Section 14A: Scope Of Disallowance Explained

CA Dev Kumar Kothari has considered the interesting question whether disallowance under section 14A of the Income-tax Act, 1961 can be made in a case where tax is paid by the assessee by way of dividend distribution tax or securities transaction tax or where shares are bought by him not with a view to earn dividends but to obtain a strategic controlling interest in the Company or to earn capital gains

Section 14A is applicable only when income does not form part of total income that is taxable income under the entire income tax Act and not when taxed under simplified scheme of taxation etc.

In view of tax imposed under simplified taxation scheme by way of DDT u/s 115 O and 115R and STT on transactions levied in lieu of income-tax, any income is not an income not chargeable to tax under the Act.

In view of probability of earning taxable income being many time higher than probability of earning exempted income in case of shares of companies and units of mutual funds, it is wrong to say that investment is made, and expenses in form of carrying costs, are incurred only to earn exempted income.

Therefore, S.14A is not applicable in case of shares and units which can yield taxable income, and exempted income only because tax is levied under simplified scheme.

Income-Tax Act:

As per preamble to the Act this is an "Act to consolidate and amend the law relating to income-tax and super-tax".

In this preamble it is not stated that it is for levying and collection of tax, but it is to consolidate the law relating to income-tax and super-tax. Therefore, without going in details for present purpose we assume that the law is in connection with tax on income and super-tax.

Therefore, any tax levied under this Act or any other relevant Central Act on income (whether directly or indirectly in lieu of income tax) is in nature of tax on income.

Expenditure not allowable in view of S.14A:

Sub-sections (1) and (2) being relevant to this study is reproduced below with highlights:

Expenditure incurred in relation to income not includible in total income.

14A.[(1)] For the purposes of computing the total income under this Chapter, 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.]

[(2) The Assessing Officer shall determine the amount of expenditure incurred in relation to such income which does not form part of the total income under this Act in accordance with such method as may be prescribed, if the Assessing Officer, having regard to the accounts of the assessee, is not satisfied with the correctness of the claim of the assessee in respect of such expenditure in relation to income which does not form part of the total income under this Act.

Crucial wordings and aspects:

We find two sets of wordings in the sub-section (1) these are given in first column and in second column significance is discussed:

We find use of first expressions ‘total income under this chapter’ which is used in relation to ‘total income of assessee’ which is to be computed under Chapter IV.

We find that the second expression ‘total income under this Act’ used in sub-section (1) and (2) both, this expression means chargeable or taxable income under the entire Income-tax Act.

If it was intended only in relation to the assessee whose income is to be computed, then similar expression could have been used that is ‘which does not form part of total income under this chapter or ‘which does not form part of total income of assessee’ instead of words ‘which does not form part of the total income under this Act.

The Income tax Act is a self contained and integrated code. As per scheme of the Act, some incomes are taxable in hands of the recipient of income whereas some incomes are taxable in hands of person who pays or distribute income. When a tax is finally collected (that is not in nature of tax deducted or collected on behalf of recipient of income) at distribution stage, then the income in respect of which such tax is collected is nothing but tax on income. Therefore, it cannot be said that such income does not form part of total income under this Act.

Once it is found that dividend forms part of ‘total income under this Act’, and a taxable income is computed, and tax is imposed and collected, then S.14A will not at all be applicable in relation to such income which has already been include in taxable income in some other scheme of imposing tax on income.

Similar is case in relation to share in profit of firm which is exempt in hands of partner, because tax has been paid by the firm. Other income of partner received from the same firm by way of interest, salary etc. is taxable in hands of partner as it is allowed to the firm as expenditure. Therefore, it can be said that the share in profit of the firm which has suffered tax in hands of the firm is not an income which does not form part of total income under the Income Tax Act. Therefore, S. 14A will not be applicable in respect of the same.

Similar language has been used in Rule 8D and also in memorandum explaining insertion of S.14A. A reading suggests that it was intended to apply S.14A only when any income is not forming part of chargable/ total income under the Income-tax Act.

Above aspect has not been considered so far:

On reading of reported judgments and on discussion in groups and tax authorities, it is found that the above aspect has not been considered and even contended in any reported case, so far our reading could cover reported judgments.

Purpose of S.14A:

14A was introduced to overcome judgments of the Supreme Court in case of CIT vs. Indian Bank Ltd. (1965) 56 ITR 77 (SC) in which interest on tax free bond was exempted, CIT vs. Maharashtra Sugar Mills Ltd. 1973 CTR (SC) 489 : (1971) 82 ITR 452 (SC) (agricultural income in course of business of sugar mill was fully exempted under IT Act) and Rajasthan Warehousing Corpn. Vs. CIT 242 ITR 450 (SC) { full exemption u/s 10(29) was allowed . In these cases exempted income were derived in course of business of and there was no tax in any other manner direct or indirect or on some other party who paid such income.

S. 14A is intended to apply in such circumstances, where income does not form chargeable income in context of the whole Act. It is not intended to apply to income which form part of chargeable income, and tax has also been finally collected under simplified manner of taxation.

Exempt income in true sense:

An income can be considered as exempt only if tax in not collected on it in any manner. If a tax on income is collected directly or indirectly and such tax is not refundable of adjustable against any other liability of tax on income, then tax has been finally collected and the related income has suffered tax under the I.T.Act and it is not an exempt income or income not chargeable to tax.

Dividend – in old scheme tax was paid by shareholders, wherein a large portion of dividend was exempt from tax for several reasons. The additional tax payable by companies and mutual funds, on distribution made all dividends taxable and tax collected from companies and mutual funds are finally collected tax. Only as a consequence to tax on distribution exemption for dividend is granted in computation of shareholders. Therefore, it is wrong to say that dividend referred to in section 115 O is not part of taxable income, in the overall context of tax on income or ‘total income’ in the Act. Shares and units of mutual funds are purchased mainly to earn gains by way of appreciation and dividend is merely incidental. Average yield by way of dividend is about 1%, therefore, no one will invest in shares merely to receive dividend. Merely because dividend is earned and it is excluded from income of shareholder that too because tax is already paid by the company, section 14A should not be applied to disallow interest and other expenses incurred in connection with purchasing and holding shares and units of mutual funds, which is also a systematic and organized activity and share are capital assets of such business activity just like land, building , furniture and plant and machinery used in any business sale of which also results profit or gains or loss under the head ‘capital gains’.

Chargeable income -Total income:

In the Income-tax Act, 1961 the expression ‘total income’ is used to mean ‘taxable income’ or ‘chargeable income’. In section 14A also the expression ‘ which does not form part of total income under this Act’ is used , this can mean only such income on which no tax at all is chargeable under the Act for example, agricultural income, or interest on some tax free bonds etc. and not such income which are taxed in some other manner or in hands of some other person. Once income tax is levied in any manner under the Act, it cannot be said that ‘it is does not form part of total income under the Act’, though it may not be included in particular hands. Thus, tax paid on income whether directly or indirectly under any provisions of the Income-tax Act, or any Finance Act is tax on income. Once a tax is levied on any income, in any manner by the Central Government, it is a tax on income and nothing else. Under our Constitution the Central Government is empowered to impose tax on income (other than agricultural income). The tax can be imposed and collected in any suitable manner provided it is tax on income.

Tax on distributed profits S. 115-O:

As per sub-section (1) tax imposed is additional income-tax, as per sub-section (4), the tax paid by the company at the time of distribution of profits, shall be treated as the final payment of tax in respect of the amount of dividend declared, distributed or paid and no further credit of such tax shall be claimed by the company or by any other person in respect of the amount of tax so paid.

As per sub-section (5) no deduction under any other provision of the Act shall be allowed to the company or a shareholder in respect of the amount which has been charged to tax under sub-section (1) and the amount of tax paid thereon.

Similarly, in respect of divided distributed by some mutual funds similar provisions are made in section 115 R.

From these provisions it is clear that the dividend paid by the company, UTI or Mutual Fund which is subjected to tax at the time of distribution is not to be allowed as an expenditure to the company or the mutual find and the tax paid by the company, UTI or mutual fund as the case may be is treated as final payment of tax for which no further credit or refund can be claimed or allowed to any one:- in particular the company or its shareholders and the mutual fund and its unit holders.

Dividend distribution tax (DDT) and Security Transaction Tax (STT) are nothing but tax on income:

From the provisions of S. 115O and 115 R it is clear that the tax paid by the company or mutual fund is an additional income-tax collected from the person who distribute dividend. Fifth proviso to S. 48 also prescribes that Security Transaction Tax (STT) shall not be allowed while computing capital gains. STT is not an allowable deduction against business income vide S.40 (a) (ib) till assessment year 2008-09 however a tax rebate is allowed. From A.Y. 2009-10 STT will be allowed as deduction from business income however tax rebate shall not be allowed. All these provisions clearly shows that DDT and STT are nothing but income-tax. Therefore, in the overall context of the income-tax Act, 1961 dividend as well as long term capital gains which are exempted u/s 10 are already taxed in other manner and the tax imposed as DDT or STT is income tax levied and collected in an easy and convenient manner.

Exemption under section 10:

Vide sub-sections (34) and (35) any income by way of dividends referred to in section 115 O and 115 R respectively are not to be included in total income.

The Income-tax Act is a self-contained code and entire enactment needs to be considered:

The income-tax Act, 1961 is a self contained code and it has to be considered as a whole and not in piecemeal manner. Therefore, it would be wrong to read section 10 (34) and 10 (35) in isolation of section 115O and 115R.

One provision cannot be read in isolation with other provisions. Though some provisions may have limited application to a particular head of income or to a particular purpose but in that case it is clearly mentioned expressly or it may be implied by the provisions.

So far the provisions relating to tax on distribution of income as contained in Chapter XIID and XIIE relating to tax on distribution of profit by companies and mutual funds respectively are concerned, it is found that the Chapters were inserted by the Finance Act, 1997 w.e.f. 01.06.97 and finance Act, 1999 w.e.f. 01.06.1999 respectively. Correspondingly S. 10 was amended by insertion of subsection 33 to provide for exemption of dividend referred to in section 115-O and then amended to income distributed by mutual funds.

Thereafter an amendment was brought and tax payable by companies on distributed profit was withdrawn and simultaneously exemption u/s 10 was also withdrawn. Again these sections were amended w.e.f. from 1.4.2003 and tax on distributed profit was again imposed and simultaneously exemption u/s 10 was again reintroduced. From the history of tax on distributed income and exemption of dividend under section 10 we can observe that the exemption u/s 10 was granted only when tax was levied at the time of distribution on the companies and the mutual funds.

Thus, it is clear that tax has all along been charged on dividend, it is only for the simplicity and easiness to collect that tax has been levied at the time of distribution and made exempt in hands of recipients of dividend. The implicit purpose is to tax entire amount of dividend distributed by companies and not to grant exemption to any dividend.

By tax on distribution even non-taxable dividend has also been made taxable:

When there was no tax u/s 115 O and 115R at the time of distribution the following categories of dividend declared was fully or partially exempted:-

a) In hands of individuals and Hindu undivided families there was exemption due to basic exemption.

b) In case of individuals and Hindu undivided families there was also exemption due to deduction provided u/s 80L.

c) Dividend paid to the companies was also partially exempted by application of section 80M.

d) Dividend paid to registered charitable institutions, other exempted institutes , mutual funds etc. whose income was exempt u/s 10 or 11 was also exempted.

e) Dividend declared in favor of the Government was exempt.

f) Dividend earned by assesses also became non-taxable because of reason that the assesses could set off their business loss, depreciation, loss under other sources etc. against dividend income.

Therefore, it can be seen that prior to tax on distribution a larger portion of dividend declared and distributed was exempted and no tax was paid thereon due to some or other exemptions or applicability of set off of losses.

No exemption on any distribution

As per provisions of section 115-0 and 115-R, there is no exemption on dividend declared, distributed and paid. The dividend is also not allowed as expenditure. The tax paid is also not allowed as expenditure. The tax collected is final tax collected. Therefore, entire amount of dividend declared, distributed or paid by companies or mutual find is subjected to compulsory and final tax payment.

Dividend is not exempt under Income-tax Act

In view of above discussion we find that although dividend is not included in the income of shareholder because of provisions of section 10 but in fact, the exemption is only because tax is already paid on such dividend and such payment is final. Earlier when there was no exemption u/s 10 tax was deducted at source at the time of payment of dividend and the records shows that a larger part of such TDS was refunded.

Simultaneous amendments in section 115-O, 115-R , Section 80L, 80M and section 10 clearly indicate that exemption u/s 10 exists only as a matter of scheme of collection of tax on entire dividend and not as a scheme to grant exemption. The tax is levied and collected in one or other form and manner. Therefore, it cannot be said that dividend covered by section 115-O or 115-R is not taxable under the Act. Dividend is definitely taxable and tax is collected in bulk at the stage of distribution instead of from shareholders or unit holders.

The provision can be compared with provisions of clubbing of income. Suppose an item of income is included in hands of parent or spouse or other relatives as per provisions of section 64. The same item of income cannot be included in the income of person to whom the income belongs (minor child , spouse or relative as the case may be). Does it mean that the income earned by minor is not taxed merely because it is not included in income of minor but income of parent? The obvious answer is No. the income has born tax in hands of parent, therefore, it is a taxable income in the overall context of the Act.

Similarly tax is paid on dividend by companies or mutual fund as per the relevant provisions. it does not mean that the dividend is not taxable or that it has not been included in ‘total income’, for levy of tax.

Shareholding is not only for earning dividend or exempted LTCG:

On a long term analysis of price earning ratio of the overall share market capitalization, we find that earning by way of dividend is hardly 1.5 to 2%. There are large number of companies which do not declare any dividend. If we consider average market capitalization at BSE and total amount of dividend declared by all companies, the yield by way dividend will not be more than 1%. Therefore, it is clear that shares are not purchased merely to earn the dividend, rather, the purpose of earning dividend though implicit, comes much after in priority. The purpose of investment in shares can be given priority as follows:-

a) To diversify portfolio of investment in liquid, appreciating assets with a greater element of risk. And to diversify in different sectors of economy, different industries and different companies thereby to reduce risk and have a balance portfolio.

b) To earn capital gains by way of short term to long term capital gains;

c) To have a controlling stake in companies and to manage companies (this will apply to investment as promoter or controller of company);

d) To earn by taking advantages of cyclical movement in profitability of industry.

e) To earn by way of intra day trading as a hedging activity and keeping portfolio active and performing.

f) To earn dividend.

Thus we find that earning of dividend is last in priority. In fact many wise investors find it more advantageous to sell shares and units cum dividend to fetch higher price. In many cases it is noticed that while selling shares cum dividend, one may realize many times more by way of price than dividend. A share sold cum dividend of Rs. 5/- at a price of say Rs.125/- may be available at a price of Rs.100-110 or even lower after some days when it becomes ex dividend. Thus, by sacrificing dividend of Rs.5/- one may earn Rs.10-25 or more extra by way of price realization by selling share cum dividend. This is because:

a. Before the date of book closure or record date there is usually short supply and Extra demand for shares so price is increased.

b. After book closure and record date, there is selling pressure and supply increase.

c. some investors have fancy of earning dividend as they consider it tax free.

Taxable earnings in hands of shareholders:

Even in hands of share or unit holders the earnings by way of share trading as trading profit or speculative profit is taxable. The profit by way of capital gains is also taxable by way of income tax and now by way of Security Transaction Tax and / or Income tax. Similarly, profits derived by managing or controlling companies is also taxable as income form business or profession or other sources. The dividend is also taxable may be in the hands of the recipient or in the hands of dividend distributor. Therefore, it can be said that any direct or indirect income derived by purchasing, holding, transferring shares in companies or units of mutual fund is taxable in one or other form under the Income Tax Act , and it is wrong to say that dividend is exempt all together.

Long term capital gain and security transaction tax (STT)

With effect from 1.10.04, security transaction tax has been imposed and when a transfer of share or unit of mutual fund bears STT then only exemption in case of long term capital gains is allowed. Therefore, it is clear that the STT is in lieu of long term capital gain tax on shares and units. The scheme of STT is also designed to tax all long term capital gains and to have an easy method of collection and there is no scope for any refund. Whereas when long term capital gain tax was imposed it was found that in many cases no tax was payable because of indexed cost being more than sale value, brought forward long term capital loss or short term capital loss, set off of losses under other heads of income etc. Whereas when STT is levied the tax is collected whether there is a profit or a loss in the transaction. Therefore, in the context of overall taxation of long term capital gains also it can be said that the long term capital gains are not fully exempt from tax though it may be exempt from Income-tax but every purchase and sale is subject to STT.

Where transaction is not subject to STT e.g in case of off market deals, STT is not chargeable and the transaction is subject to normal provisions of tax on capital gains.

For an example we can consider sale of quoted shares sold through private negotiations on ‘spot delivery’ basis and not through stock exchange. In such case the sale will not be subject to STT and the gains arising will also not be exempt. Therefore, it is clear case that STT is in lieu of income tax.

Though STT is not levied under the provisions of the income-tax Act, 1961, but is nothing but tax on income, charged and levied in a different manner. As per the provisions of the Indian Constitution it can be and has been levied under the entry and enabling provision for taxes on income and not under any other entry.

Shares purchased as stock-in-trade

In case of a trader in share he purchases shares for the purpose of trading. Therefore, capital is borrowed for the purpose of share business and it is capital borrowed for the purpose of business and therefore, interest payable on such borrowed capital shall be allowable u/s 36 and such interest cannot be disallowed by applying section 14A although dividend earned, if any, will be exempt in hands of recipient.

Shares purchased for controlling companies

Shares purchased by persons as promoter, manager or controller of companies is acquisition of shares for the purpose of business and profession of promoting, managing or controlling companies. Therefore, interest payable on capital borrowed for purchasing shares by such persons will be allowable and section 14A cannot be applied though dividend received may not be taxable, if the company has paid tax under section 115 O .

In this regard we can consider another issue of deemed dividend under section 2(22)(e), by way of loan , advance etc. such dividend is not considered dividend for the purpose of section 115 O vide explanation given at the end of the Chapter XII D. Therefore, such dividend is not a dividend referred to in section 115 O. accordingly the shareholder is liable to include such dividend in his total income and pay tax.

Shares purchased to derive capital gains

When shares are purchased as an investor the immediate purpose is to gain out of fluctuation in price of shares over short to long period. Short term capital gains are taxable. While purchasing shares, one cannot envisage the period of holding if the price appreciates the investor will not wait for share becoming a long term capital asset. From the statistics of high and low price during 52 weeks period it is apparent that the price may go up several times or may come down several times. Therefore, when share is purchased it cannot be assumed that share is purchased to gain long-term capital gain only. Therefore, even purchase of share by investors is basically to earn capital gains mostly, within short term which is taxable and in case of long term capital gain also there is tax by way of STT or if the shares are not sold through stock exchange then also long term capital gain tax will be payable. In case of unquoted shares the sale through stock exchange and the levy of STT is out of question and therefore in that case long term capital gain will be taxable. Furthermore, the future is contingent the shares, which are quoted and traded on a stock exchange today, may not be treated or remain quoted at the stock exchange in long term. The cases of de listing of companies, suspension of trading of shares is not uncommon. Many shares which were highly traded sometimes ago are now suspended, de listed or not traded for some other reason. Therefore, it cannot be assumed that the shares are purchased only to derive income by way of dividend and long term capital gain, which are exempt u/s 10.

Therefore, for whatever purpose share may be purchased it cannot be said that shares were purchased to earn tax-free income. No wise man will purchase shares to earn 1- 2% of investment by way of dividend. If the capital is borrowed to purchase shares, it cannot be said that interest is an expenditure incurred to earn income by way of dividend, which is not included in total income under the Act and which has not suffered tax. The commitment of interest begun at the time of borrowing and not when a dividend is earned. Similarly the opportunity to earn by deploying funds in other manner is lost once money is invested in shares. Payment of interest or loss of other earnings take place even when on dividend is earned. Therefore, it cannot be said that interest is expenditure to earn dividend.

Conclusion:

In view of tax imposed under simplified taxation scheme by way of DDT and STT S.14A is not applicable in case of shares and units.

In view of probability of earning taxable income being many time higher than probability of earning exempted income in case of shares of companies and units of mutual funds, it is wring to say that investment is made, and expenses in form of carrying costs, are incurred only to earn exempted income.

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