired as stock – in – trade, where the Tribunal had deleted the entire disallowance [as made by the A.O. as well as enhanced by the CIT (A)]. It was only that in that case while the A.O., after computing the amount of disallowance as per Rule 8D, had restricted the disallowance to the amount of dividend incomeand the CIT (A) had ‘enhanced’ this by bringing back the amount of disallowance to the amount as computed under Rule 8D, by holding that there is no such legal provision to restrict the disallowance to the amount of dividend. However, before the Tribunal, the argument of the assessee was fundamental, against the very invocation of section 14A vis a vis its stock in trade.
Neither the aspect of enhancement was argued by the assessee nor did the Tribunal even whisper about the same. As such, the issue was the basic principle and not at all concerned with the enhancement aspect. The Tribunal as well as the High Court proceeded to adjudicate the issue on this broad and fundamental principle and were not at all concerned with the enhancement made by the CIT (A). However, it appears, , it is assumed that the issue before both the authorities, that is, before the Tribunal and before the High Court, was only with respect to theaction of the CIT (A) in enhancing the amount of disallowance. Ultimately, it is held by the Court that “That view of the CIT (A) was clearly untenable and rightly set aside by the ITAT. Therefore, on fact, the Punjab & Haryana High Court has arrived at a correct conclusion by affirming the view of the ITAT, though we are not subscribing to the theory of dominant intention applied by the High Court”. The issue, therefore, arises is: Which view / ratio of the ITAT / High Court in case of State Bank of Patiala can said to have been approved / subscribed by the Apex Court while dismissing the Department’s appeal?
11.3 As regards the issue of shares held as stock – in – trade, here again, the Supreme Court did hold that there is a subtle distinction between shares heldas investment [for controlling purpose] and shares held as stock – in – trade and did take judicial note of the fact that in case of the latter,the dividend is received as “a quirk of fate” and it becomes immaterial “whether dividend is earned or not”. In fact, the Supreme Court did invoke, so to say, the theory of “dominant intention” and held that “In contrast, where the shares are held asstock-in-trade, this may not be necessarily a situation. The mainpurpose is to liquidate those shares whenever the share price goes up inorder to earn profits. In the result, the appeals filed by the Revenuechallenging the judgment of the Punjab and Haryana High Court in StateBank of Patiala also fail, though law in this respect has been clarified hereinabove.”
11.4 In view of the above, the eleventh issue is: Is it that this issue – applicability of section 14A (1) to the shares held as stock – in – trade – can said to have been finally and fully resolved?And if so, in whose favour?
12. Further, while the Supreme Court did make it clear that before applying the theory of apportionment the A.O. needs to record satisfaction, the Court qualified the same by further observing that such satisfaction should be that “havingregard to the kind of the assessee, suo moto disallowancemade by the assessee is not correct”. The Court further observed that recording of satisfaction “will be in those cases where theassessee in his return has himself apportioned but the AO was not accepting the said apportionment”. This appears to suggest that the assessee needs to suo moto apportion something, in contrast with the assessee’s option to offer nothing, and then only the A.O. needs to record his satisfaction. It appears that this could not have been intention but the possibility of the Department taking such anextreme view on the basis of these observations cannot be ruled out. Further, an issue may arise as regards the test of “the kind of the assessee” which, as per the Supreme Court, the A.O. has to have regard for, while recording his satisfaction. A further issue may arise with respect to the direction of the Court to the effect that :“Further, while recording such asatisfaction, nature of loan taken by the assessee for purchasing theshares/making the investment in shares is to be examined by the AO.”The issue that may arise is how to correlate the issue of adjudicating the term ‘in relation to’ in the context of ‘nature of loan’; especially when, as per the Court, the test of intention is not applicable while interpreting section 14A.
13. One aspect that needs to be clarified is regarding the impression which is being carried in the minds of many that this judgement has also laid down the proposition that the disallowance u/s. 14A cannot exceed the exempt income. This impression seems to have been created on account of an observation of the Court, while dealing with the facts in the case of State Bank of Patiala,to the effect that “That view of the CIT (A) was clearly untenable and rightly set aside by the ITAT.
Therefore, on fact, the Punjab & Haryana High Court has arrived at a correct conclusion by affirming the view of the ITAT, though we are not subscribing to the theory of dominant intention applied by the High Court”[Para 40]. As already clarified at Para 11.2 hereinbefore, the ITAT was not at all concerned with the view / action of CIT (A). The ITAT was concerned only with the action of the A.O. in invoking section 14A where the dividend was received on the shares held as stock – in – trade and it had held that section 14A is not applicable at all in such a case. So was the case of the High Court, which is clear from para 2 & 3 of the order of the High Court and which decision has been analysed earlier at Sr.5 of Part II. Though, on facts, in both the cases [Maxopp as well as State Bank of Patiala] the A.O. had confined the disallowance u/s. 14A to the extent of the dividend income earned by the respective assessee therein, the legal issue – whether the disallowance u/s. 14A can exceed the dividend income – was not at all the issue / the subject matter of arguments before Tribunal nor the respective High Court had even referred, much less,dealt with this issue. Even before the Apex Court, neither this issue was raised by either of the parties before the Court nor had any argument or discussion taken place on this aspect. The Apex Court also has not dealt with this issue specifically. Therefore, it may be difficult to infer that the Apex Court can be said to have also adjudicated this legal issue, much less, approved the proposition that the disallowance u/s. 14A cannot exceed the exempt income, simply based on such observation.
14. In summation, leaving aside the above heavy and academic discussion, for all practical purposes and from a layman’s point of view, the following three broad positions can be deduced from this decision in case of Maxopp:
(i) For determining the term “in relation to”, “the dominant purpose test” is not relevant but one has to go by the theory of apportionment, based on the observation of the Apex Court in Walfort’s case. In view of this, the Court concurred with the view taken by the Delhi High Court (in Maxopp’s case,where the High Court had rejected the assessee’s contention that section 14A has no application in a case of investment of shares as a strategic investment)and did not accept the opinion of the Punjab & Haryana High Court (in case of State Bank of Patiala, where the High Court had accepted the assessee’s contention that section 14A has no application in a case where the shares are held as stock – in – trade). The Apex Court accordingly dismissed the assessee’s appeal in the case of Maxopp.
[Para 35]
(ii) However, the Apex Court, ultimately, also dismissed the appeal of the Department against the decision of Punjab & Haryana High Court in the case of State Bank of Patiala, thereby, in effect, confirming the judgement of the Punjab & Haryana High Court[Para 40].The Punjab & Haryana High Court had categorically held that section 14A cannot be made applicable where the tax free dividend income is received with respect to the shares held as stock – in – trade. This decision of the High Court, so was the decision of the Tribunal, was on the first principle / basic principle governing section 14A (1) of the Act.
(iii) The observation of the Court, as referred at Para 13 hereinabove, may be insufficient to infer that the Court also held that the disallowance u/s. 14A cannot exceed the exempt income.
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This needs a addendum to analyse Chettinad logistics p ltd decision.
SPLENDID ANALYSIS INDEED ! A MUST READ FOR UNDERSTANDING POSTULATES GOVERNING FISCAL LAWS!!!